The Logic and Morality of Share Buybacks
Commentary from the CNX executive team.
July 11, 2023
By Nick Deiuliis and Yemi Akinkugbe
In 1982, the SEC, under President Reagan, reinstated share repurchases to the American public corporation capital allocation tool kit with Rule 10b-18 of the Securities Exchange Act. Every year since, the criticism of this crucial capital allocation option from the anti-business Left and the populist Right has grown more strident. Yet corporate business leaders will be hard pressed to find a more effective and moralistic approach to capital allocation than share repurchases, when executed at the right times by applying clinical math.
President Biden, in his 2023 State of the Union address, attacked corporate share repurchases and proposed “quadrupling the tax on corporate stock buyback” to punish the practice. President Trump was a critic of buybacks prior to President Biden. Senator Elizabeth Warren calls share repurchases “nothing but a paper manipulation” and criticizes corporate executives who utilize the tool. Senator Bernie Sanders proposed introducing a bill that will prohibit corporations from performing share buybacks unless certain conditions are met.
It seems as if the whole of government these days aims to dictate and micromanage corporate America’s capital allocation decisions. The justification proffered is the popular, yet false, premise that stock buybacks necessarily lead to significant declines in business investment. How ironic that the anti-business crowd criticizes the tactic of share buybacks because it reduces… business investment!
Unfortunately, there are more than a few influential academics and Wall Street leaders who obligingly echo politicians when attacking share repurchases. The CEO of the largest financial institution in the world once stated corporate leaders needed to be on guard against practices “to deliver immediate returns to shareholders such as buybacks…. while underinvesting in innovation, skilled workforce, or essential capital expenditures to sustain long term growth.”1
Repurchases the Right Way
Like most things in life, how one assesses share buybacks and the timing and transparency of them matter greatly. The goal of share repurchases should be to perform them in a way and during a time when the capital allocation decision increases the intrinsic per share value of the corporation for the remaining owners.
The formula for achieving such a goal is surprisingly simple.2 The board and management of a corporation should have a refined view on the intrinsic valuation of the business, one that reflects the long-term cash flow generation expectations expressed into a present value on a per share basis. That view should be methodically updated and refined as conditions and strategy change.
Publicly traded corporations can then compare that internal view of the value of the business to the current share price of the company. If the share price is at or exceeds the internal per share value view, then share buybacks do not represent a value-adding capital allocation proposition at that time and should be avoided. The time is not right.
But if the company’s view of its per share value exceeds the current share price by a significant margin, the opportunity exists to deploy free cash flow into share repurchases, and by doing so, leave more per share future value of the business to the remaining owners.3 Running this clinical math highlights periods of time when share buybacks make tremendous logical sense.
A properly executed process for assessing share repurchases means there will be times when buybacks should be declined and times when they should be eagerly pursued without risking the balance sheet. The math dictates the timing. When the process and decision filtering are consistently adhered to over the long term, share buybacks can prove to be the most effective of capital allocation tools.
The Morality of Share Buybacks
The great economist Milton Friedman succinctly stated, “there is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game...”4
There are many tactics managers must apply at different times to achieve Friedman’s view: investing capital into the assets of the business, paying top talent to incentivize performance, building a strong balance sheet, and taking the long view of local communities that are core to the business by nurturing economic and social progress. Share repurchases, when applied clinically, can be as effective as these other tactics.
Following Friedman’s view and utilizing share repurchases under the right approach is not greedy, immoral, or wrong. It is morally just because of four reasons:
- First, note who benefits when a corporation maximizes its profits through share repurchases at the proper times: the shareholder owners. Which include pensions (and their retirees and active workers), mutual fund investors (aka 401k owners), mom and pop investors, and nonprofit foundations. Sure, executives will stand to benefit by the proper application of the share repurchase tactic. But that is the essence of pay-for-performance and it places the business leader in the same shoes as those stakeholders who own the company.
- Second, share buybacks are the ultimate expression of the individual investor’s freedom of choice. Even though the initial decision to repurchase a share starts with the corporate management and the board, the transaction is not consummated until an owner decides to sell the share back to the company. It is the ultimate exercise of a free market transaction. Those owners not wishing to sell are free to hold on to their shares and end up owning a larger piece of the corporate pie. Owners looking to exit the investment have a willing buyer, the corporation itself, ready and able to transact on the other end. Each owner is ‘free to choose’ (to borrow another line by Dr. Friedman).
- Third, share repurchases when done properly do not reduce investment in business. To the contrary, they grow investment in business and the economy. Owners who decided to sell shares back to the corporation are now able to redeploy their investment into whatever venture is compelling and in need of capital. And owners who hold their shares now enjoy a larger piece of future profits from the corporation, creating higher net worth to invest and stimulate the economy further. And the corporation should realize improved valuation and investment prospects as the market begins to reflect the business’ true intrinsic value over the long term.
- Last, a proper process for share repurchases forces management and boards of public corporations to take the long view and shun the short-termism and herd mentality that plague the public capital markets. Advocates who understand the power of effective share buybacks learn to bask in times when Mr. Market misunderstands the future prospects of the business and wrongly devalues the stock. That is not a short-term problem to an effective capital allocator; instead, it is a long-term opportunity to grow the intrinsic per share value of the business.
If you doubt the case for share repurchases under the right circumstances, consider the view of the Oracle of Omaha.
Warren Buffet in his 2023 shareholder letter pushed back on share buyback critics when he said, “When you are told that all repurchases are harmful to shareholders, to the country, or particularly beneficial to CEOs, you are listening to either an economic illiterate or a silver-tongue demagogue (characters that are not mutually exclusive).” Buffet knows a thing or two about capital allocation, and investors would be well served to heed his advice.
Shun the Shrill Ideology and Embrace the Clinical Logic
Yes, the tactic of share buybacks can be poorly applied and end up harming a business.5 Yet that risk is present in all tactical business decisions and, frankly, most life decisions.6 A risk of getting share repurchases wrong does not make it immoral nor should it be grounds for limiting the ability of corporations to perform it or for investors to benefit from it.
Like many other religious tenants of the modern-day Left and, often, the populist Right, the attack on share buybacks is based purely on dogma bordering on an extreme religion. The belief that capitalism, business, and profit are unethical. That the individual company or investor should not be free to decide for themselves. And that meritocracy and survival of the fittest are to be avoided in the market.
Instead, too many politicians these days demand that government and the unelected, faceless bureaucrat should determine capital allocation decisions, along with selecting winners and losers in a stacked game. The individual, whether it be a company or investor, is subservient to the political and ideological whims of the elite and expert classes.
That belief system is more 1960s East Germany than the American legacy of a free market. If you wonder which is preferable, ask yourself which side of the wall Berliners risked their lives to end up on.
We should shun rigid ideology that limits the freedom of individual investors and that constrains the free market to optimally allocate capital. Embrace the morality and rationality of share buybacks when done right.
1 Larry Fink Annual Letter to CEO’s April 2015.
2 A fantastic book on the topic of effective capital allocation and the power of share repurchases when done right is Will Thorndike’s The Outsiders.
3 What constitutes a ‘significant margin’, or adequate margin-of-safety, is quite subjective and will rely on the judgment of the manager or director running the corporation. Yet such subjectivity will be present in all major business decisions for corporations, from M&A to capital expenditures into the going concern asset base.
4 Give a read online of Milton Friedman’s “A Friedman Doctrine: The Social Responsibility of Business is to Increase its Profits”, from New York Times Magazine in 1970.
5 The two most common mistakes when applying the tactic of share buybacks are placing too much debt stress on the balance sheet (borrowing to buy back shares instead of using free cash flow) and repurchasing shares when the stock price does not offer a substantial discount to the intrinsic value (or margin of safety). The former does not appear to be a widespread phenomenon, as the MSCI All Country World Index of Debt Issuance vs Buybacks shows little-to-no correlation between buybacks and debt issuance. The latter is a much more common error, with Warren Buffet commenting that, “American CEOs have an embarrassing record of devoting more company funds to repurchases when prices have risen than when they have tanked.”
6 A person stuck in a bad marriage does not mean the institution of marriage should be vilified by all. A badly timed investment in a small business should not serve as justification for shuttering entrepreneurship. The same logic should apply to corporate share repurchases.