A couple of days ago, legendary investor Warren Buffett published his annual letter. And he showered praise on stock buybacks. On the other hand, just a month ago, President Joe Biden criticized companies that indulged in the practice. He wanted to tax buybacks heavily.

So in today’s Finshots, we explain why stock buybacks are such a contentious issue.

The Story

Imagine a company that’s in the midst of a purple patch. It’s making truckloads of money. What can it do with the cash?

For starters, it could reinvest this money. Pick up a new project or an idea and work on it. Maybe gobble up a smaller company in a different domain and create a new business line for more growth.

Or…it could share this excess cash with shareholders. Reward them for their patience. It can do this through something called a share buyback. Basically, it offers cash to shareholders in return for a portion of their shares. Let’s say a stock is trading at $100. The company tells investors, “Okay, I’ll pay 20% extra. Give me your shares and I’ll give you cash.”

The premium over the market price entices investors to sell. And the gains they make on the sale are either tax-free or only incur a minimal tax charge. Depending on which part of the world they live in. The company puts its excess cash to use. Shareholders make gains. Everyone’s happy.

Everyone except for people like President Joe Biden. They hate buybacks.

Their contention is simple. Stocks are usually owned by the wealthy. The wealthiest 10% in America own 89% of all stocks. And when buybacks boost the stock price, it’s this select set of people who win.

Wait…how does a buyback boost a share price, you ask?

When a company pays a higher sum of money to buy its shares, that can create confidence in the minds of investors. They think, “Hey, if the company believes it’s undervalued and it is using its cash to buy stock, it must know something we don’t.” When people rush to buy the stock, it bumps up the stock price. It creates a temporary sugar high for the stock.

And since it’s the wealthy folks who’re the typical investors, they’re the ones who benefit.

Even the top executive at the company wins. Because their bonuses and compensation could be linked to stock price performance. In such a case, when they propose a buyback, it could be a matter of self-indulgence. They just need to let the buyback work its magic on the stock price. And they could pocket a tidy sum in due course.

So, critics say that instead of making the rich richer through buybacks, companies could instead pay higher wages to their workers. Provide them with better retirement and health benefits. Take care of the folks who toil hard at the company. After all, happy workers are more productive. It’ll help the company in the long run.

Or maybe, even if they don’t raise wages, the company could set the cash aside for a rainy day. It’ll at least protect the company and its workers during an economic downturn.

And there’s truth to this. Just rewind back to the 2000s. Banks were going through a purple patch and making a lot of money. And Lehman Brothers spent $4.1 billion in a stock buyback programme. 6 months later, the sub-prime mortgage crisis struck. The bank went belly up.

Or even Citigroup. Between 2004 and 2008, it spent $20 billion to buy back shares and reward investors. But then, it had to go running to the US government asking for a massive $45 billion bailout.

What if the banks hadn’t resorted to buybacks? Maybe they wouldn’t have fallen into such a mess.

And while some of these fears are valid, capitalists have their own rationale for supporting buybacks.

They say that the popular perception that companies are not investing in projects that have long-term benefits is wrong. For instance, in 2018, buybacks hit a record high of nearly $1 trillion. But companies had also increased the monies they’d invested in long-term projects by 16%. What we call capital expenditure (capex). These are projects that provide employment opportunities. So they're putting cash to use.

And giving money back to shareholders isn’t wasteful despite what naysayers claim. Because the kind of companies that do this are mature ones. Ones that have already grown large. They don’t have too many places to deploy money for big needle-moving growth anymore. So, when they return money to shareholders, it’s actually a process of recycling money. The investors will take it and put it to productive use elsewhere. Maybe into a new business that has better growth prospects and needs it. Maybe this business can create better employment opportunities. So sharing the cash with shareholders via buybacks is actually responsible management. Or atleast that’s what the supporters would argue.

Because if you discourage companies from buybacks they can take foolhardy decisions with their cash. Just to prove that they’re using the money and not keeping it idle.

A classic example is the oil and gas companies in the 1970s. Exxon Corp bought an electric motor maker for $1.2 billion and spent another $1 billion building an Informations System company (word processors and stuff). Both failed. Even their then rival Mobil Oil spent $1 billion on a company that made cardboard boxes. It failed too.

Companies had excess cash. And they put it to abysmal use with ill-conceived diversification.

The other argument is that buybacks only provide a temporary artificial boost to stock price. And when the cash from the coffers dwindles, it affects the long-term growth prospects of the company. But when investment bank JPMorgan crunched the numbers, they found that, on average, a company that executed buybacks actually beat the stock market. So investors believe that companies know what they’re doing. And reward them even in the long term.

So yeah, both sides do have valid arguments. And the debate is only like to heat up in the months to come.

But at the moment, the critics might be winning the battle. Because other than shareholders, no one is happy with what tech companies are up to. Meta and Alphabet have announced multi-billion dollar stock buybacks. And on the flip side, they’re laying off employees. They’re letting employees go saying that they need to cut costs. So how do you reconcile the two?

Maybe the answer lies in what a solution some senators in the US suggested a few years ago. They said that companies should be allowed to indulge in stock buybacks. It is helpful in many ways. But only if they tick a list to prove that they’re treating employees fairly.

Maybe we need something like that to make all sides happy? What do you think?

Until then…

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