US share buybacks are near record levels in absolute dollar terms and incrementally the discussion has shifted from academic finance journals to political stump speeches. Given the impact of the 2018 tax cuts and the upcoming 2020 US Presidential election where some are pushing for a reset of the form of American capitalism. Proponents argue that buybacks optimize capital allocation for companies unable to invest at a higher rate of return than its cost of capital, particularly when agency costs exist between corporate management and investors. On the other side of the argument, opponents of buybacks, however, contend that they are shortsighted and lead to less innovation and investment, suppress job growth and exacerbate income equality.
While we acknowledge that companies with large share repurchases do invest less, our findings suggest that the US economy does an efficient job at recycling share repurchase capital into venture capital and private equity that get investment into the most innovative hands that seldom are big, mature megacap firms. Private equity and venture capital firms have raised $2 trillion in this decade, an unprecedented amount in the history of the money management industry. Those firms have made total investments of $5 trillion, an amount that far outweighs the retained earnings of public companies. This has had a meaningful impact on innovation and growth of the US economy as we unambiguously observe that capital works its way into the highest returning public companies across the economy over time, whereas in Europe trapped capital in low return businesses has been a disadvantage to capital allocation, and presumably economic growth.
Beyond ideological posture, the additional agency costs of buybacks are dictated by a company’s leverage, growth opportunities, and capital allocation track record. Companies that have an incremental above cost of capital return opportunity set for investment should indeed invest organically. M&A gets a little trickier as it destroys incremental shareholder value more often than not. However, intrinsically if M&A can achieve a high return, then that would also be an appropriate use of capital; management history of success is very important here. If growth opportunities do not exist, then cash should be returned to shareholders if shares are undervalued and leverage is at a reasonable level. If shares are fair-to overvalued, and leverage is okay, then dividends are the best policy.
Finally, when a company executes a share buyback, the share price paid greatly matters to remaining public shareholders. Companies tend to buy back more shares when profits are at peak levels, which often coincides with peak valuations – this does not serve investors well. We question whether management teams and boards of directors perform or expect the same level of planning and analysis for share repurchases as they do for other forms of capital deployment, such as capex, R&D and M&A.
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