Spurred by the allure of cheap debt, the stock market has all but ceased to be a mechanism for capital to be invested in public companies and has increasingly become a mechanism for capital to be extracted from them. As aptly summarised by the economist and author, John Kay:

‘As a source of capital for business, equity markets no longer register on the radar screen. In both Britain and the US, funds withdrawn through acquisitions for cash and share buybacks have recently routinely and considerably exceeded the amounts raised in rights issues and IPOs.’

For stock investors, it is important to ponder the impact on their wealth of this capital extraction. More particularly, the growing prevalence of stock buybacks – which has sparked a heated and sometimes fuzzy debate – must be considered carefully. Helpfully, this debate was addressed with customary clarity by Warren Buffett in his 2016 letter to Berkshire Hathaway shareholders:

‘Repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value. Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent. My suggestion: Before even discussing repurchases, a CEO and his or her Board should stand, join hands and in unison declare, “What is smart at one price is stupid at another.”’

The growing role of debt has been crucial. According to data from the ‘McKinsey Global Institute’, the outstanding stock of corporate debt globally has more than doubled since 2007. Within that growing debt pile, the global value of corporate bonds outstanding has more than trebled, more than doubling as a share of GDP. Importantly, the more recent rise in its cost has yet to have a significant impact on its growth.

While stock investors have certainly enjoyed a significant flow of dividends in recent years – notwithstanding the temporary disruption of the pandemic period – the surge in executed buybacks has also been striking. On the surface, this should be a positive for stock investors, but focussing on executed buybacks can be misleading.

More relevantly, the focus should be on net stock issuance. Although small relative to corporate investment, this has nonetheless been positive in every year since the market trough in 2009 with the single exception of 2013. Notably, while a large quantum of buybacks has been executed, share destruction has been non-existent at an index level. The historic need for equity may be fading, but public companies in aggregate have still been tapping stock investors.

As summarised by Buffett, for stock investors buybacks are not necessarily good or bad: most crucially, it depends on the price.

Furthermore, the Buffett comment implicitly assumes that management intent is at least positively aligned with the shareholder and that buybacks result in actual share destruction. But this assumption does not always hold, and it can prove particularly costly if the true motivation is financial engineering effectively designed to favour management and employees.

In contrast to the transparency and simplicity of dividends, buybacks can be opaque and complex. The following real examples – company names excluded – underline the complexity of buybacks, and the challenge of assessing their impact stockholders:

  • Stock A, a ‘good’ buy-back:

The company is buying stock from the open market. As can be seen from a close examination of the consolidated balance sheet, the company doesn’t hold ‘treasury shares’ and is therefore destroying the shares bought back.

  • Stock B, a ‘bad’ buyback:

The company, in 2017, bought back $2 billion of shares, but this program is used mainly to offset the issuance of shares for its incentive and remuneration program. In fact, deep in the notes, the company reports:

Between 2016 and 2017 the total number of shares issued didn’t change. The shareholders didn’t benefit from the buyback program, but at least the company mitigated the dilutive impact of the remuneration program. 

  • Stock C, a ‘questionable (arguably ugly)’ buyback:

The company reports: ‘During fiscal year 2017, we repurchased a total of 15 million shares for $739 million and paid $261 million in cash dividends to our shareholders, equivalent to $0.485 per share on an annual basis’.

Given the above statement shareholders may believe that they are getting rewarded from the dividend and from the share repurchase program. However, only the dividend element is returning value to them – the share repurchase program is used only to partially offset the dilutive impact of the new stock issued.

Digging deeper, it looks as if these new shares are largely the result of a convertible bond that had been exercised – a relatively common, if often overlooked event.

Stock buybacks have been a significant, and growing feature of stock-markets in recent years. Spurred by cheap debt, this accelerating capital extraction is not necessarily a positive development for stock investors. When funded precariously, done at the wrong price, and/or designed to reward management and employees, buybacks can be significant destroyers of investor wealth. To benefit from the good, and to avoid the bad and the questionable, a thorough analysis of price, funding, and execution, is always needed.