Buybacks are Keynesian

Just a quick thought. Sometimes at the University of Chicago they teach you concepts that turn normal thought on its ear.

One of the first lectures I heard was that there was a “marriage market”. There was a supply curve and a demand curve for marriage, and each of us interacted in that market to maximize our utility. We are all rational investors when it comes to marriage.

If you don’t believe in the power of the individual investor, and you don’t think differently after a Chicago MBA, you were going through the motions. I digress.

Buybacks have been the rage for a while on Wall Street. More than a few companies engage in them, the most recent famous one being Warren Buffett’s buyback of Berkshire Stock ($BRK.A $BRK.B). The reality is they just line the pockets of corporate management and investment bankers that devise them.

Generally, when a company buys back stock it’s signaling to the market a couple of things. First, it doesn’t have a better use for its capital. It can’t get a positive net present value rate of return on expansion. It can’t invest the stock in some other type of security, or in another firm for acquisition because the numbers don’t add up.

Management doesn’t want cash sitting on the balance sheet because that puts a big target on the companies back. Excess cash makes the company cheaper to acquire.

This leaves two choices. Dividend or stock buyback.

When they buyback stock, investors often think that the float of the company is going to go down. It never does, because normally the company reissues stock via an options package. Over time the float builds up and if cash builds up again, management simply buys themselves out of their options.

Buybacks are Keynesian because they are sold to investors as “priming the pump”, “creating demand for our stock”, or “our stock is being incorrectly valued by the market so we are buying it.”

Mr. Market is efficient though, and never wrong at any given point and time. Why is one executive team or investment banker smarter than the market? Using company cash to buyback stock signals nothing-except that the executives of the firm cannot figure out a productive use of the cash to expand their business to increase shareholder value. That’s not good or bad, it just is. Sometimes there isn’t anything a company can do with it’s excess cash.

Dividends on the other hand adhere to the Chicago School. The power of individuals acting on behalf of their own self interests create a macro market that is smarter than any one individual. Companies should empower their shareholders with the excess cash that’s rightfully theirs anyway. Shareholders are taking the real money risk on the company buy buying shares.

If the individuals decide to reinvest the dividends in the company that pays them, it’s their choice and benefits the company. However, they could use the cash to do something else. Each individual investor has their own metrics on net present value and decides on their own what to do with the money to earn the greatest return for themselves.

This idea is the same as big government lowering your taxes, or raising your taxes. When power of decision making is put into the hands of individuals, the market works better and the economic outcome for all society is greater than if a centrally planned decision is made.

Think about that the next time you read about a buyback.

tip of the hat to the Instapundit.

tip of the hat to the Daily Crux.


Instapundit on his link mentioned the tax advantages to buybacks. I didn’t get into the principles of tax in my post. Obviously, if you receive a dividend, you get taxed. The corporation also pays taxes twice, double taxation. However, the core principles that I outlined above hold true.

Moral of the story: Government ought to cut taxes on dividends to 0%, since the company already paid corporate tax on them. This will force companies to take excess cash on their balance sheets and redistribute it to shareholders. Private stimulus if you will!

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  • MBD1120

    Mr. Market is actually a manic depressive, prone to wild fluctuations in mood and views on market value – In other words, used in the Graham/Buffet sense, hardly efficient.

    • We disagree. The market knows much better than the executive what the value of the firm is, unless the executive starts buying stock with their own cash.  When they use company cash it means nothing since it is virtually a no risk transaction to the executive.

      • MBD1120

        Company execs are by and large extremely prone to confirmation bias and overconfidence. In that sense, buybacks are often a poor use of capital – on that we agree. As an investor, I prefer dividends to buybacks almost universally.

        I think our disagreement stems from a rigid view that markets are always efficient, in an infallible sense. I do think markets are efficient, probably most of the time. However, opportunities to capitalize on inefficiencies certainly exist, particularly at market extremes.

        • I don’t think markets are infallible, I do think they are efficient. There is a difference.  Efficient markets mean that the price you see on a share of stock prices in every bit of public information that the market knows about the company.  

          Fama is correct, markets are efficient. 

  • Ar

    Is it insider trading if the company knows what it may do in the future, and accordingly performs a stock buyback?

    • No, because they file all that stuff with the SEC and it’s transparent-but you asked an excellent question.

      Insider trading generally happens when a company insider tells an outsider about material developments before the rest of the market knows that they are happening.  

      Only way you can beat the market is if you have more info. 

  • Guest


    • updated. the other thing I might say is tax rates are different for funds holding the stock, individuals holding the stock, and other companies that might be invested.

    • point well taken and covered in the UPdate. But, the principles are the same.

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  • Tomhynes

    At UVA business school, I was taught that, absent taxes, there is no difference between buybacks and dividends. You haven’t articulated one either. If management is going to give itself options, it will do so whether it uses dividends or stock buybacks. 

    Absent taxes, and investor an always change a dividend into a stock buyback and vice versa buy buying  or selling the stock.

    • I wasn’t taught either.  I think there is differentiation in academic circles.  There is a huge difference in the perception of who’s money it is.  Corporate cash isn’t the corporations money-it’s the shareholders money.  

      • Tomhynes

         “Corporate cash isn’t the corporations money-it’s the shareholders money.”
        Legally, it is the corporations cash, the same as all other corporate assets. Do you mean “I would prefer it if corporations should distribute excess cash to the shareholders”?

        What exactly is the “differentiation in academic  circles”? What is the different perception?

        • No, the cash belongs to the shareholders.  Management is just the caretaker of it.  Think about what happens in bankruptcy.  Accounts Payable get paid, Bondholders are paid, assets liquidated in some manner and then all the cash that’s left over goes to the shareholders.

          Differentiation-if you search the internet, you can find studies in favor of buybacks, and in favor of no buybacks.  I think it depends on your philosophy.  Isn’t that the same as Keynesian economists arguing with classical economists?  Who has been more consistently correct?  Classical for sure.

          I think the same logic applies to buybacks.  Companies that buyback shares mostly do worse, not better than the market. 

  • Aussie Pete

    Australia has a system of dividend imputation. When a dividend is paid to a shareholder it is “franked” and the amount of franking is deducted or offset from the shareholder’s assessable income. This avoids the double taxation of dividends. For a full explanation consult your international tax planning expert.

  • Dombrunone

    Not all buybacks are created equal.  Look at the number of outstanding shares of ExxonMobil.  It has dropped over 400 million since the XTO merger.  The shares used to purchase XTO were not new issues, but were stock buybacks over the previous 8-9 years, at an average cost of ~$50/share.    The shares used to acquire Mobil in 1999 were buybacks also.

    Is their growth being restrained?  Well, YES, to some extent, by a socialist government, and by other countries who own the national oil companies which are their main competitors.

    EM has raised their dividend for each of the last 24 years.  This year they have a large capex program. Other free cash flow is used for stock buybacks.  When part of an overall business plan, share buybacks can be a profitable means of adding value.  Dividends are double-taxed, but buybacks are not.

    • you are talking about M+A and the various math equations around it.  I am talking about a straight buyback.

      In M+A, many times a buyback is used to set a price so the market can find transparency.  In that case buybacks are useful.  

      They are a waste of capital if just a straight buyback. Investors should be outraged.  It’s their money.

  • A buyback is better than a dividend, because once you start a dividend its costly to lower it.  Whereas you can get rid of that cash with a one time buyback easily.

    • I mean costly in terms of signaling. 
      I’m trying to play the devil’s advocate here.

      • What if the company declares a one time special dividend?  Market will price accordingly.

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