During the pandemic, there has been severe hostility to firms buying back their own shares, a practice only made legal in the UK in 1981. Opposition to stock repurchases is associated with allegations of ‘short-termism’, but there is little evidence to support such claims.
In the last three decades, stock repurchases have become a popular way of returning money to shareholders in the UK, the United States and continental Europe. Yet prior to 1981 in the UK and 1982 in the United States, it was illegal for companies to buy back their own shares. And during the Covid-19 crisis, President Biden has called on chief executives to refrain from doing so.
Repurchases boost a company’s earnings per share (EPS) and offer management a flexible tool that augments ordinary dividends. While dividends remain the dominant way in which companies return cash to shareholders, stock repurchases have grown in importance in the UK over the past two decades (Armitage and Gallagher, 2020)
Among many commentators, there is a view that chief executives buy back their own shares to manipulate short-term share prices, and this ends up being funded by cutting investments and increasing corporate debt levels. While this critique of ‘short-termism’ is flawed, stock repurchases do indeed pose a risk to uninformed investors and employees.
But there is little evidence to suggest that stock repurchases should be illegal. Indeed, recent studies have documented the significant positive long-run returns of corporate share buyback programmes that ultimately accrue to investors. The cash returned to shareholders can then be reinvested elsewhere in the economy to the benefit of society.
How do stock repurchases work?
Companies looking to return cash to their shareholders have two options: pay dividends or repurchase shares. Dividends are regularly paid out as a part of the company’s after-tax profits and shareholders will pay ordinary income tax when receiving the dividends. This way of returning cash is especially beneficial for shareholders who rely on a regular and predictable income.
Alternatively, stock repurchases are a simple mechanism to return cash to shareholders in exchange for their ownership of the company. When conducting a stock repurchase, the company purchases its shares from its shareholders at a price above the current market price. This premium provides shareholders with an incentive to give up their ownership of the company. Compared with ordinary dividends (which are taxed annually), stock repurchases offer shareholders more tax-efficient return as no taxes are incurred until the actual proceeds materialise.
Why do firms repurchase their own shares?
One study that surveyed US corporate executives finds that repurchases are a complementary tool to dividends as they are more flexible. Executives use this flexibility to increase repurchases when they perceive the share price as being too low (Brav et al, 2005).
Increasing a firm’s share price in this way allows management to share their ‘insider’ valuation with investors (Ikenberry and Vermaelen, 1996; Ben-Rephael et al, 2014). By increasing the share price, executives are able to take advantage of (potential) undervaluation. Firms can issue cheap debt to fund the repurchases, effectively lowering the company’s capital costs (the current low-interest rate environment makes this very attractive).
Repurchases also allow firms to fend off takeovers, to counter the dilution effects of stock options and ultimately to distribute excess cash (Dittmar, 2000).
Nevertheless, executives are accused of focusing on short-term returns and increasing their bonuses as their remuneration is to a large extent dependent on the company’s share price.
Is the short-termism critique warranted?
The core of the short-termism critique is that when executives use share buyback schemes, they forgo valuable investment opportunities in favour of short-term returns. It is argued that the repurchases come at the expense of long-term interests: investments are crowded out, debt levels are increased and EPS figures are boosted. This mechanism artificially boosts share prices and executive compensation.
The general view is that companies shy away from making transformative investments in favour of paying handsome returns to investors (for example, Wang et al, 2021). As a consequence, wealth becomes concentrated only in the upper echelons of society, productivity is reduced and wages lowered (Lazonick, 2014).
In addition, it is argued, when buybacks are financed using debt issuance, this reduces a company’s financial flexibility, risking its ability to provide stable ordinary dividends in the future (Fliers, 2019). This is especially important in the UK where ordinary dividends are only supplemented by repurchases (Armitage and Gallagher, 2020).
It is important to note that there is more to stock repurchases than achieving short-term gains. In the absence of any viable and value-enhancing long-term investments, repurchases might be a good strategy to distribute excess cash to investors. In contrast with ordinary dividends, which are subject to ordinary income taxes, repurchases are taxed as capital gains. Stock repurchases provide an advantage to investors because the capital gains tax is lower than the ordinary income tax rate.
Stock repurchases also keep executives from investing in unprofitable ventures and from squandering excess cash (for example, empire building). In such cases, repurchases prevent value destruction. And while repurchases are on average associated with positive short-term excess returns, it is important to note that these excess returns depend on the possibility of undervaluation and liquidity in the equity market (Manconi et al, 2019).
Further, even though an increase in the EPS may look like a positive sign to an uninformed investor, a seasoned investor will adjust valuations to resemble the reductions in both cash reserves and shares outstanding. This will effectively cancel out any EPS effect arising from share buybacks (Pettit, 2001). Clearly, stock repurchases are more than a tool for generating short-term returns and maximising executive compensation.
Recently, the UK’s Department for Business, Energy and Industrial Strategy (BEIS) commissioned a report examining stock repurchases. The report shows that for FTSE 350 companies, there is no relationship between stock repurchases and EPS targets or executive incentive schemes linked to these targets.
In a survey of UK executives, the report documents that the most important considerations are not the performance targets, but rather the availability of good investment opportunities (BEIS report, 2019).
What are the positive long-term effects of stock repurchases?
Announcements of stock repurchases around the world are followed by positive long-run excess returns on average, especially when these repurchases are followed by subsequent repurchases (Manconi et al, 2019; Bargeron et al, 2017). A study examining these effects documents that over a period of four years, firms that execute stock repurchase programmes outperform their peers by as much as 12% (Ikenberry et al, 1995).
This evidence holds up across the world, attenuating concerns of repurchases destroying long-term value (Manconi et al (2019). That is, in the absence of good investment opportunities, repurchases are a way of responsibly returning money to investors (Palladino and Edmans, 2018). To illustrate this, Figure 1 shows that firms in the European Union executing repurchases programmes have outperformed the MSCI Europe index by more than 6% since 2016.
Other positive long-term effects can be summarised as follows:
- Stock repurchases prevent takeovers: The increase in ownership concentration can deter takeover bids as the cost of acquiring a company’s shares is higher after a buyback than when it pays cash dividends (Bagwell, 1991; Dittmar, 2000).
- Increase in institutional ownership concentration: Institutional investors prefer investing in firms that repurchase frequently, in contrast with the typical individual investor, who prefers investing in firms that pay dividends (Grinstein and Michaely, 2005).
- Reduced excess cash: Firms rely more on internal funding rather than external debt issuance to conduct repurchases, leading to a significant drop in cash holdings (Wang et al, 2021).
Should stock repurchases be illegal?
Between 1981 and 2009, a large number of countries legalised stock repurchases, among them the UK (1981), the United States (1982), the Netherlands (1992) and Turkey (2009). These legalisation efforts have spurred the rise and popularity of repurchases.
The most recent study documents that companies that started repurchasing shares immediately after legalisation did so at the expense of capital investments, research and development (R&D) and future profitability (Wang et al, 2021). It remains unclear if these effects persist across all companies that have initiated stock repurchase programmes long after legalisation.
Even though short-term considerations such as boosting EPS figures and executive compensation might be drivers of stock repurchases, making repurchases illegal may not be needed. As the BEIS report highlights there is no relation between EPS targets and stock repurchases. While on average there is no evidence for executives misusing stock repurchases, individual excesses might still exist.
To prevent this, stock repurchases and the circumstances in which they are executed need to be closely monitored. To align executives with long-term shareholder interests, EPS target-based pay packages could be replaced with deferred share awards and long-term share packages. More detailed reporting requirements on executive pay and better engagement between boards and shareholders will prevent executives from executing myopic strategies.
During the pandemic, stock repurchases have gained a lot more attention. Firms have cut back on repurchase programmes because they have been requesting ‘state aid’ or they have face government-mandated curbs on repurchases. Even before the crisis, repurchases were already under scrutiny for causing short-termist behaviours (Palladino and Edmans, 2018).
Yet in today’s world with corporate productivity under pressure and income inequality increasing, adequate governance is a must. To this end, stock repurchases should not come at the expense of value-enhancing investments, nor should they reduce a company’s financial flexibility to critical levels. Stock repurchase programmes should be consistent with the long-term growth and core business strategy.
Figure 1: Performance of firms with stock repurchase programmes versus MSCI Europe
Source: Refinitiv (previously Thomson Reuters)
Note: The pale red line represents the relative performance of the MSCI International Europe Buyback Yield Price Return Index (MYEU0BUY0PUS) versus the overall MSCI Europe Price Index (MIEU00000PUS).
Where can I find out more?
- Share repurchases, executive pay and investment: July 2019 report examining the motivation of UK companies to undertake stock repurchases. It was prepared by PwC for the Department of Business, Energy and Industrial Strategy.
- Banning Buybacks: Economist William Lazonick shares his perspective on why share buybacks should be banned in this video by the Institute for New Economic Thinking (INET).
- Why Stock Buybacks are Dangerous for the Economy: January 2020 article by William Lazonick and co-authors providing arguments to abolish stock repurchases.
- The Case for Stock Buybacks: September 2017 article where Alex Edmans provides arguments in favour of stock repurchases.
- Should the US Rein In Share Buybacks: An article in the Financial Times where Alex Edmans and Lenore Palladino share their differing views on share buybacks.
Who are experts on this question?
- Philip T. Fliers, Queen’s Centre for Economic History, Queen’s University Belfast
- Sweta Pramanick, Marie Curie Early Stage Researcher and Queen’s University Belfast
- Alex Edmans, London Business School
- William Lazonick, University of Massachusetts Lowell
- Ronan Gallagher, University of Edinburgh Business School
- Seth Armitage, University of Edinburgh Business School