Public companies have two ways to deploy capital: through growth investments, such as capex, working capital, R&D, mergers and acquisitions, and by returning capital to investors via dividends and share buybacks (share repurchase). This week’s chart reveals that over the past two decades, dividend payouts were increasingly stable and share buybacks demonstrated more volatility.
The acceleration of stock buybacks has garnered more attention recently. Some politicians argue that stock buybacks have boosted stock prices by manipulating earnings per share (EPS), benefitted corporate executives at the expense of employees and shareholders and driven up leverage of balance sheets by financing buybacks with debt.
These worries stand to reason. Executive compensation is linked to EPS, which can be boosted by share buybacks. Stock buybacks can destroy shareholder value as well, as repurchases typically occur during a bull market when the valuation is higher. Even though most stock buybacks are financed with free cash flow, some companies may use net debt to finance buybacks while also cutting their tax bill. The concerns apply for some, but not all of the companies. Even though shareholder return has increased significantly in recent years, growth investment remains stable at about 8% to sales.
However, stock buybacks can be beneficial. I’ll illustrate this from three perspectives: buybacks’ impact on shareholders, companies and emerging companies.
Compared to dividend payouts, stock buybacks are a more efficient way to return capital to shareholders. First, share buybacks offer greater tax incentives for shareholders than dividends do. Investors who elect to sell their shares to the company only pay tax for the difference between the selling price and cost, whereas with dividends, the full amount is taxed. Second, share buybacks provide time value of money to shareholders, as they can defer tax payments until they sell the stocks.
Stock buybacks also offer more flexibility for corporations to distribute cash compared to dividends. Given increased competition, it’s hard for companies to generate predictable and solid earnings, so they tend to shift to flexible dividends in the form of buybacks. Consequently, the aversion to cutting dividends is more significant than pausing share buybacks. Stock buybacks also help with market liquidity as they increase the demand for stocks.
Additionally, stock buybacks are an efficient way to redistribute capital to emerging companies. Two kinds of companies usually engage in higher stock buybacks, with the first being companies in the late cycle since it is harder for them to generate high return through growth investment compared to younger companies. Investors can allocate capital to younger companies and generate higher return, making their investment more efficient and boosting the economy in the long run. The second type is large companies, which often hire well-educated, experienced employees who earn relatively high incomes. Investing capital in younger and smaller companies that hire less experienced employees helps to reduce income inequality in society.
A bull market and rising earnings will help boost stock buybacks. We have seen the acceleration of buybacks during recent years due to economic expansion and fiscal policies. Despite the drawbacks, stock buybacks may also benefit the economy in the long run. 2018 saw record-high buybacks, and I expect robust share buyback activities in 2019 as well.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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