Essay on Stock Buybacks, False Arguments, and Fraud

The Great Misleading

There are some frauds so well conducted that it would be stupidity not to be deceived by them.

Charles Caleb Colton (Lacon, 1825)

 

A corporation cannot invest in itself.

When a corporation buys its own stock, the number of outstanding shares decreases.

A corporation cannot invest in itself.

Stock buybacks involve paying cash to shareholders in order that the company may cancel stock, although sometimes repurchased shares are held in treasury.

In either case, the effect is the same as when a bond is called – there are fewer securities in circulation and the company has less cash.

The intent is similar to that of a dairy farmer who dumps milk to increase prices.

Buybacks Boost Stock Prices

An important part of the explanation for the stock boom of the 1990s is that companies had been spending more than one trillion dollars over two decades to take stocks off the market.

With relatively fewer stocks and more investors, many of whom were encouraged to invest by tax incentives, stock prices were driven higher.

The great bull market was slow to get started.

Experts were needed to affirm that buybacks were good for investors.

It took many issuers engaging in buybacks before the flash point was reached.

Later, to keep the boom going, experts were needed to affirm that buybacks were good for investors.

Issuers bought the support of accountants, lawyers, and Congress. The SEC, taken in by this spurious logic, removed restraints on manipulation and did not require accurate disclosure of the cost of buyback programs. Investors were not warned of the negative implications of buybacks.

Arguments For Buybacks

Buyback deception was supported by two main arguments.

Buybacks, it was claimed, were just a more tax-efficient form of dividends. In other essays, we show how the arguments regarding earnings, productivity, and innovation were misleading.

Buybacks could not support prices in the Crash of 2000-2001.

What remains to be seen is whether buybacks were beneficial for the long-term investors that made up most of the market.

Those who deny that stock buybacks drive up prices point to specific cases in which stock prices fell, despite repurchases.

Buybacks were not able to support prices in the Crash of 2000-2001, although repurchase programs were ratcheted up to record levels.

Some even contend that SEC rules against manipulation are so strict that companies are not allowed to manipulate prices.

With so much money involved, alternative explanations and rationalizations are to be expected.

To be sure that we have not misjudged the motives of corporate executives, we must look into the counter-arguments supporting stock buybacks.

SEC Rule 10b-18

There is an argument that buybacks cannot influence stock prices, because to do so would be against the law.

American securities law has prohibited stock manipulation since the 1930s.

The market manipulation that went on in the 1920s, with tricks such as wash sales, round-robin trading, and pump-and-dump schemes, inspired these rules.

SEC Rule 10b-18, however, provides corporations with a safe harbor from charges of manipulation when the issuer follows certain guidelines on timing, price, volume, and the method of repurchasing stock.

This rule does not stop a company from forcing prices up, which is bound to happen when stocks are taken from the market.

The SEC grants safe harbor for executives to manipulate the market with buybacks.

The SEC Rule 10b-18 restrictions focus on a small set of manipulative practices that might mislead investors.

For example, the SEC bars buybacks in the last thirty minutes of a trading session, because speculators often refer to closing prices when opening the market the next day.

Issuers also may not buy their own stocks at prices higher than the previous trade, nor may they use more than one broker on any day, since such tactics might be used to fake transactions.

Rule 10b-18 says that company purchases of company stock on the exchange may not exceed twenty-five percent of the average trading volume in the last month, but there is no limit to large block purchases.

An issuer can privately purchase large blocks off the market and still buy twenty-five percent of the stock traded before the last half-hour of the session, as long as each trade is not higher than the last independent price.

SEC Rule 10b-18 has many loopholes.

With excess supply removed, an independent investor trying to acquire stock will have to pay a higher price, and once a higher independent price is established, the issuer may move back into the market and force prices even higher.

After September 11, 2001, the SEC loosened even these lax requirements, with the intent of encouraging issuers to manipulate prices upwards following the terrorist attack on America.

Obviously, if the SEC has bothered to issue a safe harbor rule on buybacks, the government must recognize that buybacks are indeed manipulative.

The SEC seems to be saying, manipulation is OK, as long as it is orderly and brokers get their commissions.

Failed Buybacks

Another non sequitur argument is that buybacks do not always work.

When news about a company is bad and when investors are motivated to sell, issuers are powerless to keep prices from falling.

Equity prices are set by the small percentage of shareholders that come to the market. When there are few buyers, other than the issuer, sellers may swamp the market.

However, if the news on the company is favorable and there is no selling panic, a strong buyback program can easily force prices upwards.

Furthermore, in Capital Flow Analysis we do not focus on individual companies, but rather on result of what many companies do and that together moves the market.

Buybacks will fail to jack up prices in bear markets.

When the overall supply of stocks is reduced relative to demand, covariance between stock prices will result in an upward trend in average prices, although individual stock buyback programs may fail.

Buybacks will also fail to jack up prices in bear markets. In a market crash, issuers acting in concert cannot stand against an army of determined sellers. In the Crash of 2000-2001, the value of stocks in circulation was thirty times corporate earnings.

All the cash that corporations could scrape together was not enough to counter determined selling pressure by investors. Also, foreign issuers sold into the 2000-2001 bear market, neutralizing the effect of domestic buybacks.

There is high covariance among stocks in the market. Buybacks inflate prices of issuers that engage in repurchase programs. When many issuers are engaged in buybacks, many stocks rise, and stocks of companies without buyback programs also rise.

The Nine Buyback Fallacies

In order for a public company to initiate a program to repurchase its own shares, the executives must go before the board of directors and argue the merits of the proposal.

Directors have a fiduciary responsibility to weigh such proposals in the shareholders' interest.

Management must tell investors of the plan, without lies or deception. The financial press must also be swayed.

An Internet search reveals thousands of sites of consultants, accountants, executive groups, seminar organizers, associations, investment bankers, academics, and other apologists for stock buyback programs.

Certainly some executives understood the fraudulent basis for buyback claims, and instead looked to their wallets.

There may be corporate executives that lack the intellectual capacity to understand the larger implications of stock buybacks or the inclination to question techniques taught in prestigious business schools and lauded in the financial press.

However, there were certainly some that understood the fraudulent nature of the claims and that, looking to their own wallets, enthusiastically and earnestly promote these schemes.

As one might expect for a practice involving over one trillion dollars during the last generation, there are many arguments that support the claim that buybacks are 'good for investors' and in a company's best interests.

The most frequently advanced of these fallacies are as follows:

The Paper Profit Fallacy: Buybacks inflate market prices, and this is in the investor's interest. This ignores the fact that market capitalization is not real wealth. Shareholders cannot all turn their portfolios into cash at the same time. As more investors sell, the market price falls. The only way for shareholders to cash out at the same time is to liquidate the company. A buyback program that inflates stock prices only benefits investors who actually sell shares. When all shareholders move towards the exit, those who linger will find that their wealth has evaporated.

The Faith in the Future Fallacy: Buybacks are said to show that company executives have confidence in the future of the company. However, when a corporation buys back its shares, it does not make an investment, but only a distribution of assets to some shareholders. If the managers had confidence in the future, they would leave the cash in the company, rather than give it to a few shareholders.

The EPS Betterment Fallacy: Buybacks may temporarily improve earnings-per-share (EPS) and return on equity (ROE). Some say that improvements in these indices are good for investors. When a corporation has some assets with lower yields than other assets, a buyback program may result in a short-term increase in earnings per share and fleetingly higher returns on equity. However, shareholders cannot spend earnings-per-share or convert ROE into cash. Investors benefit only from cash dividends, not paper profits. Like the snows of winters past, earnings-per-share that are manipulated upwards in one season, often disappear in the next. Moreover, the net present value of the cash flow of investors who sell out is usually higher than that of investors who hold stocks for the long run.

The Invest-in-Yourself Fallacy: Executives often assert that the best investment a profitable company can make is to buy its own stock. However, when a company pays more for its shares than intrinsic value, which has usually been the case, the directors are making a bad investment and harming shareholders. In any event, stock buybacks are not investments, but only a reduction in capital.

The Stock Option Fallacy: There are claims that companies need stock options to attract the best employees. Buybacks are said to support stock option programs in ways that do not dilute equity. This argument is hollow on several grounds.

  • First, it is not necessary to pay multi-million dollar salaries to attract competent executives.
  • Second, options link executive pay to rising stock prices, not to management performance.
  • Third, by using buybacks to fudge their own performance measurement (in terms of market prices, EPS, and ROE), executives are cheating.
  • Fourth, there would be no dilution of equity, if there were no option programs.

The Takeover-Insurance Fallacy: Buybacks protect a company from hostile takeovers, by making stock too expensive. Protection from takeovers also shelters incompetent management. High share prices do not benefit long-term stockholders, especially those that are precluded from selling by being locked into 401(k) plans and IRAs. When stocks are overpriced, dividend yields fall and volatility increases. By using company cash to pay higher dividends rather than to finance buyback, stock prices would still increase, but long-term shareholders, not management, would benefit.

The Tax-Efficiency Fallacy: It is claimed that buybacks distribute cash in a way that is more 'tax efficient' than dividends. During the Great Bubble, the tax on capital gains tax was less than the tax on dividends. However, buyback programs distribute corporate reserves only to those shareholders who sell, many of whom are executives cashing in stock options. There is no tax advantage to shareholders who do not sell.

The Capital-Adjustment Fallacy: Some contest that buybacks allow companies to dispose of excess cash and fine-tune capital structure, making the firm more efficient. However, the fair way to distribute cash is to pay dividends. 'Fine-tuning capital structure' sounds good, but to the long-term investor it is meaningless, but harmful gobbledygook.

The Phony-Money Scam: Some experts say that buybacks inflate stock prices, thereby facilitating the takeover of other companies. This may be true, but is hardly a justification, since such conduct is unethical. For the shareholder of the acquiring company, it may be slick business to pump-up the price of the shares that will be exchanged for uninflated stock that is fairly valued. Buybacks used in this way defraud shareholders of the target company, and the shareholders of the acquiring company that are aware of this are accomplices in an immoral scheme, although not currently subject to legal sanction. Management may use this strategy to engage in a series of takeovers of target companies in order to get fresh funds to continue stock buybacks that will allow them to continue to divert stockholder funds to their bank accounts by means of the exercise of inflated stock options and excessive salaries linked to stock prices.

When not examined closely, these arguments seem plausible, especially when wrapped in stories of improved productivity, innovation, and increasing profits.

The propagandists of the trillion-dollar buyback movement have been very skilled in cloaking their motives with arguments that seem reasonable.

However, none of their propositions can withstand scrutiny.

The Ethics of Buybacks

Buybacks are unfair and damaging to long-term investors for two reasons.

A stock buyback program gives corporate assets to only a few shareholders. The honest way to distribute reserves is through dividends. To be fair, repurchases need to be distributed pro-rata to all shareholders.

However, during the Great Bubble, American tax authorities deemed that fair and equitable distribution of profits was a dividend and subject to higher taxation than capital gains.

Tax authorities deem that fairer and more equitable distribution of profits should be subject to higher taxes.

Consequently, in order to benefit from 'tax efficient' capital gains rates, buybacks must be unfair.

To test the fairness of buybacks, we may compare the present value of cash flow for two sets of shareholders: those that sell into a buyback and those that do not.

Buybacks might be fair if the present value of cash flows for both groups of investors were the same.

I have set up electronic spreadsheets to run this analysis, and the reader may wish to do the same. In my analysis, I assumed that in ten or twenty years a company would be liquidated at book value, with proceeds distributed to all shareholders.

The variables in the model were the discount rate, the returns on high- and low-yield assets, the breakdown of high- and low-yield assets, the dividend payout rate, the growth rate, total company assets at the beginning, the initial number of shares, and the buyback rate. The output showed earnings per share, buyback price, profits, book value, and the stockholdings, dividends, and cash flows of each group

Depending upon the parameters, the net present value of cash flow to shareholders who sell into buyback programs may be greater or less than that of shareholders who do not. It is possible to find certain combinations of variables in which buybacks seem fair or even advantageous to long-term investors (and therefore disadvantages to short-term investors). There are also circumstances in which the rate of buybacks may be so small as to be trivial.

However, although there may be circumstances in which the practice may seem to be fair or innocuous, there are more cases in which buybacks are blatantly unfair to long-term investors. With parameters that match the way buybacks have been used during the Great Bubble, the practice has been almost always been against the interests of long-term investors.

When buybacks exceed one percent of equity and absorb more than five percent of profits, as was common in the last two decades, the net present value to shareholders who sell into buybacks is usually greater than that of shareholders who hold securities for the long term. The difference can be substantial.

The corporate executive, therefore, is faced with the following ethical choice: distribute excess cash as dividends which is fair to all shareholders, or use the money to buy back stock from a few shareholders (some of whom are corporate executives) which is generally unfair to one or the other group of shareholders.

Buybacks Below Intrinsic Value

Buybacks may seem reasonable and ethical when the purchase price is less than intrinsic value.

This has not been the case during the Great Bubble when most stocks were over-priced. However, the ethics of even this use of buybacks is open to question.

Benjamin Graham and David Dodd in the investment classic, 'Security Analysis', opposed buying back stock on the market, even when done at less than intrinsic value, as shown in this quote:

During the 1930-1933 depression repurchases of their own shares were made by many industrial companies … The stock was bought in the open market without notice to the shareholders.

This method introduced a number of unwholesome elements into the situation. It was thought to be 'in the interests of the corporation' to acquire the stock at the lowest possible price.

The consequence of this idea is that those stockholders who sell their shares back to the company are made to suffer as large a loss as possible, for the presumable benefit of those who hold on.

Although this is a proper viewpoint to follow in purchasing other kinds of assets for the business, there is no warrant in logic or in ethics for applying it to the acquisition of shares of stock from the company's own stockholders.

The management is the more obligated to act fairly towards the sellers because the company itself is on the buying side.

(“Security Analysis – Principles and Techniques”, Benjamin Graham and David L. Dodd, Second Edition, McGraw-Hill Book Company, New York and London, 1940.)

Consequently, we can see that buybacks are unfair to long-term shareholders when the price is too high and unfair to short-term shareholders when the market is too low.

In short, buybacks are unethical and unfair, even though the SEC and Wall Street may condone the practice.

Many of those who benefit from buybacks do not realize that the practice is unethical or disadvantageous to company shareholders.

Like slavery in the Old South, when immoral behavior becomes the norm, ordinary people are unlikely to see the wrong.

They have been taught these techniques when getting their credentials as Masters of Business Administration.

Boards of directors vote to approve every program and each scheme is vetted by prestigious accounting firms, lawyers, and even the Securities and Exchange Commission.

By the millennium, buybacks had become a respected custom of American business.

Like slavery in the Old South, when immoral behavior becomes the norm, ordinary people are swept up and are unlikely to perceive the wrong.

July 25, 2004

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