Stock Buybacks

Posted by Jeff Carter
on May 15th, 2011

The trend is for companies to pursue stock buybacks rather than dividends. My gut tells me that buybacks only line the pockets of management and the investment bankers that carry them out. The long term shareholder gets ripped off.

Let’s look at two sources to see if I am correct. First, academia. Someone somewhere must have done a dissertation or a study on it. Much easier to persuade a board of directors to approve a buyback for management if you have a finance geek that can validate your actions with a study. Since many boards are payed with options, they look at buybacks favorably-since it takes them out of their options and they get more money!

One article published in the Journal for Financial Economics in 1999 found that
“Between 1985 and 1996, the number of open market repurchase program announcements by U.S. industrial firms has increased 650% from 115 to 755, and their announced value has increased 750% from $15.4 billion to $113 billion. Correspondingly, dividends have only risen by a factor of just over two during the same period; aggregate dividends for all industrial firms listed on Compustat have risen from $67.6 billion to $141.7billion.”

Doug Skinner did a slightly different and more recent study. He found “When firms repurchase stock with the intention of reissuing the shares to employees who exercise stock options or as part of acquisitions, these repurchases are a means of financing transactions rather than earnings payouts.”

He also found that, “This suggests that earnings drive the level of repurchases over 2–3-year windows but that managers time repurchases within those windows in a manner that depends on factors such as repurchasing when the stock price is low (Brav, Graham, Harvey, and Michaely, 2005; Peyer and Vermaelen, 2006), to offset dilution associated with employee stock options (Kahle, 2002), to boost reported EPS (Bens, Nagar, Skinner, and Wong, 2003), or to distribute excess cash (Jensen, 1986).”

Good earnings cause management to buyback stock. Because management also controls the accounting, they potentially can manage earnings so that they engage in a stock buyback on a cyclical basis. Wonder if that cyclical basis correlates to the timing of any option pool?

At the end of his study, Skinner hypothesizes that dividend paying firms will be rare in the future. Once you begin paying a dividend, the firm creates market expectation. Ending that dividend can have severe signaling and market consequences. Buybacks will be the preferred method in the future to distribute cash to shareholders.

But you can’t quantify ROI on a buyback. Maybe that’s really the reason management likes them? There is no hard measure to see how they are doing.

One over riding incentive for the firm to engage in a buyback versus dividend is taxes. The firm, and the dividend recipient pay taxes on those dividends. The Federal government is the disincentive. Tax policy goes against the grain of the principle of taking risk, owning shares in a company and getting a return. The cash flows of the company belong to the shareholders, not management.

Stock repurchases usually do nothing to the float of a stock. Why? “Monthly decreases in shares outstanding are not offset with subsequent increases in shares outstanding since it is possible, even when a firm is actively repurchasing shares, for shares outstanding to increase as the result of exercise of executive stock options, distribution of Treasury shares to employee benefit plans or even contemporaneous stock issues. We improve on the Stephens and Weisbach (1998) CRSP measure of share repurchases by adjusting for new stock issues; 22 of the firms in our sample issue new seasoned equity while having an active open market repurchase program in place.” Options packages add to the float.
This leads me to believe that management is managing EPS, and getting themselves out of options by using stock buybacks.

So, what does the market say about companies that consistently buyback stock. I picked some that the studies cited, and a couple of my own. Here are the charts. I picked a 5 year time horizon, graphed it in terms of percent change, and compared it to the S+P.
ORCL

ORCL Stock Chart by YCharts

DELL

Dell Stock Chart by YCharts

CME

CME Group Stock Chart by YCharts

COST

COST Stock Chart by YCharts

NPK

NPK Stock Chart by YCharts

I threw NPK in there because they do not do share repurchases, but issue dividends and a special dividend from time to time. While every businesses stock price is affected by more than just dividend policy, it looks pretty gray as to if the market prefers dividends to buybacks.

More research is needed. C’mon academics, get to it.

Note:
I cited two studies, they are:

Financial Flexibility and the Choice Between Dividends and Stock Repurchases by Murali Jagannathana , Clifford P. Stephensa, Michael S. Weisbach-Journal of Financial Economics

The Evolving Relation Between Earnings, Dividends, and Stock Repurchases by Doug Skinner-Journal of Financial Economics

Great comments here, and some at our Facebook page.

One other observation: Free markets like choice. Buybacks remove the freedom of choice from the shareholder. Central planning vs Free markets.

Who’s money is it? The shareholders or the management team? If the money belongs to the shareholder, then management is infringing on shareholder rights by engaging in buybacks.

The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.