Is There a Problem with Stock Buy Backs?

Is there a problem with stock buybacks or are stock buy backs always bad?

The standard answer is no, there is a place and time for stock buybacks. The problem with a lot of recent stock buybacks is that a lot of them were not done following what I would call the ‘old standards’ on when to do them and were mainly done with the objective of boasting the stock price by reducing the number of shares to boast the earnings per shares. i.e. Less shares for the same amount of earnings means higher earnings per share. The hope was that would cause the price of the stock to rise as a result.

A typical company, especially large ones that have been in business for a long period time, are usually profitable. The company then has to decide and see what to do with its profits. In the past there was an expected order or priority as to what to do with the profits in the following order of logical priority:

1: Save enough cash to last through the next expected downturn.
Companies would make sure there would be enough of a combination of cash plus available borrowing to make sure the company would be able to survive the next recession. Some companies, especially cyclical companies like car companies or heavy industry concerns, would have a plan in place as to what to do when sales started to drop in order to be able to ride out the next economic downturn.

2: Make sure all needed capital spending needed to maintain sales and profits is made. After the company has enough cash saved or available to make it through a recession, a company needs to repair and replace all equipment needed to maintain sales and profits. Without such spending, the companies’ tools, equipment and machinery will simply wear out and their employees will be unable to do the work needed. While companies can put off replacing equipment for a few years, eventually all machinery will break down and be unrepairable, equipment will wear out and completely break leaving workers unable to do work the company needs done. As such, while capital spending can be put off for a few years, it does not ‘go away’ and will eventually have to be spent, maybe in an emergency situation after revenue is lost.

3: Expand operations, invest in new products, research and development for the future; in short, investments in future revenue and profit. Once a company has taken care of a reserve of cash to survive a downturn, and made sure that its equipment is all in order and working, the company can take a look at expansion for the future. As long as the expected long term return on new project, no matter what it is, exceeds the long term cost of financing, then the company should take on and fund new opportunities to increase revenue and profit.

4: Return funds to the shareholders.
Once all of the above three items are done; cash saved for the next economic downturn, done needed capital spending, invested in new opportunities that the profit will exceed the cost of financing; THEN the company should look at distributing PROFITS to the shareholders and decide how to do it. One very important item to note, is that this distribution to shareholders should only be done with PROFITS from the company, NOT from borrowing.

There are two methods to deciding how to distribute profits of the company to shareholders; share buybacks or dividends.

The more ‘tax friendly’ option is a share buyback since the profit on shares held for more than one year would be typically taxed at the lower capital gain rate instead of the margin income rate for the shareholder. The disadvantage of a share buyback is that for a shareholder to get any cash they would need to sell some of their shares, which if done all the time, would result in the shareholder having no more shares. The company could partly offset this problem by doing a stock split from time to time, especially if the price of the shares are rising. In this way, the shareholder could sell a few shares from time to time to get cash but would get more shares that would enable them to sell off a little every once in a while. (It is also possible that a shareholder could use the shares for a margin loan but that is not a good idea since now you have to make sure the shares do not lose their value or you will have to repay the loan.)

The other option is that the company can pay dividends to the shareholders from the company’s PROFITS. Note that I put profits in capital letters since if a company is not generating a profit it should NOT be paying out dividends or doing share buybacks since it would need to be borrowing to make the payments. Borrowing to make payment does not make any sense. People are investing in companies because they want to invest in a business for the future, they are NOT looking to be repaid with, in effect, their own money that put into the company to finance it. i.e. If there are no profits, the company is paying out money borrowed from everyone financing the company, which is NOT the reason people invest in companies.

While a number of companies in recent years are having problems because they made large share buybacks with borrowed funds, most of these companies can work their way out of their situation over the course of several years. As long as they are making a profit, and stop payments to shareholders that are not made from profits, these companies will improve as time goes on, be able to build up a cash reserve, do all needed capital spending, invest in new opportunities and then start to make distributions to shareholders from profits.

It will be a long road for many companies, such as GE, GM or IBM, but it can be done as long as they are making a profit and over time things will improve dramatically.

Good Luck and Take Care,

Louis J. Desy Jr.
Wednesday, November 28, 2018