Buybacks are Keynesian

Posted by Jeff Carter
on September 30th, 2011

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.

UPDATE

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!

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.