23 thoughts on “Stock buybacks”

1. As Warren Buffett once wrote:

   “There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds — cash plus sensible borrowing capacity — beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth.”
   1999 Letter to Berkshire Hathaway shareholders
   http://www.berkshirehathaway.com/letters/1999htm.html

   The rest of his discussion of repurchases is worth reading.

2. “If the corporation pays me a dividend, that is ordinary income to me for tax purposes. If the corporation instead buys back stock, the income I get comes from a higher share price, which I can hold until it is taxable as a long-term capital gain.”

   This is the correct answer – the most tax efficient way to return excess funds to shareholders. Not that complicated.

   • One other good reason: to offset the dilution caused by employees exercising stock options or vesting in RSUs (or similar units).

     • This is incorrect: dividend income from most corporations also qualifies for long-term capital gains rates.

       The big difference between the stock buybacks and dividends is that with the former, you have the ability to offset your original cost investment (your tax basis) against the repurchase price of the stock. So you only pay long-term gain on the appreciation.

       • “This is incorrect: dividend income from most corporations also qualifies for long-term capital gains rates.”

         Are you forgetting the time value of money here? Increase in stock price due to a share repurchase is fully deferred from taxation until the underlying shares are sold. Dividends are taxed upon receipt…no option to defer that tax.

     • No. That’s not a good reason. If the stock is overvalued at the time, for example, it fails the check described by Warren Buffett, then to do the buy back at that time will be adverse for the remaining majority of stockholders.

   • Most owners of most shares are rich – whose buying and selling always include tax considerations.

     Dividends go to all owners. Buyback cash this year only goes to those who sell, often as part of a tax minimization strategy on their whole portfolio and all of their transactions. Those who don’t sell don’t see cash, but do have an deferred taxed increase in their asset wealth. The shareowners have much more influence in a buyback where they can sell all, none, or some maximally advantageous amount, as compared to just getting dividend cash.

     For companies with declining top line revenue, like IBM, buybacks keep the share prices high and also reduce the outstanding shares. It would seem to also increase the volume of transactions in the market, which should increase the liquidity.

   • “If the corporation pays me a dividend, that is ordinary income to me for tax purposes. If the corporation instead buys back stock, the income I get comes from a higher share price, which I can hold until it is taxable as a long-term capital gain.”

     I’m in the tax business myself. The above was true until 1986, which is why Microsoft was known during that period as having never paid a dividend, and always bought back its shares instead. (The 1986 Reagan tax bill did away with separate tax rates for capital gains. That policy only lasted 2-3 years before Congress recreated them, but Microsoft never resumed its policy of buybacks even afterward. I don’t know why not.)

     Under current tax law, though, most corporate dividends are “qualified” and thus are taxed at capital gains rates. So I don’t think a buyback policy today would benefit most companies or their owners.

3. Stock buybacks are also a good way for management to pay themselves out of the corporate budget, assuming they have stock or options for stock.

   • As a strategy for good times, that’s plausible. But as with anything involving debt and leverage, it does seem a bit risky and something that could backfire badly in bad times.

     If a company got most of its money from stock sales, then when profits collapse, it may have to take some losses, but it doesn’t become worthless, or face a certain risk of not being able to make interest payments, and it has a lot of extra room to get some short term credit to make other payments and get it through a temporary bad time.

     If a company got a ton of its money from debts, then when things go bad, it risks default and has little room for maneuver. The shareholders are now at risk of getting wiped out and the creditors take their haircuts and own the company.

     But that would mean the executives and whoever else is paid in stock all got wiped out too in such an event. Is there some common attempt to insure themselves against such an outcome?

     • Note: most bond covenants specifically restrict the amount and timing of share repurchases (and dividends) based on strict covenant formula that are calculated monthly. It’s not like the corporate officers have carte blanche to buyback stock at the their heart’s content.

4. Don’t forget compensation-maximization. If option strike prices don’t adjust for dividends paid you are better off returning capital via buybacks.

   • This has always been my theory.

5. Matt Levine gave his explanation of buybacks in his Money Stuff column yesterday:

   But there are also good reasons for the company to prefer buybacks over dividends. The best reason is quite well known: Buybacks are more tax efficient; a dividend imposes taxes on all shareholders, while a buyback is only taxable to shareholders who actually sell (and then only to the extent of gain). Another, somewhat less good reason is also well known: Buybacks tend to be accretive to earnings per share (since they reduce shares outstanding), while dividends aren’t. Among those who dislike stock buybacks, both of these reasons are controversial; the first can sound like tax evasion, while the second can sound like accounting fakery.

   A third argument that bankers will give to prefer buybacks is that they are more “flexible.” What this means is that if you have $100 million a quarter to spend on capital return, and you spend it on buying back stock, and then one quarter you turn out to have no money to spend on capital return, you just don’t buy back any stock that quarter. It’s fine. Companies regularly start and stop buyback programs. Investors would prefer bigger and more consistent buybacks over smaller and inconsistent ones, but that is a mild preference, and if you stop buying back stock they’ll live.

   On the other hand if you have $100 million a quarter to spend on capital return, and you spend it on a regular 25-cents-a-share quarterly dividend, and then one quarter you turn out to have no money to spend on capital return, you can’t just cut the dividend. I mean, you can; it’s not illegal or anything; the shareholders can’t force you to pay the dividend. Companies do cut their dividends when they come on hard times. But expectations around dividends are way stronger than expectations around buybacks.

   And so for instance it is relatively straightforward, in the current environment, for companies to stop buying back stock to preserve cash, but it is much harder for them to stop paying dividends. We talked recently about how companies are paying dividends without profits, how “European low-cost carrier easyJet drew criticism for proceeding with a £175m payout last month to shareholders despite grounding its entire fleet.” And we talked last week about how U.S. banks want to keep paying dividends because, they argue, “cutting them would be ‘destabilising to investors.’” “That’s what creates a financial crisis,” says an analyst; “when dividends start to be ratcheted lower that shakes confidence.” I was unimpressed by this argument; I wrote:

   If you take seriously the claim that banks can’t cut dividends in a generational crisis, for fear of undermining investor confidence, then, fine, I guess, but then the obvious conclusion is that when times are good you can never let banks raise their dividends. Every time a bank raises its dividend, on this theory, it incurs more unavoidable quarterly debt and creates a new drain on its funding, one that can’t be turned off in the bad times for fear of being “destabilising to investors.”

   Now, I tend not to take that claim too seriously; I think that companies (and even banks) can temporarily cut their dividends in times of plague without causing a financial crisis. Shareholders are supposed to be risking their money; surely their income should be cut before that of bondholders or employees or suppliers.

   Still it is a very popular claim and it is worth taking a little seriously. Simply, the claim is that a company with a regular dividend cannot cut that dividend without causing a crisis of confidence that will make its financial situation worse: It might save some money by cutting the dividend, but it will spark a panic that will make it harder for it to raise money, will make customers and lenders nervous, etc. On the other hand a company with a regular stock buyback program can stop it at any time to save money without freaking anyone out.

   My impression is that most people who dislike stock buybacks dislike them more than they dislike dividends. Because of the tax-evasion and earnings-fakery arguments, because buybacks are viewed as a trick to increase executive pay, because there is a theory that they are “stock manipulation,” because dividends are sort of quaint and old-fashioned, etc. If those are your concerns I suppose you can keep disliking buybacks and grudgingly accepting dividends. But if your specific concern, now, about stock buybacks is that they wasted money that companies turned out to need for the present emergency, then you should be more concerned about dividends. Dividends are still wasting money that companies need for the present emergency, just because they are harder to turn off than buybacks are. Dividends happen every quarter whether they make sense or not; buybacks don’t.

6. It’s worth noting that long-term capital gains are taxed at (IIRC) 15%, and ordinary income is taxed at a variable but generally much higher rate.

   • This is justified by the “need” to attract investment. The rich investors would invest less without this reduced capital gains rate.

     In a low-interest world, with plenty of capital, this argument is now very, very weak. Where else are the rich investors going to invest? The lower rate is part of how gov’t makes it easier for the rich to get richer faster than the median folk.

     I support tax changes to make the median wage earner get richer faster than the top 10% or top 1%. So I’d favor equal income treatment to capital gains (from capital) as from wage income (labor).

7. One serious problem with buybacks instead of dividends is that investors don’t always have a choice in when and how much of their stock they sell.

   I speak from painful experience. In an ordinary year, I’m near the top of the bracket that pays 0% on dividends and capital gains. In 2018, however, Rockwell Collins, which I’d owned for forty-some years, was acquired by United Technologies, and I had to pay capital-gains tax on essentially the full value of my Rockwell. This kicked me into a much higher income-tax bracket, and subjected me to the 3.8% Obamacare surtax to boot.

   If I’m getting a regular stream of dividends, I can plan around it, knowing that the income and the taxes I pay on it won’t vary drastically from year to year. That’s not the case with buyback-induced increases in stock value, which don’t increase my income gradually with time and which subject me to occasional years in which I have to write an enormous check on April 15.

8. I think the incentive structure faced by managements matters. Most of them hold stock options. Buybacks benefit option holders more than dividends do.

9. I think Matt Levine is spot on: buybacks are more tax efficient not because they might or might not incur a lower tax rate, but because they distribute the tax liability away from the current holders of the stock and onto those shareholders who prefer to exit. If you’re a committed long-term holder, they shield you from taxes while you own the stock. Per Don Castigo’s point that dividends help you manage your tax brackets and future tax liabilities, you can still do that by selling a small portion of your shares each year. (I think one of the main tasks of financial education should be to point out this option).

   This argument does not negate the very good point that in a company that rewards its managers in stock options that are not adjusted for dividends, the managers would be biased to prefer that the company steer distributions towards buybacks. (The solution to this incentive problem seems simple: just adjust the option strike prices for dividends).

   From the standpoint of fundamental company value (which is all that shareholders should ultimately care about), buybacks, in practice, are only preferable if the management has an astute sense of the real value of the company; and only conducts them when its market value has dipped far below the real value. So buybacks are preferable when you trust the management to be disciplined; and dividends are preferable when you don’t. It’s a subjective choice.

10. “The corporate income tax, which is best described as a swiss cheese that is mostly holes.”

    That is a keeper. Is it a Klingism? My guess would be that it’s much older.

    While we are at it, it would be nice to have a larger glossary. It must have been done already. It provides a good primer for Cultural Literacy. For example…

    Director’s Law

    Capture Theory

    Harberger’s Triangle

    etc, &c

    • I just googled all three and got reasonable explanations very quickly.

      • Sorry–long answer follows…

        My recollection was that Deirdre McCloskey presented it as “Harberger’s Postulate: If you multiply a very large number of fractions together you get a very small number.”

        It’s funnier if you do it with a stand-up comedian’s delivery. You need to build suspense about the difficulty of measuring welfare losses from monopoly. You soften up the audience by going on for a few minutes about the buckets of ink spilled on this for decades. And of course there is the the great effort put into seeing just big a problem this is.

        Then you say “Harberger’s Postulate”: …. (wait for it…)

        “When you multiply a lot of fractions together you get a very small number.”

        That’s how I learned it. Maybe you had to be there.

        That one wasn’t quite so self-evident, because all I got was an article that mentioned three postulates. It’s in J-STOR which for me is paywalled. The abstract didn’t seem nearly so funny as the way I heard the story told, either.

11. Wondering out loud. As a shareholder, is it a higher risk for the corporation to buy back instead of give a dividend? The scenario I paint is that there is always a risk of the company stock doing a permanent crater or even being wiped out. If the corporation had given dividends over a 10 year period vs buybacks, isn’t your risk adjusted position better?

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