Interfluidity :: Share buybacks and uninformed investors

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Steve Randy Waldman

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Share buybacks and uninformed investors

Today I was reading Felix...

[F]or many decades, it was fair to assume that stock dividends, in aggregate, would rise more or less in line with the cost of living. When you bought a stock portfolio, you were buying a payments stream -- one which, you could be reasonably sure, would increase steadily over time. As such, some stock-market investors actually liked it when stocks went down, because that meant that buying future payments had just gotten cheaper, and you could buy more of them.

In the late 70s and early 80s, the S&P 500's dividend yield was over 5%, and it was not uncommon to find retirees living off their dividends. Even though the stock market was at depressed levels at the time, it had actually proved to be a perfectly good investment, because many shareholders cared only about the amount of their dividends, not the price of their stocks.

Then, however, things began to change. Stock prices started to rise much more quickly than dividends, making that future earnings stream much more expensive. And good stock market investments turned out to be not those which reliably paid a bit more in dividends than they had the previous year, but rather those which had increased the most in price.

And then Mish...

How many billions of dollars did GE [whose stock currently trades for about $18] waste buying shares back over the years at $40 or greater? $35 or greater? $25 or greater? $20 or greater? Think of where GE might be if it used the money to pay down debts rather than buy shares at absurd prices.

I see that GE is paying a dividend of 6.6% while borrowing money from taxpayers to fund operations. How long can that dividend last?

If you take an introductory finance class, you will learn that firms can return cash to their shareholders in two ways. They can issue dividends, or they can use the same money to buy-up shares from shareholders. Fundamentally, you will learn, these two approaches are equivalent: With a dividend, all investors receive some cash, but the stock they hold loses value. In a buyback some investors sell shares and receive cash, leaving investors who hold their stock with a less "diluted" claim on the assets of the firm, making the payout equitable to all shareholders.

To clarify, suppose there is a firm whose sole asset is $1,000,000 in cash and two shareholders. The firm could pay a dividend of $500,000, giving $250,000 in cash to each shareholder. Alternatively, the firm could buy out one of the shareholders, paying $500,000. In the first case, both shareholders end up with $250,000K worth of stock and $250,000 in cash. In the second case, one shareholders ends up holding $500K in cash while the other shareholder holds stock worth $500K. In financial terms, everyone gets a fair deal either way.

However, conventional wisdom has it that share buy-backs offer important advantages that may make them superior to dividends payments:

Preferential tax treatment — Investors are more lightly taxed with buybacks, especially if dividends are taxed more heavily than capital gains. With buybacks, those who sell are taxed only on net gains (a smaller amount than the cash actually received, and perhaps at a lower capital gains rate), while those who don't sell are not taxed at all until they sell sometime in the indefinite future.
Flexible reinvestment with low tax and transaction costs — With a dividend, people who want to stay invested in a firm have to accept and pay taxes on the dividend, and then incur transaction costs to reinvest the proceeds back in the firm. With a buy-out, investors who want to stay invested very efficiently do nothing, while those who want cash can sell into the buyback.
Cash-management flexibility for the firm — For whatever reason, firms are expected to keep dividend payments stable and increasing over time, even though business profits and cash needs may be very volatile. Firms that cut regular dividends are often punished by the market. Discretionary stock buyback programs allow firms to return cash to shareholders when business conditions permit and withhold payouts as cash needs grow while maintaining a smooth and stable dividend policy.

All of this would be well and good in a world with perfectly efficient markets, no asymmetric information, and investors whose portfolio preferences are continuously enforced.

But consider an uncertain world in which firms are frequently mispriced, and where many investors have limited attention and rebalance their portfolios only infrequently. (Among this latter group would be buy-and-hold investors who hold a fixed portfolio and either consume the dividends or reinvest them pro rata in a broad portfolio rather than in the issuing firm directly.) In this more realistic world, share repurchases benefit informed and flexible investors at the expense of their less informed or more rigid partners, while dividend payments reduce the ability of informed investors to profit at the expense of other investors.

Let's first consider the case where some investors know a firm's stock to be overpriced. Informed investors are more likely to sell into overpriced buyouts, extracting cash from firms at the inflated share price while concentrating the burden of future write-downs on long-term, less-informed investors. A dividend, on the other hand, would return cash equitably to all investors, automatically disinvesting slower investors from the overpriced stock, and forcing informed investors to share in losses. Of course, informed investors who know a stock to be overpriced can still sell, but without the support of a buyback program, their selling might inform the market of the firm's poor prospects, and cause the share price to fall before they can exit. (That's how information is supposed to get impounded into markets prices!) With or without the buyback program, investors in an overpriced firm must suffer the cost of a downgrade, but the cash disbursal policy affects the distribution of the losses. Returning cash via buybacks lets the informed shift losses to the uninformed, while the same cash distribution via dividends reduces the eventual cost to slow investors and forces informed investors to share more of the pain.

With an underpriced firm, the difference is less stark. Only ill-informed or liquidity constrained investors sell their shares into a buyback, concentrating future gains in the hands of both informed investors and slow buy-and-hold investors. So although informed investors do gain, the gains are more broadly shared: "slow money" as well as "smart money" benefits, the losers are ill-informed investors or random people who need cash. When an underpriced firm issues dividends, all investors are partially disinvested from a firm whose shares are destined to appreciate. But active, informed investors are likely to reinvest, potentially informing the market and provoking a revaluation towards fair value that benefits all investors. If the market adjusts quickly to the reinvestment flow, informed investors may not be able repurchase very much stock at all from less informed investors before the price adjusts, leaving the revaluation gains broadly shared among all investors rather than captured mostly by the informed.

An easy way to think about all this is just in terms of information: Share buybacks of an overvalued firm create artificial, potentially price-insensitive demand that allows informed investors to exit without suffering adverse price movements from revealing their information. Dividend payouts serve as a shock to investor portfolios that forces informed investors to periodically reveal their information, diminishing their advantage over less informed investors. So uninformed, buy-and-hold investors are less likely to be taken advantage of if they invest in firms that issue frequent, substantial dividends and don't repurchase stock than if they invest in firms that don't pay substantial dividends but use stock buybacks to "return cash".

This line of thinking opens up interesting questions about for whom a firm is to be managed. The party line is that firms should be managed for the benefit of shareholders. Even if that is true, for which shareholders should it be managed? One might conjecture that more active, informed investors have a greater influence than passive buy-and-hold investors, and create incentives for management to buyback overpriced shares even though in some sense this is bad for "the firm". (There are lots of anecdotes about hedge funds and other activist investors lobbying successfully for share repurchases by firms that turned out to be overpriced.)

Even if one imposes a fiduciary obligation on management to treat all shareholders equally, it's not clear that management is betraying its trust by working to inflate share prices and creating opportunities for the savvy to cash out. Even if the strategy harms future earning streams, it creates a valuable option that is ex ante available to all shareholders, and the option value of a firm is a real and often substantial component of its worth. If markets are not efficient, it's quite possible that maximizing current shareholder value is inconsistent with maximizing discounted infinite horizon profit streams, which leads one to question whether current shareholder value is a very useful metric of firm value from a social welfare perspective.

Steve Randy Waldman — Saturday October 25, 2008 at 8:57pm

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Devin Finbarr (mail) (www):

The major gotcha to watch out for with stock buybacks is the dilution rates. For many companies, the stock buybacks barely offset the dilution by issuing more options to the employees. Dell for instance, has the same number outstanding shares today as five years ago, despite billions of dollars of buybacks. The overall dilution rate of the S&P is something like 2%, which is above the historical norm. So we have above average dilution, and below average dividends. So much for management returning money to the shareholders.

Stock buybacks only return money to shareholders who sell their shares. This will often be savvy investors, hedge funds, and insiders. If a company is buying back stock instead of paying dividends, that's your cue as retail investor to sell. Buying stock in non-dividend paying, non-growth stocks is a suckers game. Mark Cuban has a great post driving home this point.

10.26.2008 1:32am

Nemo (mail):

Why does the stock market exist? Put another way, why is gambling broadly considered so bad for society that it is banned except for certain exceptions, and one of those exceptions is the stock market? (After all, the stock market is not so different from a card game.)

Answer: Because efficient capital allocation is a societal good. And the markets are most efficient when the well-informed Intelligent Investor profits and the ill-informed foolish investor loses. So even if share buybacks benefit the former at the expense of the latter, that is actually a good thing, since that transfer of wealth is the very reason the market exists.

However, I disagree with your analysis in a more basic way. Companies do not generally repurchase stock in such quantity that individual investors have much choice about whether to participate. Even during a buyback, almost every share that trades hands is between two shareholders, not between a shareholder and the company. Just look at the daily volume of GE, for example.

When a company buys back its own stock, that is really no different from when it buys another company's stock. What is the difference between (a) GE buying 1 million shares of its own stock and then later raising capital by selling 1 million shares of its own stock; and (b) Berkshire Hathaway buying 1 million shares of GE and then later selling them? The answer, of course, is no difference at all. The question of whether the purchase (or sale) is good or bad for the purchaser's (or seller's) shareholders depends on one and only one thing: What the price was relative to the value.

This is why GE buying shares at $50 was foolish and bad for its shareholders, not because it was unfair to stupid people.

10.26.2008 11:14am

Alex Tabarrok (mail):

The usual story is that a buyback signals that management believes the firm is worth *more* than the stock market price - not less as in your view. The market appears to agree in that a repurchase announcement typically leads to an abnormally high return.

10.26.2008 12:35pm

Modigliani_Miller (mail):

I think Alex is correct - the problem with share repurchases you point out are theoretically possible but are at odds with the empirical evidence. The reason is two-fold: First, managers tend to be better informed than outside shareholders about fundamental value. Hence they can suspend buy-backs when they feel the stock is overvalued. Second, managers usually have strong incentive to do exactly that. Managers these days are long-term stockholders themselves and would be hurting their own pocket book if they repurchased shares at an overvalued price.

Bottom line: The empirical evidence shows that firms with active share repurchase programs tend to be undervalued, not overvalued. See various papers by Theo Vermaelen with different co-authors for the details

10.26.2008 1:01pm

Steve Randy Waldman (mail) (www):

Alex & Modigliani_Miller — I do know what the usual story is. And I don't deny that the usual story may frequently hold: I conjectured that active investors may have disproportionate influence over buyback policy, but that needn't be the whole story. As described, when firms purchase undervalued shares, there is little wrong with the usual buyback story... liquidity sellers and the misinformed lose, but they would have lost in any case.

However, the usual story sows the seeds of its own destruction. Since it has become conventional wisdom that buybacks signal undervaluation, shares often see a "pop" upon their announcement, That creates an incentive to use buyback programs to manipulate price, and it seems that some shorter-term investors lobby for firms to do just that.

To really evaluate the claims made above, we need to look at what happens to firms conditional on other valuation measures. And, sure enough, Theo Vermaelen does just that, and finds that "value stocks" outperform following repurchase programs, but "glamour stocks" do not. (JFE, 1995) I'm scholargoogling from home (i.e. abstract only), haven't done a real lit search on this — the post was a spew of pent-up conjecture. But I think it's right, am willing to stand behind the logic unless you can show me fairly persuasive evidence to the contrary. So far, my scholargoogling turns up mostly consistent results.

Uninformed investors — and by those I mean investors who know they are uninformed, buy-and-hold, index type investors — have little to gain from the good signaling in buyback announcements by undervalued firms. They have opted out of the information-processing game, have decided themselves to be disadvantaged and thus seek strategies for piggybacking on the equity premium without trying to evaluate multiple conflicting signals. I don't dispute the story that managers of undervalued firms may use buybacks to signal undervaluation to informed investors. I just claim that they may also use buyouts to pay off informed investors when firms are overvalued, and since uninformed investors have little to gain in the undervaluation case and much to lose in the overvaluation case, uninformed investors would be wise to adopt a policy favoring firms that payout in regular dividends rather than discretionary buybacks.

10.26.2008 1:52pm

Steve Randy Waldman (mail) (www):

Nemo — I largely agree with you. This post was a bit uncharacterstic, in that I was starting with Felix's point, that once upon a time dividends made shareholding friendlier to uninformed investors. Stable dividend payouts that firms struggle to maintain despite firm setbacks make common equity more bond (or preferred stock like), allowing long-term investors to ignore valuation issues and treat heir holdings like income generating perpetuities, except in extremely bad states of nature. Conditional on "normal times", big dividend payers "devalue knowledge" (stealing Barry Bosworth's excellent coinage), informed investors have less advantage over uninformed investors in the valuation decision that with stocks whose return is sequestered into cap gains.

But whether that's a good or a bad thing depends upon the balance between two social goods: 1) the ability of good firms to raise equity financing cheaply; and 2) the ability of markets to discriminate between good and bad firms. Firms that return cash by share buybacks as a matter of policy ought to attract "gamblers" — informed or think-they're-informed investors, who will actively set share prices, assisting with goal (2). But when index investors get wiser than they are (and some of Jeremy Siegel's new index funds might open the door), it should be harder for buyback payers to attract cheap capital.

I don't want to claim that buybacks are "bad". I'm usually focused like a laser on social good (1), that markets should perform the information work of distinguishing good from bad investments, and that uninformed investors probably have little business purchasing common stock. I'd much rather see much wider use of exchange-traded preferred stock by uninformed investors (which of course would require that firms issue a great deal more of that), and let the common stock market be a dog-eat-dog informational horse race.

But even so, there is a deeper issue with buybacks, which is that to the degree the dynamic I describe does exist, the definition of a "good" firm as evaluated by informed investors is skewed. We want informed investors to value firms, but not based on their ability to offer enticing options to the swift in zero-sum games, but on their ability to produce profits by delivering goods and services. The stock-market casino has no purpose if "good" stocks are those that have better craps tables, with no underlying connection to the economic activity of the firm. As I say, I love informational investors and dislike free-riding by the proudly uninformed. But a stock market where the best profits are had by choosing firms that facilitate transfers rather than choosing firms that are valuable enterprises serves no social purpose. Better capital markets would segregate these two groups of financiers. Those who know they are uninformed would occupy sheltered, low-risk, moderate return niches, while those willing to play the information game would transfer funds from one another in a challenging competition among players, not by the easy plunder of free-riders.

10.26.2008 2:23pm

Steve Randy Waldman (mail) (www):

Nemo — BTW, only the most informed investors "know" exactly when firms are actually buying back, and that's just inside dealing. In general, investors can't distinguish between selling to the firm and selling to other holders. But informed investors execute their divestitures from overvalued firms strategically to avoid adverse price action — they sell in small quantities into spike, trade in "dark pools", etc. — and the price insensitive demand associated with buyback programs create greater opportunities for successful execution of such strategies. No one knows they are getting "cash from the firm" with buybacks: the cash return takes the form of a change in the character of the market that increases the likelihood that sellers execute their trades cheaply.

10.26.2008 2:31pm

Steve Randy Waldman (mail) (www):

Dave — The whole question of stock buybacks motivated by option compensation is a tricky one. I self-consciously avoided it, because all of a sudden the story becomes much more complicated. We can posit a "fairly valued" (rather than over-or-undervalued) firm for simplicity, and still we have to worry about the level of compensation implicit in the options relative to the value of employee contributions to the wealth of pre-existing shareholders. The "level of compensation" is hard to gauge, because employees are insiders with better knowledge of future performance (not to mention the ability to influence that performance, which is why firms claim they use options), because employee options have different characteristics than other options (especially given that they frequently get reset, not to mention back-dated), etc. It's a big, huge can of worms, and I didn't go there mostly because that would be too long a story and I don't have a strong sense of what the ending should be (other than that, like you, I am cynical that option-based compensation ends up being a good deal for less informed investors).

Mark Cuban's tales always restore ones faith in the perfect beauty and rationality of capital markets.

10.26.2008 2:41pm

Guest post:

Buybacks may favor "smart" money vs. passive money, but the larger driving force is that buybacks are more favorable to management vs. all shareholders.

First, a constant buyback program typically allows management to obscure the wealth transfer from owners to employees via stock options issuance. The reason buybacks seem to occur more often at high prices is partially a function of the fact is that is when dillution from in the money options is most evident.

Second, non-scheduled buybacks allow mangement to time and manipulate EPS. At the same time, they can announce a big buyback to get a temporary pop to the stock, while reserving discretion as to when to actually use funds to buy shares. A dividend policy forces managment to commit to a long term plan, and can't be maniuplated. If a company paid 10 cents last quarter, people notice if they don't keep the dividend the same or increase it. Even dedicated analysts are hard pressed to remember the rate of change of share count quarter over quarter.

I find traditional agency issues to be the driving force here, with tax considerations less important in recent years and different shareholder types' interest to be minimal at best.

10.26.2008 4:46pm

JKH:

SRW –

I must take exception to the idea that “informed investors” should be subsidized by a firm's deliberate execution of a high valuation buyback, apparently with the sole objective of rewarding this group's presumed superior intelligence and stock valuation perspicacity. This smacks of an elitist, classist view of a single shareholder group. Why on earth should “informed” sellers be granted additional market liquidity via a buyback, simply to facilitate their price assured exit from the stock at their chosen valuation? What social function does this satisfy?

“Of course, informed investors who know a stock to be overpriced can still sell, but without the support of a buyback program, their selling might inform the market of the firm's poor prospects, and cause the share price to fall before they can exit.”

Pity the poor informed investor who can't get out of his overvalued position without moving the market! Siphon that price-sensitive supply before the price changes! Heaven forbid should the overvaluation be corrected too soon by the mass selling of those who've registered such superior valuation judgement! Ensure the uninformed masses remain ignorant while the informed are bailing! Good grief.

“One might conjecture that more active, informed investors have a greater influence than passive buy-and-hold investors”

They certainly will have a greater influence if subsidized by the issuer like this. What on earth is the justification for coddling institutional equity traders with such a rigged game? Informed investors should operate according to the rules of the game, on a level playing field, like everybody else.

Share buybacks should be executed at a lower rather than a higher price for good reason. It increases earnings per share for all shareholders who choose not to sell into the buyback, and increases them more at the lower price than the higher price. This approach features pricing logic similar to that of a reverse auction.

Those that choose not to sell can value the remaining shares accordingly – informed or not. But all investors should have the right not to participate in a share buyback without being adversely impacted by market timing that is pathologically biased in favour of transferring capital to a presumed “informed” class.

I suppose it's just that I'm not overly impressed by the social/economic value added by institutional equity traders, and certainly not such that I would choose to reward them with such biased largesse. Implicit in this, I also believe in the democracy of valuation in short and long term investing, rather than an elite authoritarianism according to the views of professional short term information traders.

My apologies for the exclamatory tone here, with a touch of sarcasm; worse, having thought about this today, I've somehow managed to include absolutely nothing of what I know about share buybacks in this comment.

10.26.2008 4:58pm

VoiceFromTheWilderness:

Stock buy backs can be used to boost a CEO's compensation, as well as to make his performance look better to naive investors who only look at stock price.

Dividends can't.

An informed investor knows that stock price often have nothing to do with a businesses fundamentals, but dividends generally will. The time a dividend can be out of whack with a companies financial status is much smaller than the time a stock price can be.

10.26.2008 8:52pm

Steve Randy Waldman (mail) (www):

JKH — Wow. I don't disagree — I hope you didn't take the piece as cheerleading for the transfer of wealth from less informed to more informed investors. Your reaction seems quite opposite Nemo's above. I tried to keep the piece fairly neutral, and my own view is somewhere in between: Yes, an important function of stockmarkets is to reward information collection, which implies a transfer of wealth from the less informed to the more informed speculators, and there is a venerable view of "noise traders" in markets that suggests that an important role of uninformed traders is effectively to subsidize market-makers and informed investors as the market seeks accurate prices.

But using share buybacks as a means of effecting such a transfer is problematic, because (if you buy my reasoning) such buybacks allow informed investors to profit by in part hindering price discovery. Further, the discretionary and opaque nature buybacks leaves open the possibility of profit from information irrelevant to the ultimate economic prospects of the firm. To the degree that's true, the information that is rewarded harms the allocation decision that serves to justify informed investor compensation. On balance, my view is that transfers from less-to-more-informed are not inherently bad, but using share buybacks to effect them is probably a bad practice.

Adding to this that we haven't found a good way to resolve the tension between the two social goods I identified responding to Nemo: large-scale financing of good projects (which may require piggybacking by informed investors) and discrimination of good from bad firms (which requires transfers from the less to the more informed). This is a tangle of issues, and I didn't want to take a strong normative position, except maybe to suggest that transfers to informed investors unrelated to firm economic prospects is bad.

You seem to come out where I think you should, though: angry, from the perspective of not-short-term-inside/informed-investors that maybe some people have an advantage over slower/longer-term investors with respect to share buybacks, which should lead you to prefer firms that don't generally engage in buybacks (and that return cash through dividends) if you wish to be a slower/longer-term/not-hyperinformed investor.

Anyway, you needn't apologize for your passionate tone! I'm glad you're mad, actually, just don't be mad at me!

10.26.2008 11:00pm

Steve Randy Waldman (mail) (www):

Guest post — I don't disagree. I deliberately chose not to consider traditional agency issues (i.e. management looking after its own interests in preference to those of any group of shareholders), not because I think they are irrelevant to what's problematic about buybacks, but because I think it interesting that even if you put those issues aside and assume the best, buybacks lead to difficult questions about firm valuation, price discovery, and diverging interests of different shareholders. The popularity of buybacks may well be much more related to the discretion they give management to serve its own ends. Similarly, I think that buybacks are very related to option compensation, but I decided to sit that one out too. This post tells a ceteris paribus kind of story... holding management quality and option compensation constant, what's the effect on different groups of shareholders of returning cash via buybacks rather than dividends as a matter of policy (ie sometimes when shares are overvalued, sometimes when shares are undervalued).

I don't really try to understand what motivates managers to use buybacks, which is the heart of both your post, and Alex T / M & M above.

10.26.2008 11:08pm

Steve Randy Waldman (mail) (www):

VFtW — "The time a dividend can be out of whack with a companies financial status is much smaller than the time a stock price can be."

A very nice point.

10.26.2008 11:59pm

Devin Finbarr (mail) (www):

Steve - The stock market should be rewarding people who make good judgments about which companies will create the greatest future profit with a dollar of investment. The market should not be rewarding investors who have inside or special information about how the earned profit will be returned to the shareholder. Every investor with a share of stock is entitled to an exact equal share of the profits.

For comparison, imagine a company's profits were very regular and well known, but the dividend was highly irregular. "Informed" investors could profit by buying right before the dividend and than dumping the stock before a long dividend dry spell. This irregular dividend is not rewarding informed decisions about how to invest capital to generate profit. It is rewarding guessing about how already obtained profit will actually paid back to the shareholders. If the speculator had actual inside knowledge, the transaction would be fraudulent.

If a company really desires to return money to the shareholders via buybacks, it should do it in analogous fashion to how a company pays out dividends. Companies paying dividends aim to pay a consistent amount, on a regularly scheduled basis. A successful company tries to consistently increase the dividend by a little each year. Buybacks should work the same way. The company should aim to buyback $x worth of stock a month, every month, and gradually increase x from one year to the next. Investors should punish inconsistent and wildly fluctuating buybacks the same way they punish wildly fluctuating dividends.

10.27.2008 2:26am

Steve Randy Waldman (mail) (www):

Devin — Certainly agreed: To the degree investors profit by having privileged information about the timing of buybacks, that is a bad thing by nearly any reasonable criterion.

It would also be illegal, under regulation FD and many other doctrines. The specific timing of share purchases would be material and non-public information, which insiders are not permitted to act upon or reveal selectively. The buyout program is publicly announced, of course, but not the timing of purchases.

Still, it's quite possible that by means proper or improper, some investors learn or can infer the timing of transactions, and thereby profit. Thus the problem.

But you'd violate the core mythology by which buyback programs are usually justified if you insisted they stick to a fixed rate or schedule. Management claims they will purchase shares they believe are undervalued, thus increasing the wealth of shareholders who don't bail (and the wealth of shareholders who do bail, who benefit from increased demand). If you eliminate management discretion, you cannot claim that purchases are timed to capture undervaluation.

Theoretically, buybacks reward all investors equally regardless of whether they sell or not. So, buyback supporters would bristle at your implication that all shareholders don't get equal benefit from the profits, as they would with a dividend. It's only when buybacks are for overvalued stock that the practice helps some shareholders at the expense of others. Ex post, it's obvious that recently a lot of share buybacks have been of overvalued firms (since the market's current estimate of nearly all firm values has fallen dramatically).

Alex T. & M_n_M above would claim that usually buybacks are of undervalued firms, as they are supposed to be. I'd guess they'd say using the current dislocations as a benchmark of recent history is unfair. That aside, my guess is that over time buybacks have been less and less tethered to management judgments of undervaluation as the signaling story they describe create incentives for some shareholders and some management figures to buyback shares regardless of price, in order to achieve a market pop. Informed investors understand the market pops, in general, to be unwarranted, and sell, leading to the circumstance you detest (me too).

10.27.2008 3:37am

JKH:

SRW –

A few more (dispassionate) thoughts:

The primary reason why firms buy back their shares is not because they believe their shares are undervalued. That's a tactical implementation issue. The strategic reason is because they have excess capital, beyond what is required for investment and dividends. If firms can't make a case for excess capital, they have no reason to be buying back shares unless they are being irresponsible and deliberately seeking to leverage into an undercapitalized state. I'm sure that's happened as well.

But in the prudent sense, the share buyback decision is not completely discretionary. The firm must first have excess capital.

A necessary condition for excess capital is that the firm has exhausted projects where it can achieve its target risk adjusted return on capital. This is true even when the hurdle rate and the available rate both exceed the firms cost of capital. If the firm has a policy target rate, it has no obligation to deploy capital simply because it can exceed its cost of capital at a lesser rate.

Excess capital will then be invested in the risk free asset, which is cash. This must be the case. If it were not, excess capital would be invested in a risky project that doesn't meet the risk adjusted hurdle rate, or target return, which is a contradiction.

Therefore assume such a state where excess capital is invested in risk free cash, pending distribution. The firm has a choice to distribute via a dividend (increase) or a buyback.

Consider the case of a buyback:

Before the buyback, each share essentially represents a claim on a combination of risk free cash and risky assets. The market will implicitly value each embedded component.

The price/book ratio for cash will be 1:1 because it is risk free. Since the firm is generating excess capital from profit, the price/book ratio for risky assets will be greater than 1:1. And the P/B ratio for the firm will be the combination of the two.

It can be shown algebraically that the buyback will drive the firm P/B up to the risky P/B. This is a reflection of the changed risk profile of outstanding shares. But algebraically, it happens because the book value B is driven down due to the expense of the buyback. And this forces P the share price to remain unchanged.

Similarly, post buy back EPS increases because the remaining shares earn a higher rate of return, given their higher level of risk. But the P/E is higher for the same reason. A higher P/E offsets a higher E. Again, P is unchanged.

Thus, the effect of buybacks on share price is generally overstated, at least for an efficient market. This is not generally understood analytically.

Nevertheless, share buybacks may give a temporary boost to the stock price, as demonstrated empirically, but this is due to bandwagon perception and interpretation more than fundamental value effect.

Assume the market is not entirely efficient, and an “informed investor class” exists that can recognize when stocks are undervalued and overvalued. Further assume that the firm's management is similarly informed. Then the question becomes how management should behave with respect to decision on share buybacks in these different pricing environments.

One possibility is that firms should time stock buy backs in order to support the interests of the informed class at the expense of an uninformed one. Buying stock at the high offsets the marginal pricing effect of informed investors who want to sell. This strategy benefits the informed investor who sells stock and is a cost to the uninformed investor who holds or even buys.

The conventional wisdom is the opposite. To the degree that firms actively time share buy backs according to stock value, they should buy at the low. This exacerbates the marginal pricing effect of informed investors who also want to buy, and is a cost to them.

For a full comparison of decision making in context, consider a matrix of stock price environment, management action, and investor action. This matrix includes not only the possibility of share buybacks, but the possibility of share issuance.

Assume 2 price states (low price, high price), 3 possible management actions (buy, sell, hold), and 3 possible informed investor actions (buy, sell, hold). (Management sell = share issuance.) It's clear that at a low price, informed investors will buy along with management, while others may do anything, with selling the least logical and holding neutral. At a high price, informed investors will sell while others may do anything, with buying the least logical and holding neutral. Management may even sell (issue) along with informed investors.

Thus, the informed investor will do the same thing in the same stock price environment, regardless of management action. The informed investor should be indifferent to management's capital actions. Management capital actions only affect marginal liquidity benefits or costs.

Specifically in the case of a high price environment, the informed investor can always execute an informed strategy otherwise in the open market and take advantage of the long term outlook accordingly, without the added marginal effect of any additional buy back induced liquidity.

Firms that focus on market timing for the purpose of direct manipulation of their stock price for any reason tend to fail at this objective in the long run. Focusing on the stock price is generally a bad use of management attention.

Moreover, management may lack the flexibility to act on stock views for other reasons. The conditions that allow buy backs tend to be cyclical. Firms tend to build up excess capital when times are good and the stock price is buoyant. They tend to be short on capital in the reverse conditions. Consequently, buy back prices can be expensive as a matter of circumstance.

The pro cyclical tendency of buyback costs parallels the pro cyclical tendency of excess capital generation and even excess capital identification. Current Basel capital attribution rules for banks are also pro-cyclical, for example. There is no countercyclical tightening of capital requirements in boom times when system or macroeconomic risk is increasing. (This may change.) Consequently, firms unload excess capital through buy backs that they might otherwise have needed in a regime of counter cyclical capital requirements.

The choice between dividends and buy backs is a separate issue. For starters, it is a choice that presents a conflict of interest insofar as executive stock options are concerned. Dividends lower the value of stock options. So executives will prefer buy backs for this reason alone.

Many investors prefer dividends for good reason. Dividends are a diversification tool. Not only do they provide regular income, but they allow flexibility in asset reallocation and rebalancing, while being neutral on market timing. Dividends are a potential countercyclical reinvestment mechanism, because investors can reinvest according to dollar cost averaging, where more shares are purchased when the stock is cheap, and vice versa. Conversely, managements tend to blow their brains out cyclically on stock buybacks. Managements tend to buy back stock when it is expensive. They get caught up in the bubble mentality and do a poor job in risk and capital management through full cycles.

Firms should not discriminate amongst shareholders with capital policies that provide an actionable advantage to an “informed” class. Management shouldn't be seeking perverse wealth redistribution from an uninformed to an informed class of investors, and it shouldn't be focusing its efforts on stock market timing. Firms should set a stable dividend policy supplemented with broader capital management tools that include buybacks, issuance, or capital reserving as appropriate.

10.27.2008 8:31am

Uninformed Investor:

Let's consider the issue from the perspective of a firm much smaller than a GE and therefore presumably less analyzed and efficiently priced and probably with less credibility with its shareholders who are more dependent on faith and story-lines than well analyzed histories and prospects. Let's assume their management seeks to use a buy back program, even one funded with scarce but hopefully not borrowed capital, to signal to shareholders that management believes in their company, believes their shares are dramatically under-valued and therefore represent a great value. Certainly they can issue press releases saying the same things but is there not dramatically greater credibility in actually acting on that notion. Would this not serve to increase their market capitalization, if their belief is well founded, rather than being a neutral capitalization issue.
Further, smaller firms may also frequently find their stock prices seriously under-valued due to the actions, often questionable and as we know sometimes in violation of the rules for short-selling, of short-sellers. Would such a buy-back progam not dissuade short sellers if once again the stock price is seriously under-valued and the program is well executed.
Which raises the final question, what would be the most effective form of a buy-back program under these circumstances, is it likely to have the desired effect and how should shareholders analyze and react to such an event.

10.27.2008 3:04pm

Richard H. Serlin (mail) (www):

Wharton's Jeremy Siegel in his book Stocks for the Long Run provides some good evidence and logic for hearty dividend payments, and that high dividend firms have and will continue to provide above average risk adjusted returns. The main idea is that dividends help enforce good corporate governance. With executives committed to a steady large dividend that leaves less excess cash laying around for them to waste on empire building, pet projects, etc. It's hard to not pay a regular dividend that you have paid for years, because that makes the market worry that there's trouble, and the stock may drop a lot.

Another advantage is with the firm having to regularly pay a high dividend it's harder to mislead by cooking the books. If the firm really is deep in the red, even if they cook the books it will show from it being forced to cut or discontinue the dividend. And, at least with the current change in tax law (which is set to expire soon), there is little or no tax disadvantage to dividends for many investors.

10.28.2008 4:18pm

Richard H. Serlin (mail) (www):

With regard to taxes, also please note:

...the President pointed out that about half of all households own stock. This is consistent with the most recent data from the Federal Reserve Bank's Survey of Consumer Finance. What this statistic ignores, however, is that nearly two-fifths of this stock is held in retirement accounts, such as 401(k)s and IRAs. This distinction is crucial, because capital gains and dividend income accruing inside these retirement accounts is not subject to taxation, and thus would not receive a tax benefit from the reduction in the tax rates on capital gains and dividend income.

From Center on Budget and Policy Priorities

10.28.2008 4:31pm

Richard H. Serlin (mail) (www):

Another great book by Siegel which gives good logic and evidence for the benefits of dividends is "The Future for Investors". This is also a really fascinating book. He does a great job of showing the great importance of data storage and dissemination technologies throughout history and today in advancing science technology and economic growth. Thus, the internet and further advances in information technology and telecommunications are crucial, and great government investments given the market problems that will cause these things to be grossly underprovided by the pure free market -- externalities, the zero marginal cost of ideas combined with difficulties in patenting and in especially price discrimination, and many more.

10.28.2008 11:56pm

Bruce in Tennessee:

Investors might feel better if stock buybacks were used like stops in stock transactions. We have this extra cash lying around, and we hereby pledge to buy shares of our company when the stock hits 16....

Too radical?

10.29.2008 7:40am

Bruce in Tennessee:

Investors might feel better if stock buybacks were used like stops in stock transactions. We have this extra cash lying around, and we hereby pledge to buy shares of our company when the stock hits 16....

Too radical?

10.29.2008 7:40am

JKH:

Bruce in Tennessee,

There's probably some element of that in tactical implementation of a buy back program - like buying on dips.

But such tactics are usually in the context of mid to late cycle excess capital generation, when the stock has already experienced a significant cyclical run up in price.

10.29.2008 9:43am

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