From the hazy, notoriously myopic perspective of Wall Street, short-term performance is put on a pedestal. The long-term is an abstract concept nowadays, and quarterly scrutiny puts pressure on company executives to perform or be replaced.
Enter stock buybacks, a tailor-made tool many public companies use for getting cash off the corporate balance sheets and into the hands of shareholders. By repurchasing its own shares on the public markets, buyback plans provide guaranteed short-term demand for the company’s stock, giving shares an upwards bias.
Sounds like a pretty sweet deal in theory.
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However, all too often the risks of stock buybacks, the motivations behind them, the way they’re conducted and their long-term consequences aren’t taken into consideration. In fact, they’re often the wrong move altogether.
There are more than a few reasons why.
Timing. One glaring problem with stock buybacks: If they occur when shares are massively overvalued, it actually destroys shareholder value instead of creating it.
“If a stock is selling at an all-time high and a huge valuation premium to the market and similar stocks, a buyback does not really make any sense,” says Jim Wright, a Covestor portfolio manager and chief investment officer of Harvest Financial Partners, a registered investment advisor in Paoli, Pennsylvania.
Steven Fazzari, professor of economics at Washington University in St. Louis, says some companies may think that they can time the market and buy shares back when those shares are undervalued.
“But I am skeptical of a firm’s ability to time the market systematically,” he says.
Sure, company executives should know more about the state of the business and the true value of the firm’s stock than the public. Still, only a handful of investors have been able to routinely earn market-beating returns over long periods of time; by no means is timing the market a walk in the park — even for companies themselves.
Opportunity cost. Excessive buybacks can indicate the age of innovation and growth is over, says Nandkumar Nayar, a finance professor at Lehigh University.
“If the management of a firm thinks that the best use of the company’s money is to buy back its own stock, this may be a signal that organic growth of the company’s business” is exceedingly low,” he says. “The firm also has given up money that could have been used to enhance the company’s operations through increased CAPEX investment, R&D, etc.”
One such example is Eddie Lambert, the chairman and CEO of Sears Holdings Corp. (ticker: SHLD) since 2013. When Lampert took over Sears, “he was thought to be the next Warren Buffett,” says Yale Bock, a Covestor portfolio manager and president of Y H & C Investments in Las Vegas.
But Lampert’s capital allocation decisions since taking the reins show that isn’t the case. Lambert “used capital to buy back an enormous amount of stock without investing in his retail stores in a productive, efficient, or effective manner,” Bock says.
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That led to problems. “Consequently, the store base has been neglected and numerous locations and business lines have been shut or sold,” Bock says.
At the end of the day, stock buybacks are somewhat of a conundrum. Would you really want to invest in a company that had few avenues of growth other than artificial financial manipulation? On the other hand, if there are better investments to be had, buybacks are a waste of money.
But the difficulties don’t end there.
How are they financed? Buybacks become even more complicated when companies repurchase their shares with debt, which is a double risk.
If the company has the cash flows to cover loan payments going forward — and is certain the stock price will appreciate at a rate higher than the loan’s interest rate — it can make sense. But it’s nearly impossible to know both parts of this equation.
“If the company takes on huge amounts of debt to finance the buyback, then the leverage levels of the firm may cause financial distress in the future, harming the stockholders who remain,” Nayar says.
Conflict of interest. Public company executives are supposed to work to maximize shareholder value. Often, however, they can be incentivized to maximize the value of their own bank accounts. When executive bonuses are tied to reaching certain earnings-per-share benchmarks, management will be incentivized to buy back stock even if it’s not in the best long-term interest of shareholders.
Adding insult to injury, executive bonuses tied to EPS are often paid in newly issued shares. This counteracts the buyback by putting more shares on the market, and if executives decide to cash out it puts downward pressure on the stock.
So, are stock buybacks evil?
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Not by a longshot. If there’s plenty of cash on the balance sheet, there aren’t better investment opportunities, and/or if the stock is trading at a huge discount to its intrinsic value, buybacks are a good idea. But the sheer number of ways they could end up coming back to bite shareholders make them a risky proposition.
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Why Stock Buybacks Are Often a Lousy Idea originally appeared on usnews.com
