William Lazonick makes the case against stock buybacks in the latest issue of BusinessWeek. In his article “The Buyback Boondoggle“, He argues that companies spend huge sums of money on buybacks that they could have invested in innovation and employment. From the article:
The amount of money spent on buybacks is staggering. From 1997 through last year, 438 companies in the Standard & Poor’s 500-stock index spent $2.4 trillion on them. In 2007, as profits soared, the average buyback bill for each was about $1.2 billion—a record amount. And faced with a dramatic drop in their combined net income in 2008, these companies trimmed buyback spending, but not proportionately: The buyback-to-profit ratio, which was already unprecedented in 2007, more than tripled in 2008, from 0.90 to 2.80.
He further observes that buybacks helped weaken major American firms to the point that they required government bailouts when the economy deteriorated:
If bailed-out General Motors (GM) had banked the $20.4 billion distributed to shareholders as buybacks from 1986 through 2002 (with a 2.5% aftertax annual return), it would have had $35 billion in 2009 to stave off bankruptcy and respond to global competition.
And the bailed-out banks? Eight of the biggest spent a total of $182 billion on buybacks from 2000 to 2007. That reduced their ability to cover their bets on derivatives, exacerbating the crisis they created in the first place.
At the heart of the issue is the conflict of interest between shareholders and management, on one hand, and other corporate stakeholders such as employees, customers, suppliers, local communities, and nations, on the other. Shareholders have limited liability, so they can profit by extracting as much money from companies as possible during good times, even to the point of taking on debt to pay dividends–a common private equity practice. If the companies subsequently go bankrupt, the shareholders have already pocketed their profits. The greater the likelihood of bankruptcy, the greater the incentive for shareholders to take money out.
A more subtle problem is that shareholders have difficulty quantifying and verifying the value of long-term investments, so they prefer short-term investments or cash distributions. Thus managing for shareholder value becomes managing for the short term, leading to underinvestment in innovation, human capital, and organizational capital.
As Lazonick points out, executive compensation in the form of stock shares and options create incentives for senior managers to buy back shares, since buybacks both distribute cash to shareholders and increase demand for shares.
In the article, Lazonick proposes banning share buybacks, but this won’t solve the problem of short-termist incentives embedded in executive compensation linked to stock price. So how about limiting the value of stock grants and options to 5% of base salary for employees of publicly traded companies?