The worrying wave of share buybacks on US stock markets
For several years now, in order to combat the global financial crisis that began in 2007-2008, the monetary authorities of the main economic zones concerned have implemented monetary policies known as "unconventional."
Roland Pérez, University of Montpellier
These policies have resulted in cuts in key interest rates (going as far as zero interest rate policy, or even negative rates) and virtually unlimited credit supply (quantitative easing) via central banks.
Companies, particularly the largest ones, have benefited greatly from these accommodative policies. They have been able to access loans even more easily than before and more easily than small businesses via bank credit or the bond market. In addition, the sharp drop in borrowing costs has had the effect of lowering the cost of capital, in line with the relative share of the company's debt compared to its equity.
The temptation is then great, not only to resort heavily to borrowing to finance their activities, but to go further by using part of these debt facilities to buy back their own shares, which will reduce their equity capital, corresponding to what analysts call "double leverage."
Virtue... in theory
Indeed, since the introduction of the new monetary policies, changes in the financial structures of large listed companies have clearly reflected these trends: a considerable increase in bond issues and bank loans, accompanied by growth in share buyback programs, with cash reserves remaining high on balance sheets.
Divestment in the form of share buybacks is not negative in itself. The theoretical justification for such a transaction is understandable; it is consistent with the free cash flow theory set out by Michael C. Jensen in 1986. In short, if the managers of a listed company consider that they have excess cash after making investments at the required rate of return (i.e., covering at least the cost of capital), it is wiser to return this surplus to shareholders rather than use it in a suboptimal manner.
Dennizn/Shutterstock
The divestment that corresponds to share buybacks is consistent with this logic, which, along with other decisions (investment choices, refocusing, outsourcing, etc.), reflects the increasing financialization of companies. By drying up excess cash, share buybacks help to "discipline" managers, in the same way as debt servicing (and sometimes in combination with it when these buybacks have been financed by borrowing).
While such a theoretical justification can be argued in favor of share buybacks, it can also be criticized on several grounds: first, there is no guarantee that the sums returned to shareholders will subsequently be reinvested in attractive investments. Shareholders who respond positively to the buyback proposal will do whatever they want with the money they receive, including not investing it, spending it elsewhere, or hoarding it. Thus, while share buybacks contribute to the fluidity of financial markets, they in no way guarantee the optimal allocation of resources.
More of a drug than a vitamin
Secondly, this idealized view of how markets work ignores the bias that buybacks introduce into the functioning of these markets when they involve significant amounts. By weighing on current transactions through demand for shares and influencing future transactions through "mechanical" improvements in earnings per share, share buybacks have an apparently positive effect. However, as these effects are linked to each individual transaction, the question arises as to whether they will be sustained over a longer period.
Finally, we cannot ignore the relationship between these transactions, which tend to support—sometimes artificially—stock prices and executive compensation, which is often linked (in large part through bonuses and incentives) to the level of these prices.
The interactions between the risks outlined above paint a picture of the reality of financial markets that is quite different from the virtues attributed to them in theory. In practice, these markets are often suboptimal and subject to actions carried out in the interests of particular players. In this context, the euphoric effect of share buybacks should perhaps not be classified as a tonic, but rather as a stimulant; in short, more of a drug than a vitamin...
A worrying situation in the United States
The number and scale of share buybacks on US stock markets have grown exceptionally in recent years. In 2018, the amount reached $1 trillion for companies in the S&P 500; the same is expected for the current year, unless appropriate measures are put in place.
Relevant opinion circles in the United States have begun to express concern about this trend. Financial analysts fear that the current situation, which is very favorable for stocks—corresponding to an "alignment of the planets"—may only be temporary. "The stock markets are setting records, but profits, tax cuts, cheap borrowing, buybacks, and the Fed's patience are unlikely to last," wrote Markets Insider at the end of April. According to Bloomberg, only share buybacks are preventing the stock market from turning around. Some analysts go further and even call for a ban on such transactions.
Regulatory authorities—the Securities and Exchange Commission (SEC)—are becoming wary and stepping out of their usual reserve. SEC Commissioner Robert Jackson has stated that this wave of share buybacks benefits executives more than shareholders. Political parties are also taking a stand. The Democratic Party was the first to express concern about the growing importance of share buybacks, calling for stricter regulation at the beginning of the year.
At this stage, it does not seem possible to predict how the situation will evolve, given the uncertainties surrounding economic and monetary policies, particularly in the United States. We can only outline a few scenarios based on various possible assumptions:
- Less lax regulations—comparable to those in force in the European Union—would oblige the players concerned to comply. The consequences for the financial markets could be negative in the short term, but stabilization with less unbalanced structures seems possible.
- A change in monetary policy—via an increase in key interest rates and the end of quantitative easing —would likely have comparable effects, especially if these global measures were combined with minimal regulation as mentioned above.
On the other hand, if neither of the two previous policies were implemented, i.e., in the absence of share buyback regulations and with accommodative monetary policies (ZIRP and QE) remaining in place, there is a risk that the current wave of share buybacks will continue and intensify, becoming a veritable tsunami that far exceeds the trillion-dollar mark reached in 2018 for the S&P 500. This could lead to a widening disconnect between the real economy and its financial representation via the markets. The conditions for a new financial bubble would then be in place... Future historians could then speak of the autophagy of market finance.
Roland Pérez, Professor Emeritus, Montpellier Research in Management, University of Montpellier
This article is republished from The Conversation under a Creative Commons license. Readthe original article.