This is an abbreviated version of an article from Without Objection. See the full version here.
A popular critique of last year’s tax reform bill is that most of the benefits went to Wall Street instead of Main Street. Instead of re-investing capital into growth projects or wage increases, corporations directed tax savings, in many cases, towards re-purchasing their own stock.
To be fair, plenty of legitimate criticisms of the GOP tax bill exist, but the increasing number of stock buybacks is not one of them. The argument against share repurchasing is often exaggerated and assumes that corporate strategies are based on political cycles rather than business cycles.
Back to basics
Before diving into this debate, we should first agree that a market-based economy does not guarantee positive outcomes, though it does produce widespread benefits over time. Our expectations of corporate behavior should follow similar logic.
Corporations, the culprit of the criticism, exist within the economy to maximize shareholder value. But achieving this goal comes in all shapes and sizes. Timing is everything. As business conditions change, the methods corporations use to achieve this goal will vary.
Corporate strategies are rooted in fundamentals, which sometimes requires patience. If the argument is purely that tax cuts should result in immediate growth in order to be effective, then maybe the critics are right. But I would argue immediate capital investment was never the expectation (regardless of how the bill was messaged by the White House and Congress) and isn’t necessary to realize value from the law.
Lower tax rates have already boosted project economics for many companies, giving some corporations the rates of return necessary to move forward with investments. In other cases, they’ve provided the buffer necessary to remove burdensome debt off their books, which enhances a company’s overall value.
Other benefits take longer to surface. Healthy companies build strong balance sheets through disciplined budgeting rather than reckless spending. Capital spending and R&D budgets benefit the most when they are targeted, high-value investments. These can take time to get right. When they do, hiring ensues and the innovation and enhancements to products and services ripple across the economy.
Market cycles are just that – cycles. Not the “new normal”
The criticisms of share buybacks don’t take into account that markets are cyclical. It would be concerning if the practice dominated corporate behavior into perpetuity. But tactical methods like this are more seasonal than they are permanent.
Market dynamics are constantly changing. Growth conditions will return and necessitate capital investment, though the timing of this will be different across industries and strategies. Corporations will either respond accordingly or suffer the consequences of failing to keep pace with competitors that gear up to meet consumer demand.
The oil and gas industry is a prime example of a cyclical industry. You’re probably familiar with the more famous cycles, but here’s a more subtle one:
Since Q2, the markets have held public oil & gas companies (with exposure to US onshore unconventionals) accountable for how “disciplined” they are with their earnings. Investors are skeptical as to whether they can turn unconventional drilling opportunities (shale, “fracking,” et al) into profits, particularly in this volatile geopolitical environment. So they’ve favored companies who have re-purchased shares, resulting in a corresponding share price boost (to maximize shareholder value) while punishing those who deviate from this strategy via aggressive capital investment programs. Eventually, more investment into exploration and production will have to occur in order to fill the gap between supply and demand. But for now investors are keen for companies to hone their expertise and processes before accelerating growth.
Buybacks are only a subset of the larger picture
Even if we assume the criticism of buybacks is valid, the impact is exaggerated.
The scale of share buybacks is necessarily relegated to public companies listed on stock exchanges. While over 3,500 public companies exist today, there are over 7 million private companies, far outpacing the number of companies able to re-purchase shares.
What’s more, according to a recent Harvard Business Review article, S&P 500 companies account for less than 50 percent of business earnings and less than 20 percent of employment. This means, of course, that the balance of earnings and associated investment war chests comes from privately held companies.
Don’t get me wrong, public corporations still play an outsized role in the economy. But putting it in perspective should temper the criticism against the practice of share buybacks.
It’s not just the wealthy who benefit
When a company re-purchases shares, it reduces the number of shares available in the market. This concentrates the company’s value in fewer shares, which naturally boosts the overall value of each individual share. In this way, buybacks enhance the financial position of shareholders.
So who are these shareholders?
Well, according to a 2016 Gallup study, over 50 percent of Americans held stocks in 2016 (a low point since the survey began in 1998). This equates to more than 164 million people. For comparison, the top 1 percent would only be 3.2 million people. Moreover, roughly 35 percent of shares were held by middle class Americans, according to the study.
What’s more, a great deal of the shares are held by institutions that represent wide swaths of Americans, most notably those holding 401(k) plans and pension plans that serve as public retirement fiduciaries for our teachers, first responders, and civil servants. These won’t get counted in surveys, because they’re representation is aggregated at the institutional level under very corporate sounding company names. But they are most certainly beneficiaries in a big way.
We shouldn’t blame CEOs either. Less than 3% is owned by corporate management teams. Not only is this a minor share of the total, it’s a good thing for management teams to have skin in the game. Otherwise, there’s no incentive to deliver on performance and growth targets that shareholders demand.
The flip side is important too. It’s true that wealthy individuals and private equity firms do hold corporate shares and could benefit financially from corporate buybacks. But this is a positive, because the cycle doesn’t end there. What are we assuming beneficiaries do with their boosted income? If they’re savvy investors like most would presume, they’re likely reinvesting earnings into other companies – public and private – that need the equity injections to fuel future growth and development that spur job growth and innovation.