Published on Dec 06, 2019 in The Index Fund Bubble
Last update: Dec 13, 2019
The strategy is simple. There are essentially four ways a company can allocate excess profits.
Executing #1 is the goal of every CEO, but sometimes there just aren’t any good investments to make. Or the CEO isn’t skilled enough to see those investments and take the calculated risk.
It’s becoming more and more common for executives to shy away from reinvestment because they are afraid of making bad investments. One bad investment can ruin their reputation and career. And in the end, they really only need to hang on to their job for 3-5 years before they become independently wealthy.
Returning money via a dividend is a strategy that seems optimal if there aren’t good places to reinvest, but the problem is that this is a taxable event. Shareholders pay their marginal income tax on dividend income, which for some people can reach >50% with federal, state, and local taxes. This is especially true for wealth individuals, who own the majority of public stocks.
Many executives lucky enough to take the reins of successful companies have historically decided to sit on a lot of cash, waiting for the day they’ll find the perfect opportunity to reinvest. But cash in the bank makes almost no return and secretly the executives probably don’t ever plan to use it. They’d rather rake in their guaranteed bonus/salary year after year than take any unnecessary risk, even if it’s in the best interests of the company, shareholders, and the economy.
So #1, #2, and #3 are all non-optimal. What about #4, buying back shares?
Share buybacks are the golden ticket. Companies can buy their own shares off the public markets, which reduces the total number of shares in circulation. That means that the cashflows from the company will be split fewer ways each quarter when dividends are paid. This almost always leads to a stock price increase proportional to the share buyback so that the dividend yield is equal to what it was before.
And the best part about share buybacks… They aren’t taxable events!
When you own shares in a company that buys back shares and the stock price of those shares goes up, you don’t pay tax on the gains because they aren’t “realized.” You’ll only pay tax if you sell. And many wealthy people have learned that it’s best to never sell.
Think about what this tax situation is incentivizing. You have wealthy people all across the country telling corporate executives to buyback shares because it’s (a) tax free and (b) a guaranteed outcome.
Share buybacks make almost no contribution to the economy—it mostly benefits the rich who own significant shares of public companies. Of the four financial allocation choices outlined above, share buybacks are best for shareholders, but worst for employees and the general economy.
Do you want to hear a staggering statistic? In 2018 share buybacks within just the S&P 500 companies outpaced research and development investments in the entire US. This feels backward to me and very “bubbly.”
Famous investors like Buffett and Singleton made share buybacks famous because they’d wait for share prices to be “below intrinsic value” before they bought them.
The stock price of a company fluctuates randomly based on the news, investor sentiment, etc. These legendary investors made lots of money by waiting until the confluence of these factors led to what they believed was a depressed share price. Essentially, they were buying their own shares at a discount.
As the 10-year bull market has raged on, we’ve seen company after company buyback shares. And hey, it’s looked like a genius move so far. When everything is going up, any share buyback will look like it was executed below intrinsic value.
And that’s the problem—I think that a lot of these share buybacks have been done exceeding intrinsic value. Corporate executives are buying back shares left and right because that’s what their shareholders are telling them to do. The music will stop at some point when the market goes down and everyone realizes that many of the share buybacks were actually bad deals.
I talked about how corporate debt is at record highs in my first post of the Index Fund Bubble series. What makes what I call the “Share Buyback Bubble” even scarier is that many companies have used debt to repurchase shares. They weren’t in the fortunate position of needing to choose how to allocate extra cash. They had no extra cash. In order to appease shareholders, corporate executives have extended their tenure and inflated their bonuses by buying back shares with debt regardless of price compared to intrinsic value or long-term risk.
Keep in mind that corporate profits haven’t increased on a inflation-adjusted basis since about 2014.
The run up of the stock market that we’ve seen in the last few years can mostly be attributed to share buybacks and speculation (the average P/E of the S&P 500 is also at record highs)—not productivity or cash flow increases.
Share buybacks pose a risk to both investors and the economy, especially for holders of index funds.