We all remember the story of the three little pigs. The first little pig invests minimal time or effort and builds a house of straw, which the big bad wolf comes along and blows down. Excessive buybacks can be like building a house of straw, and today's big bad wolf is a global pandemic and its economic consequences.
In a buyback, a company goes into the market and buys its own shares at the prevailing market price from a willing seller and then retires those shares, reducing the number of shares outstanding. While buybacks are often associated with concerns about executive pay and income inequality, buybacks do not directly affect wages and compensation; a company's compensation plan and profit margins are the primary factors that drive pay outcomes.
It could be that companies are buying back their shares because they lack productive ideas for growth — and it is better for the economy to reallocate capital than to invest in unproductive ideas. In many cases, buybacks can help move money from businesses with plenty of capital to other areas of the economy — economic theory assumes those selling shareholders reinvest that capital into new opportunities with higher potential future returns. For example, if GM did a buyback, an investor might choose to sell their shares into the buyback and then take the proceeds to invest in Tesla.
While buybacks can encourage investors to move their money elsewhere, over-distribution of capital leads to a lack of financial flexibility for the company, which can create destructive short-term behavior, especially in a challenging economic environment. Recent research from FCLTGlobal shows that over-distribution of capital (defined as distribution of cash in excess of free cash flow) is a factor clearly associated with lower long-term value creation.
Analysis shows that distributions to investors (i.e. buybacks and dividends) in excess of free cash flow are associated with weaker return on invested capital (ROIC). Roughly 38% of global companies (MSCI All Country World Index) exceeded their free cash flows with issuances in 2018, and they underperformed their peers in terms of ROIC by 26%.
Dividends, like buybacks, are not a problem in their own right. In fact, many retail investors count on them for income, and dividend yield is an important investment consideration. While companies don't have contractual obligations to pay regular dividends, there is an implicit expectation that dividends will be maintained, and no company wants to cut its dividend blithely. Special dividends are similar to buybacks, although in the United States and some other countries, dividends receive less favorable tax treatment than buybacks.
Euro-zone banks tend to lean heavily on dividends, rather than buybacks, to distribute capital to shareholders. Last week the European Central Bank asked Euro-zone banks to freeze dividend payments in light of the coronavirus crisis, and Eiopa, the EU's insurance and pensions regulator, urged insurers to halt dividends and buybacks. Because banks need to lend to keep the economy going and companies need to have financial flexibility in this challenging environment, they cannot be like a house of sticks.
In the U.S. the much anticipated stimulus package requires companies that receive government aid halt buybacks and dividends. This will likely check certain industries where buybacks have run rampant, at least while they are getting assistance from taxpayers. While stronger than straw, companies that pay excessive dividends may also not be able to withstand the wolf at the door.
Buybacks and dividends can be conducted sensibly — the numbers show that strong companies maintain cash in excess of what they're distributing to shareholders. This gives them flexibility to expand, or in this case, to weather whatever's at the door. The third pig took the time and effort to build a house of bricks, and his house endures the wolf's huffing and puffing.
Apple paid a dividend in 1995 and did not issue another until 2012, the same year it instituted a buyback program. In that span of time it launched the iPod, iTunes, iPhone and iPad — all things that required significant capital investment. Microsoft didn't pay a dividend until 2003 — 16 years after it went public.
Like the tale, it seems unfair that those who are irresponsible and didn't plan for the future are bailed out by those who were more diligent and managed their risk well. While none of us predicted a global pandemic, we get this same feeling of inequity when we see companies that have over-distributed their capital seeking bailouts from governments, employees, taxpayers or companies who have been far more responsible. This excludes, of course, smaller private companies that have fewer means to prepare for such an event and that have been hit hardest by the pandemic.
Surprisingly, just 48% of the much maligned airline industry exceeded their cash flow with buybacks and dividends, according the MSCI ACWI from 2018. Companies in the railroads and trucking (72%) and electric utilities (71%) industries overdistributed their capital with far more frequency.
Governments and companies around the world are grappling with how to both manage through the current crisis and position themselves to grow and be resilient once the crisis eases. As policymakers and executives consider their decisions in this challenging time, we ask them to continually ask themselves: "Is this the right decision for the long term?"
In particular, decision-makers around the world could ensure that, like in the U.S., companies who receive aid do not overdistribute their capital — as a litmus test, having buybacks that do not exceed cash flow over a three-year period. This leaves the option open for companies that have managed their capital responsibly and preclude other firms from making expedient decisions that lead to being blown away by the next wolf at the door.
— By Sarah Keohane Williamson, CEO of FCLTGlobal, a nonprofit organization that develops research and tools that encourage long-term investing