With numerous problems in the world, it was a little surprising to see Senators Chuck Schumer and Bernie Sanders, state they will introduce a bill requiring companies to increase employee compensation before they can repurchase their own stock. They elaborated that their bill would require a $15 per hour minimum wage, seven days of paid sick leave and “decent pensions and more reliable health benefits” before allowing share buybacks.
I see why the senators attacked share buybacks—it is low hanging fruit in an era of increasing populism. Last year corporations spent a record $1.1 trillion buying back their own stock.
However, just because a lot of money was spent buying back shares, does this mean the government should dictate how private businesses allocate profits? Additionally, if we attack buybacks, why stop there? Should the government mandate a certain minimum or maximum dividend level paid by companies, too?
In consideration of this proposal, it is worth recognizing that the U.S. is not the only game. Corporations must be competitive across the globe. Even if the senators were successful in requiring these stringent requirements, companies outside the U.S. would not have to comply.
If the plan were passed the Law of Unintended Consequences would rear its ugly head as markets are highly competitive and capital flows where it is most efficiently utilized.
From this, expect certain outcomes. First, the cost to comply would be significantly higher for U.S. based companies. Domestic businesses would be distinctly disadvantaged relative to foreign competitors. Secondly, U.S. based companies would be encouraged to locate elsewhere in the world. This would result in employing fewer Americans and sending more capital outside our nation.
These points were also main components behind the lowering of corporate tax rates in 2017.
Regardless of the Schumer/Sanders plan, it is worth discussing why share buybacks are quite positive.
In running a company, management has a legal mandate to efficiently allocate capital. To deliver capital back to shareholders, a company has two options.
First, they can declare a cash dividend. Although the cash flow is nice, it suffers from double-taxation and cash received must be reinvested once in a shareholder’s hands. Secondly, a corporation may repurchase its own shares in the open market.
Conceptually, a buyback is no different than buying a partner out. Assume a company has 100 shareholders with each owning one share of stock. If the company makes $500,000 per year, earnings per share are $5,000.
Assume management finds their own stock to be the most attractive use of net earnings and at the same time 20 shareholders want to cash out. If the company buys back the stock, the company still makes $500,000. However, it is now spread over 80 shares—not 100. As such, earnings per share increase to $6,250.
Given this, share buybacks can enhance value for long-term shareholders and provide cash to those looking to sell. Additionally, unlike a dividend that is taxed twice, the earnings used in share buybacks are only taxed once. As such, a buyback delivers shareholder value with less taxation drag. When a company buys their shares in the open market, no one is forcing this transaction. Everyone is a willing participant.
It is unfortunate that certain elected leaders have called stock buybacks a tool of rich shareholders and greedy corporate executives that damages the economy and hurts ordinary workers. A buyback offers the same increase in value per share for any and all shareholders. Furthermore, whether you are buying or selling shares, everyone is a willing participant.
It is also interesting to note that buybacks have been championed by long-time Democratic supporters like Warren Buffett and Jamie Dimon.
Capitalism and corporate ownership are far from perfect—but it the best system we have. Corporate management must make intelligent investment decisions at all levels. This is true whether evaluating personnel, technology, machinery or share buybacks. If management only focuses on one facet, to the detriment of other key components, any company will become less competitive.
Regardless of what anyone says, capital allocation is extremely difficult. And the government has not proven to be effective allocators of capital. Knowing this, rarely will more government intervention deliver the desired results—especially without a variety of unintended consequences.