Buybacks have gotten a bad rap lately. Some politicians want to tax them. Some companies are barred from making them while they receive government funds, (which I think is fair) and some have quietly wound them down so they can preserve cash during the pandemic.
There is a lot that can happen in 4 months but as it looks right now with the pandemic raging, the Main Street economy in free fall and millions unemployed, it seems there is a good case for a left leaning presidency and Congress that may want to put some clamps down on buybacks. They will need to start thinking of ways to raise revenue by then, which I discussed here, but targeting buybacks may not be the most efficient way to raise revenue, although at the moment it seems popular. Dividends offer an example of why.
Dividends were taxed at the ordinary rate for many years until economists pointed out that these were profits being taxed twice. Once at the corporate level and once at the distribution level to shareholders.
The proposed remedy to this double taxation which came with the second Bush administration, was the qualified dividend. This was taxed at a rate more similar to that of long term capital gains with that efficiency in mind. So at the time, you would have thought these lower rates of taxing dividends would have produced a boom in dividend payments.
The opposite seems to have happened though. Rather than pay out a higher percent of earnings as dividends, firms upped their repurchases of their own shares to a level never seen before.
Why Buybacks are Preferred
One reason for this was obvious, even with dividends being taxed lower, share buybacks are not taxed, at least not initially. So there should be a natural preference for buybacks for both managers and investors.
To understand why, take the point of view of a shareholder who is investing for the long haul, say 10 to 20 years, and wants the best return they can get over that period. Reinvested dividends are an important part of total return which doesn’t always get the respect it deserves. Just take a look at dividends as a percentage of the return of the S&P 500 by decade assuming they were reinvested.
Source: suredividend.com
But those dividends are being taxed every year. Gains through price appreciation aren’t paid until the shares are sold. The annual payment of taxes reduces the annual return from dividends, the capital gain in 10 or 20 years for a price appreciation however, gives the shareholder a better after tax return.
Buybacks reduce the number of shares, so in theory, the same earnings next year on a company level, with fewer shares outstanding, will increase the earnings per share and hence the stock price.
So essentially, buybacks are a more efficient way to return capital to shareholders from a tax perspective. It’s worth noting that the result of buy backs, capital gains, is already taxed, it’s just taxed when the shares are sold rather than when the buybacks occur. Again, this increases the after tax return for shareholders and is a more efficient way returning capital.
Buybacks also can be scaled up or cut back with less fanfare than a cut in dividends. Dividends, according to a few academic studies, appear to follow cultural phenomena. In Europe and Japan, they are looked at more similar to how we look at buybacks in the US, meaning they are a corporate payout for shareholders that is subject to the profitability of the company, meaning they rise and fall with earnings. In the US however, the dividend is deemed more sacred, and shareholders have severely punished stocks that cut their dividends in a way they dont in other markets. It seems US investors like slow incremental raises in their dividends that never go down.
However buybacks are not a new phenomenon, they have never been taxed before. Why are there no stories of corporations buying back stock in the 70’s and 80’s? How did they get to be such a hot topic now and are they really out of control?
The Buyback Binge Documented
On the face of it, the answer looks like a yes, buybacks and total payout is much higher than it was in the 70’s and 80’s. As of 2018, non financial companies on US exchanges were paying out almost 30% of their operating income as compared to less than half that in the 70’s and 80’s.
Source: NBER
This phenomenon has produced a number of questions from economists and researchers. If corporations are not investing in new projects or their workers and simply buying back their own stock, what is motivating this? Is it a lack of investment opportunities? Is it short term thinking and not seeing the benefits of investing in workers? Or is it the nebulous corporate greed?
Or could it be that the structure and makeup of the market has changed in a way that there are more companies around that tend to pay out more?
A newly published paper from professors at Ohio State and the University of Arizona steps back to ask a basic question: are payouts abnormally high in the past 20 years? The authors create 2 models based on data that goes back to 1971. They adjust payouts for inflation and they include both dividends and net buybacks in their calculations. Net buybacks here are calculated as the gross buybacks net of share issuance.
They find that dividends averaged 14.4% of operating income from 1971 to 1999 and 14% from 2000 to 2017. In contrast, net repurchases averaged 4.8% of operating income before 2000 and 18.3% from 2000 to 2017.
What they also find is that their models somewhat accurately predict an increase in buybacks. In one model 38% of the buybacks were predicted from higher profits, but 62% was explained by firm specific factors. What were these factors that seemed to be most important? Firms were getting larger and older in the period from 1999 to 2018 as opposed to those from 1971 to 1998.
Although the authors simply want to ask the question of whether payouts were abnormal or not since the year 2000, their study leads to more questions as to why exactly there are more bigger and larger firms in the market compared to the period from 1971-1998.
Where the Small Firms Are
A number of studies have been pointing to evidence that industry is becoming more concentrated across all sectors in the most recent decades. The top four firms in a number of industries have increased their share of the market substantially during this time. This is bad news for consumers, workers and well, everybody except the shareholders and executives of these companies.
This concentration can produce higher prices for consumers across all goods and services simply from the lack of competition. We see this on a micro level with cable and internet service. In parts of New York City, where you get your internet service from isn’t really a choice if it’s installed in your home. Each of the internet providers has a small geographic monopoly in an area or boro. I assume this is a similar case in many parts of the country.
Mergers have been getting bigger for a while. The data on payouts highlighted above is for non financial companies but banks have definitely not been immune to mergers, especially since Glass-Steagall was repealed, which separated consumer and investment banking. The top 5 banks now control about 46% of all banking assets in the US as opposed to 1996 when the top 5 held around 29%.
Source: Federal Reserve of St. Louis
The last recession simply bumped up a trend that had already kept since the year 2000. This recession may see even more increases in concentration.
The reason being that even more companies are doing poorly now than during the Great Recession. Large public companies are only a small part of the actual economy. Most of the economy consists of small businesses, mom and pop type shops that employ the owners and a few people. The large corporations, represented on stock exchanges have better access to capital and professional management that can exploit a crisis like this if they have been operating responsibly in the past.
This seems to set up 2 things for the future, the risk that these large firms will gobble up even more small firms that are struggling with the economic situation and further concentrate industry in the hands of a few, and also further disconnect the stock market from the actual economy, which we are seeing right now.
Conclusion
The linkage between payouts and industry concentration is one of the topics that I would like to see more research on based on the conclusions of the payout paper. It could serve as a valuable policy tool for politicians and media starting to look not at the outcomes of concentration (buybacks) but what may be at the root of the problem (lack of competition and industry concentration).
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