The alarming surge in share buybacks on U.S. stock exchanges
For several years now, in an effort to combat the global financial crisis that began in 2007–2008, the monetary authorities of the major economic regions affected have implemented so-called “unconventional” monetary policies.
Roland Pérez, University of Montpellier
These policies have led to cuts in key interest rates (including the zero interest rate policy and even negative rates) and to virtually unlimited credit supply (quantitative easing) through central banks.
Companies, particularly the largest ones, have benefited greatly from these accommodative policies. They have been able to access credit even more easily than before and more readily than small businesses through bank loans or the bond market. Furthermore, the drastic drop in borrowing costs has lowered the cost of capital, in proportion to the relative share of a company’s debt compared to its equity.
The temptation is therefore strong not only to rely heavily on borrowing to finance their operations, but also to go a step further by using part of that debt to buy back their own shares, which will reduce their equity—a phenomenon analysts refer to as “double leverage.”
Virtue… in theory
Indeed, since the implementation of the new monetary policies, changes in the financial structures of large publicly traded companies have clearly reflected these trends: a significant surge in bond issuance and bank lending, accompanied by an increase in share buyback programs, while balance sheets continue to hold substantial cash reserves.
A divestment in the form of a share buyback is not inherently negative. The theoretical rationale for such a transaction is understandable; it is consistent with the free cash flow theory first articulated by Michael C. Jensen in 1986. In short, if the management of a publicly traded company believes it has 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 way that would be suboptimal.
Dennizn/Shutterstock
Share buybacks, as a form of divestment, fit squarely into this logic, which—along with other decisions (investment choices, strategic refocusing, outsourcing, etc.)—reflects the growing financialization of corporations. By draining excess cash reserves, share buybacks thus help to “discipline” management, just as debt servicing does (and sometimes in conjunction with it when these buyback operations have been financed through borrowing).
While such a theoretical justification can be made in favor of share buybacks, it can also be criticized on several grounds: first of all, there is no guarantee that the funds returned to shareholders in this way will subsequently be reinvested in profitable ventures. Shareholders who have responded positively to the buyback proposal will do as they please with the funds received, including making no investments, spending them elsewhere, or hoarding them. Thus, while share buybacks contribute to the liquidity of financial markets, they in no way guarantee an optimal allocation of resources.
More of a drug than a vitamin
Furthermore, this idealized view of how markets function overlooks the bias that share buybacks introduce into market dynamics, particularly when they involve significant amounts. By influencing current transactions through demand for shares and affecting future transactions through the “mechanical” improvement of earnings per share, share buybacks appear to have a positive effect. However, since these effects are tied to each specific transaction, the question arises as to whether they can be sustained over a longer period.
Finally, we cannot overlook the connection between these transactions—which tend to prop up stock prices, sometimes artificially—and executive compensation, a significant portion of which (bonuses and incentives) is tied to those stock prices.
The interactions of the risks outlined above paint a picture of the reality of financial markets that is quite far removed from the virtues attributed to them by theory. In practice, these markets are often suboptimal and subject to actions driven by operations carried out in the interests of specific players. In this context, the euphoric effect of share buybacks may 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 U.S. stock exchanges have grown exceptionally in recent years. In 2018, the total amount reached $1 trillion for S&P 500 companies; the same is expected for the current year unless appropriate measures are put in place.
Relevant circles in the United States have begun to express concern about this trend. Financial analysts fear that the current situation, which is highly favorable for stocks—amounting to an “alignment of the planets”—may be only temporary. “Stock markets are setting records, but earnings, tax cuts, cheap borrowing, buybacks, and the Fed’s patience are unlikely to last,” wrote Markets Insider in late April. According to Bloomberg, only share buybacks are preventing the stock market from turning downward. Some analysts go further and are even calling for a ban on these transactions.
Regulatory authorities—the Securities and Exchange Commission (SEC)—are growing wary and stepping out of their usual reserve. SEC Commissioner Robert Jackson has stated that this wave of stock 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 scale of stock buybacks, calling for stricter regulation earlier this year.
At this stage, it does not seem possible to predict how the situation will unfold, 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 lenient regulations—comparable to those in force in the European Union—would require the relevant parties to comply. The impact on financial markets could be negative in the short term, but stabilization with less unbalanced structures appears possible.
- A shift in monetary policy—through an increase in key interest rates and the end of quantitative easing —would likely have comparable effects; all the more so if these broad measures were combined with minimal regulation, as mentioned above.
On the other hand, if neither of the two aforementioned policies were implemented—that is, in the absence of regulations on share buybacks and with the continuation of accommodative monetary policies (ZIRP and QE)—there is reason to fear that the current wave of share buybacks will continue and intensify, becoming a veritable tsunami that far exceeds the $1 trillion mark reached in 2018 for the S&P 500. We would then risk seeing a widening disconnect between the real economy and its financial representation through the markets. The conditions for the emergence of a new financial bubble would then be in place… Future historians might then speak of the self-destruction of the financial markets.
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.