By Mark Hulbert
There may be good reasons for the 1% excise tax on stock buybacks that is part of the recently passed Inflation Reduction Act — just not the ones Congress debated. Those arguments too often were based on misinformation, misleading assumptions, or just plain wrong.
It’s worth reviewing those arguments, since Congress is unlikely to stop at a 1% tax on buybacks. At its current rate, according to the Congressional Research Service , the tax is projected to raise an average of just $7.4 billion per year over the next decade, which is hardly more than a rounding error relative to the federal government’s nearly $7 trillion in annual spending. Given the desire to raise more revenue, this new excise tax may be just the veritable camel’s nose under the tent.
A good starting point in discussing share buybacks is to put them in context, since some of the more overheated rhetoric about repurchases exaggerates their magnitude. As you can see from the chart below, buybacks in fact represent a small and declining percentage of the stock market.
Instead of focusing on the gross number of repurchases, which many do, the chart nets that gross number by how many new issues companies may also have created. Since share issuance often is of equal or greater magnitude than repurchases, net repurchases can tell a far different story than gross repurchases. And it’s the net number that is most relevant to allegations that, because of buybacks, corporations are in the process of “self-liquidating” and “shrinking” (as some have contended).
To calculate the net number, the chart takes into account both the dollar value of new shares corporations are issuing and those that they are retiring — either due to repurchases or mergers and acquisitions. When new issuance exceeds repurchases, values in the chart will be positive. When repurchases exceed new issues, in contrast, the values will be negative.
As a percentage of the stock market’s overall market capitalization, net issuance of non-financial U.S. corporations amounted to minus 1.9% as of the end of the first quarter of 2022 (the latest for which Federal Reserve data are available; the negative percentage means repurchases exceeded new issuance). This latest rate compares to minus 4.1% at the end of 2008.
Even if repurchases are considered problematic, therefore, we would need to recognize that they have become less of a problem over the last decade.
One of the primary criticisms of repurchases is that they are used by unscrupulous corporate executives to boost their companies’ stock price, sometimes immediately prior to their exercising stock options or selling shares. This does sometimes happen, but (as I discuss below) there are steps that can be taken to discourage the practice that don’t involve an excise tax.
In any case, there’s evidence that this was more of a problem when repurchases first grew in popularity, in the 1980s and 1990s. That’s because the market’s reaction to repurchases has changed. Several decades ago they more often than not led the underlying stocks to outperform the market. This has not been the case in recent years, which is perhaps one reason why net repurchases as a percentage of the market have declined over the last decade.
Consider a 2015 study by Neil Pearson, a finance professor at the University of Illinois at Urbana-Champaign, Inmoo Lee, dean of the KAIST College of Business in South Korea, and Yuen Jung Park, a finance professor at South Korea’s Hallym University. They found that, in contrast to the pattern that existed prior to 2001, since 2001 fewer than half of the stocks of repurchase companies beat the market over the three years following the announcements of their buybacks.
In an email, Lee said that he and his co-authors have not updated their study with data from the past few years, and he is unaware of any other academic study that has. But he said he has no reason to believe that more recent data would lead to a different conclusion.
Confirmation of this comes from the performance of an ETF that invests in companies for which repurchases greatly exceed new issuance: Invesco BuyBack Achievers ETF /zigman2/quotes/203779514/composite PKW -1.86% . This ETF invests in those companies that, according to Invesco , “have effected a net reduction in shares outstanding of 5% or more in the trailing 12 months.” Over the past decade, according to FactSet data, this ETF lagged the S&P 500 /zigman2/quotes/210599714/realtime SPX -2.11% by 1 percentage point annualized.
Is returning cash to shareholders a bad idea?
An underlying assumption in the debate about repurchases is that there’s something nefarious about a corporation returning cash to shareholders that it doesn’t otherwise need for ongoing operations or investment in future projects. That’s a curious argument, since it assumes corporate executives know best how to invest their excess cash. That is not always, or even regularly, the case.
History is filled with examples of when this assumption was misguided — when excess cash instead led corporate managers to undertake foolish projects and “empire building.” Nothing is too good when you’re spending other peoples’ money, after all. As Harvard’s Michael Jensen put in a now-famous 1986 article , “corporate managers are the agents of shareholders, a relationship fraught with conflicting interests.” The right thing to do, Jensen concluded, is to find ways to force corporate managers to “disgorge the cash.” Repurchases are one such way.
It is interesting to note in this regard that there have been times in U.S. history when Jensen’s attitude was shared widely. In fact, according to a 2019 column by the Wall Street Journal’s Jason Zweig , in some periods the distrust of corporate managers was so strong that they were required to use excess cash to repurchase shares. In those past periods, it was considered nefarious when corporations did not repurchase their shares.
I suspect that many who currently demonize repurchases would find it distasteful to realize that they are implicitly showing more trust in corporate management than in these prior periods of U.S. history.
Preventing misuse of buybacks
It is the case that some corporate managers time repurchase announcements in order to manipulate share prices prior to the exercise of those managers’ options or the vesting of their equity grants. There are ways to eliminate any temptation to engage in such behavior that don’t involve an excise tax.
One way is for corporations to structure their compensation contracts so that the prices at which executives would exercise their options or sell their shares would be based on a longer-term average — such as over a three-year period. In that event, corporate management would be incentivized to approve a repurchase program only if they thought that it would increase the price of their companies’ underlying stocks over a longer period. Everyone wins in that scenario.
One consequence of this debate may be that, going forward, investors will favor the stocks of companies that adopt such compensation arrangements, and encourage others to follow suit.
Hear from Ray Dalio at MarketWatch’s Best New Ideas in Money Festival on Sept. 21 and 22 in New York. The hedge-fund pioneer has strong views on where the economy is headed.