5 Foolish Reasons Stock Buybacks are Bad

Are stock buybacks bad? Some politicians have targeted buybacks but are sadly misinformed. There are better solutions to the problems they’re trying to solve. And to understand why buybacks aren’t bad, let’s start with a simple question…

Are sidewalks bad?

If you’re a politician or lawyer, you might answer yes. You might get some votes or money out of it. But for the rest of us, I hope it’s a resounding NO. Sidewalks aren’t bad… sure, there are murderers that use them and some sidewalks are in need of repair, but should we ban all sidewalks for everyone?

When there’s a problem, it’s usually better to fix the source of the issue…

Why are Stock Buybacks Bad?

Stock buybacks were illegal up until 1982. Regulators considered them a form of stock price manipulation. And this is just one of many reasons people think stock buybacks are bad. Let’s look at five of the top arguments against buybacks…

1. Buybacks can Manipulate Stock Price

When a company announces a large buyback program, it can easily move share price. But this is true for any big capital allocation decision. It’s unavoidable and the real problem is if insiders trade on the information before it’s public knowledge.

… but insider trading has been illegal since 1934. So if the SEC is doing its job well, no worries here.

2.  Misaligned Executive Compensation

Some CEOs and other executives have compensation tied to per share valuation metrics such as earnings per share (EPS). And since buybacks reduce total shares outstanding, they can boost EPS and in turn, executive compensation.

Simple solution here… the board of directors can stop rewarding this behavior. Don’t attach major compensation to malleable short-term metrics. Or at the very least, if there is stock based compensation, have a long vesting period and staggered exit. If an executive tries to juice their short-term earnings, it will hurt them longer-term.

3. Stock Buybacks Limit New Investment

There are lots of flaws with this argument. But here’s the only counter argument we’ll need… when you add restrictions to the flow of capital, you limit its ability to go where it’s treated better.

In a study by the Tax Foundation, they found that buybacks don’t displace long-term investment, and in some ways, even support it.

Companies that have large buyback programs are often mature in their industries. They can’t reinvest the money with reasonable expected rates of return. So they give it to investors through dividends or buybacks. The investors can then determine what to invest in next – after paying capital gain taxes.

4. Tax Advantages from Stock Buyback Make the Rich Richer

Buybacks don’t magically eliminate shares. There’s an investor at the other end who has to pay taxes if they have a gain. And for investors that keep holding on, they will have to pay more in taxes if the buybacks do in fact end up boosting the company’s valuation over the long run.

In a 10-year bull market, of course the rich get richer. But during the next recession, the rich will lose a lot more of their wealth than non-savers… but I doubt we’ll see those headlines.

5. Financing Buybacks with Debt

The Fed has artificially pushed down interest rates. This has caused companies to leverage up and some have financed buybacks with debt. This is similar to leveraged recapitalization. And it isn’t inherently bad. Although, many companies buy back shares at high valuations.

Borrowing from future cash flows and paying a premium for shares isn’t a good move. But this shouldn’t be a valid reason for doing away with buybacks. Let investors decide if executives and board of directors are making bad moves. In my mind, it’s a red flag if a company announces a big buyback program when its share price is looking lofty.

Make Stock Buybacks Illegal Again?

No. See logic above… and if you think you have important points I’ve missed, please comment below.

Final Thoughts

If you co-owned a business, shouldn’t you be able to decide where your profits go? If you want to buy out another investor’s stake, you should be able to do that.

Stock buybacks are not bad. They’re just another tool in the financial tool belt.

History has shown that free markets via capitalism have been one of the best systems to advancing humanity. Although, I admit capitalism still has plenty of flaws, some of which I cover here: Why Socialism is Great in Theory but Terrible in Practice.

With history as a guide, we should let investors determine who’s using their tools to create the most value. Because ultimately, companies that don’t create more value than they consume, will fail and cease to exist.

As an investor, I look for great businesses trading at attractive valuations. The onus is on me to determine if stock buybacks are bad with each company I invest in. Buybacks are not inherently bad.

I hope you enjoyed my research. And if you enjoyed it or learned something new, please share the article or your thoughts in the comments below. I read every comment 🙂

Invest mindfully,

Brian Kehm

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  1. Financial independence December 4, 2019

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