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Stock buyback are killing the American economy


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Granted, I just skimmed part of that piece, so maybe I'm missing the point (hey, gotta pick how you spend your time...), but just from the premise, I wonder if they would write an article about how "dividends are killing the American economy"?

 

Buybacks are just a return of capital to shareholders, who then can spend it however they want (investing, consuming... all things good for the economy).

 

 

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If you think in term on how to grow a company, buyback doesn't grow a company. I think this is one reason BRK doesn't really do buyback unless the it's beneficial to the shareholders. When they use that money to purchase a new company and then grow it, it will eventually benefit the long term shareholder more.

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If you think in term on how to grow a company, buyback doesn't grow a company. I think this is one reason BRK doesn't really do buyback unless the it's beneficial to the shareholders. When they use that money to purchase a new company and then grow it, it will eventually benefit the long term shareholder more.

 

Do dividends grow a company? Why aren't people mad at dividends? (my answer: Most people don't understand capital allocation, most regular investors still think that dividends are somehow magic free money)

 

What's the difference between a shareholder getting back money and then using the capital somewhere that helps the economy vs a company investing directly somewhere that helps the economy?

 

Why is growth good? Not all companies can grow profitably, and if they can't, they should return capital. If they can, they should invest in growth, but even that might not use up all their capital (how are Apple or Mastercard supposed to use up all their FCF without diluting their good business with acquisitions that are worse than what they already have?).

 

It's a case by case thing, there's no one-size fits all.

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In a recent white paper titled “The World’s Dumbest Idea,” GMO asset allocation manager James Montier strongly challenges the 40-year obsession with “shareholder value maximization,” or SVM, documenting the many ways that stock buybacks and excessive dividends have reduced business investment and boosted inequality. Almost all investment carried out by firms is financed by retained earnings, Montier points out, so the diversion of cash flow to stock buybacks has inevitably resulted in lower rates of business investment. Defenders of SVM argue that investors efficiently reallocate the profits they reap from repurchased shares by investing the proceeds into more promising enterprises. But Montier shows that since the 1980s, public corporations have actually bought back more equity than they’ve issued, representing a net negative equity flow. Shareholders aren’t providing capital to the corporate sector, they’re extracting it

 

 

https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IIBoe1yul9uERnfCmQoglFl9k5qwJSfHx8w%2fWCnFLmEb2MC9GoFnZVlslR5NzCRY1ajgn503icBv67VQg%2fNVUMWsYvi3A2%2fL%2bS28A7Pthjp7LmOfLYQfHMJc

 

The World’s Dumbest Idea

 

James Montier

 

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In a recent white paper titled “The World’s Dumbest Idea,” GMO asset allocation manager James Montier strongly challenges the 40-year obsession with “shareholder value maximization,” or SVM, documenting the many ways that stock buybacks and excessive dividends have reduced business investment and boosted inequality. Almost all investment carried out by firms is financed by retained earnings, Montier points out, so the diversion of cash flow to stock buybacks has inevitably resulted in lower rates of business investment. Defenders of SVM argue that investors efficiently reallocate the profits they reap from repurchased shares by investing the proceeds into more promising enterprises. But Montier shows that since the 1980s, public corporations have actually bought back more equity than they’ve issued, representing a net negative equity flow. Shareholders aren’t providing capital to the corporate sector, they’re extracting it

 

 

https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IIBoe1yul9uERnfCmQoglFl9k5qwJSfHx8w%2fWCnFLmEb2MC9GoFnZVlslR5NzCRY1ajgn503icBv67VQg%2fNVUMWsYvi3A2%2fL%2bS28A7Pthjp7LmOfLYQfHMJc

 

The World’s Dumbest Idea

 

James Montier

 

 

Should be called "The worlds dumbest white paper".  This is how it is supposed to work.  If shareholders never got their money back, and then some, why would anyone invest?  Just like people take on a lot of debt when they are young and need less when they are established, the same is true with companies.  Capital is needed during the growth stage and investors are payed back later. The fact that a company has the potential to eventually payback shareholders many times its initial capital needs is what makes capital available on the markets in the first place. It is what makes the system work.  TANSTAAFL.

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In a recent white paper titled “The World’s Dumbest Idea,” GMO asset allocation manager James Montier strongly challenges the 40-year obsession with “shareholder value maximization,” or SVM, documenting the many ways that stock buybacks and excessive dividends have reduced business investment and boosted inequality. Almost all investment carried out by firms is financed by retained earnings, Montier points out, so the diversion of cash flow to stock buybacks has inevitably resulted in lower rates of business investment. Defenders of SVM argue that investors efficiently reallocate the profits they reap from repurchased shares by investing the proceeds into more promising enterprises. But Montier shows that since the 1980s, public corporations have actually bought back more equity than they’ve issued, representing a net negative equity flow. Shareholders aren’t providing capital to the corporate sector, they’re extracting it

 

 

https://www.gmo.com/America/CMSAttachmentDownload.aspx?target=JUBRxi51IIBoe1yul9uERnfCmQoglFl9k5qwJSfHx8w%2fWCnFLmEb2MC9GoFnZVlslR5NzCRY1ajgn503icBv67VQg%2fNVUMWsYvi3A2%2fL%2bS28A7Pthjp7LmOfLYQfHMJc

 

The World’s Dumbest Idea

 

James Montier

 

It's interesting to see that internet Buzzfeed-style click-bait headlines have made their way to the academic world.

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The article does raise some issues:

 

First, companies are exactly great at capital allocation. With dividends at least investors get to make the choice..

 

Second, short-term incentives may push companies toward buybacks that lift the stock price above option strikes rather than pursue value-enhancing investments that payoff over the long-term. From the CEO and board's perspective, they don't really know how long they'll be at the company for, and their stock options have finite lives. So, why pursue something that will pay off decades years down the road when they can buy stock, get a huge bonus and quit/retire/get fired?

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It's interesting to see that internet Buzzfeed-style click-bait headlines have made their way to the academic world.

 

Montier is not academic. He's in investment management.

 

 

Regarding his paper, I think it has some good thoughts. But parts of it are crap.

 

I agree with him that CEOs and top management in USA are way overpaid. I vote against in most proxy advisory votes (FFH and BRK are two exceptions. There are more but not many more).

 

I think he is partially right about short-term incentives for a lot of CEOs. This is not very good. However, without SVM, the companies may be deadweight dinosaurs that just exist to exist and do not provide good capital returns to shareholders. There's a number of Euro and Japanese companies that are run like that. I am not sure if Montier would be happy to work for any of them or invest into them.

 

I think a bunch of people also agree that stock buybacks above intrinsic value destroy wealth for shareholders while creating rewards for management. I doubt this is SVM though. ;)

 

It is possible that public companies are underinvesting. However, this is capitalism. If public companies are underinvesting, then private (or other public companies) can snatch their marketshare by overinvesting. I doubt that everyone in USA just made a cartel and decided not to invest and keep margins high. There is some rationality in not overinvesting and not plunging into price wars. It actually shows management rationality that they don't do it unless they see an edge.

 

The drop of labor wealth is mostly due to globalization. SVM is likely not a big contributor. Like Munger says, people complaining about drop of labor wealth are complaining about millions of Chinese climbing out of poverty. Would USA be in a better position if it was protectionist and did not allow cheaper labor in China/India to contribute?

 

 

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It's interesting to see that internet Buzzfeed-style click-bait headlines have made their way to the academic world.

 

Montier is not academic. He's in investment management.

 

I meant that in the broadest sense of the word. This isn't exactly something that Jane Average would read in between two reality show episodes.

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The article does raise some issues:

 

First, companies are exactly great at capital allocation. With dividends at least investors get to make the choice..

 

Second, short-term incentives may push companies toward buybacks that lift the stock price above option strikes rather than pursue value-enhancing investments that payoff over the long-term. From the CEO and board's perspective, they don't really know how long they'll be at the company for, and their stock options have finite lives. So, why pursue something that will pay off decades years down the road when they can buy stock, get a huge bonus and quit/retire/get fired?

 

Most companies and managers being bad is a general problem, it doesn't have anything to do with buybacks specifically. Whatever system you put them in, most people will make mistakes, follow the herd, put their interests above the shareholders', grow for growth's sake, waste money, focus on the wrong things, follow fads, etc.

 

Investors get more of a choice with buybacks than with dividends, actually. With dividends you don't have a choice but to get it and pay taxes. With buybacks, you can decide to sell shares in pro-rata to the buyback or not (and then be taxed less).

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The article does raise some issues:

 

First, companies are exactly great at capital allocation. With dividends at least investors get to make the choice..

 

Second, short-term incentives may push companies toward buybacks that lift the stock price above option strikes rather than pursue value-enhancing investments that payoff over the long-term. From the CEO and board's perspective, they don't really know how long they'll be at the company for, and their stock options have finite lives. So, why pursue something that will pay off decades years down the road when they can buy stock, get a huge bonus and quit/retire/get fired?

 

Two scenarios both give investors a choice. With buybacks you can do nothing and keep re-purchase of shares in the company (at no tax cost) or you can sell shares in equivalent value to the amount of the buyback.

 

With dividends you pay tax and you can choose to do nothing and thus keep your yield or you can use the dividend to buy more shares.

 

Being in silicon valley I would prefer less investments by companies because I have seen the waste and destruction to the economy done by wasteful R&D. I would prefer the valley go back to the way of the 70's and 80's when ideas came from passion rather than now where it is more motivated by greed.

 

 

 

 

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The problem in my mind is that many buyback programs (while never explicitly stated) largely are conducted (a) to offset stock option dilution and (b) irrespective of stock price.

 

I had a debate with a running buddy (who works in finance) about buybacks, and I think he generally views buybacks as always good...

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The problem in my mind is that many buyback programs (while never explicitly stated) largely are conducted (a) to offset stock option dilution and (b) irrespective of stock price.

 

I had a debate with a running buddy (who works in finance) about buybacks, and I think he generally views buybacks as always good...

 

It wouldn't be the first thing that people are wrong about.

 

Buybacks aren't always good, just like dividends aren't always good or investment in the business or M&A isn't always good.

 

If a company is doing something stupid, the solution is to not invest in it. We'll never be able to turn all CEOs in Warren Buffetts. Even if for most companies buybacks are a stupid choice, that doesn't make buybacks themselves bad, just like M&A isn't bad in itself just because most companies destroy value for the sake of empire building. With a hammer you can build a house or hit yourself in the head, it's just a tool. You certainly wouldn't want to restrict/outlaw buybacks/M&A/hammers...

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The article does raise some issues:

 

First, companies are exactly great at capital allocation. With dividends at least investors get to make the choice..

 

Second, short-term incentives may push companies toward buybacks that lift the stock price above option strikes rather than pursue value-enhancing investments that payoff over the long-term. From the CEO and board's perspective, they don't really know how long they'll be at the company for, and their stock options have finite lives. So, why pursue something that will pay off decades years down the road when they can buy stock, get a huge bonus and quit/retire/get fired?

 

Two scenarios both give investors a choice. With buybacks you can do nothing and keep re-purchase of shares in the company (at no tax cost) or you can sell shares in equivalent value to the amount of the buyback.

 

With dividends you pay tax and you can choose to do nothing and thus keep your yield or you can use the dividend to buy more shares.

 

Buybacks give you a choice whether or not to pay taxes, dividends give you no choice and force you to pay taxes.  If you choose to use your dividend to buy more shares, you would have been better off with a buyback.

 

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The arguments that investor can decide for themselves with dividends makes no sense.

 

If the stock is undervalued, buybacks are always better

 

If the stock is overvalued, buybacks are bad. But why hold the stock? The fact that the investor is holding an overvalued stock means that he will not invest it somewhere else in a better way. He is holding an overvalued stock after all!

 

I see that a lot on this forum too. If you prefer a company to pay dividends, you should sell the stock right away. Because either you can invest it somewhere else with a better return, or you are holding a overvalued company. This is simply rational, and not some matter of preference like some think.

 

Finally you could argue that the index investor will be hurt by this. But on average you would say an index is unlikely to be very over or under valued? As it balances out, so in that case buybacks aren't that bad? If companies are slightly overvalued, the fact that the investor doesn't pay tax on the dividend makes up for it no? And on average, over time, I would say buybacks are not very likely to take place when stocks are overvalued. Unless there is some systemic bias that makes CEO's buyback overvalued stock, but not undervalued stock.

 

 

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The arguments that investor can decide for themselves with dividends makes no sense.

 

If the stock is undervalued, buybacks are always better

 

If the stock is overvalued, buybacks are bad. But why hold the stock? The fact that the investor is holding an overvalued stock means that he will not invest it somewhere else in a better way. He is holding an overvalued stock after all!

 

I see that a lot on this forum too. If you prefer a company to pay dividends, you should sell the stock right away. Because either you can invest it somewhere else with a better return, or you are holding a overvalued company. This is simply rational, and not some matter of preference like some think.

 

Finally you could argue that the index investor will be hurt by this. But on average you would say an index is unlikely to be very over or under valued? As it balances out, so in that case buybacks aren't that bad? If companies are slightly overvalued, the fact that the investor doesn't pay tax on the dividend makes up for it no? And on average, over time, I would say buybacks are not very likely to take place when stocks are overvalued. Unless there is some systemic bias that makes CEO's buyback overvalued stock, but not undervalued stock.

 

There's a lot of other concerns that can make different people prefer certain things, though. For example, if you are living off of your portfolio, getting dividends can make it easier to get through downturns without being forced to sell at the wrong time because you have bills to pay.

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From the article: "Before 1982, when John Shad, a former Wall Street CEO in charge of the Securities and Exchange Commission loosened regulations that define stock manipulation, corporate managers avoided stock buybacks out of fear of prosecution."

 

Apparently Henry Singleton didn't get that memo.

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From the article: "Before 1982, when John Shad, a former Wall Street CEO in charge of the Securities and Exchange Commission loosened regulations that define stock manipulation, corporate managers avoided stock buybacks out of fear of prosecution."

 

Apparently Henry Singleton didn't get that memo.

 

I wonder if tender offers were considered to be different from buybacks in the open market.

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The arguments that investor can decide for themselves with dividends makes no sense.

 

If the stock is undervalued, buybacks are always better

 

If the stock is overvalued, buybacks are bad. But why hold the stock? The fact that the investor is holding an overvalued stock means that he will not invest it somewhere else in a better way. He is holding an overvalued stock after all!

 

I see that a lot on this forum too. If you prefer a company to pay dividends, you should sell the stock right away. Because either you can invest it somewhere else with a better return, or you are holding a overvalued company. This is simply rational, and not some matter of preference like some think.

 

Finally you could argue that the index investor will be hurt by this. But on average you would say an index is unlikely to be very over or under valued? As it balances out, so in that case buybacks aren't that bad? If companies are slightly overvalued, the fact that the investor doesn't pay tax on the dividend makes up for it no? And on average, over time, I would say buybacks are not very likely to take place when stocks are overvalued. Unless there is some systemic bias that makes CEO's buyback overvalued stock, but not undervalued stock.

 

yadayda, I see your point. But it is based in a totally rational , efficient market. But we all know management often do not have the best interest of the shareholders in mind, or they may not be rational, or they may not see the value if they are an undervalued company.  Case in point are the many japanese netnets, what wonders they would do for the stock price and earnings if they would buy back their shares with all their money. But instead they give out a puny 1-2% dividend and think that is enough.

 

 

 

 

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As a general phenomenon I don't like companies levering up and doing buybacks when it actually worsens their capital structure (as is mostly the case). It's a bad sign for the economy as a whole that companies aren't willing to invest into capex and that the perceived IRRs on buybacks exceed the ones of additional investments into a company's business.

 

If a company actually has too much cash on its balance sheet and no use for it, buybacks will always be preferable to dividends because of taxation. Even with overvalued stocks you as a shareholder can balance unreasonable buybacks by selling the equivalent amount of shares (but then why are you holding overvalued shares in the first place?).

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The article does raise some issues:

 

First, companies are exactly great at capital allocation. With dividends at least investors get to make the choice..

 

Second, short-term incentives may push companies toward buybacks that lift the stock price above option strikes rather than pursue value-enhancing investments that payoff over the long-term. From the CEO and board's perspective, they don't really know how long they'll be at the company for, and their stock options have finite lives. So, why pursue something that will pay off decades years down the road when they can buy stock, get a huge bonus and quit/retire/get fired?

 

Most companies and managers being bad is a general problem, it doesn't have anything to do with buybacks specifically. Whatever system you put them in, most people will make mistakes, follow the herd, put their interests above the shareholders', grow for growth's sake, waste money, focus on the wrong things, follow fads, etc.

 

Investors get more of a choice with buybacks than with dividends, actually. With dividends you don't have a choice but to get it and pay taxes. With buybacks, you can decide to sell shares in pro-rata to the buyback or not (and then be taxed less).

 

Certainly, if buybacks are done properly, they are somewhat more tax-efficient by allowing you defer taxes. However, the key is if they are done properly.

 

If you believe that on average share buybacks are value-destructive (or even non-value-enhancing), and that shareholders are better capital allocators, than perhaps dividends offer a better route for investors despite the lack of tax deferral.

 

I'm not suggesting that the mechanism itself is flawed, merely the incentives that allow most companies to exploit this mechanism. I mean if we assume a world where buybacks aren't allowed. Then you have less situations where companies would repurchase stock at 100x P/E to push up stock prices vs. investing in R&D/factories that can generate large returns 20 years down the road or paying a dividend to shareholders who can reallocate the dividends.

 

Obviously, you can argue that the company may just use the excess cash to purchase a couple of corporate jets. However, from an optics perspective, shareholders would easily dismiss that as excessive and wasteful. On the other hand, things like poorly timed share buybacks continue under the veil of shareholder-friendly governance.

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