Buybacks and Dividends

(Bloomberg) -- Picture yourself as the CEO of a big, publicly traded company. You want to keep your shareholders happy and justify a big bonus for yourself. One solution is to invest your profits in developing new products, building factories or opening stores. Making money this way is hard: It requires identifying opportunities, managing new initiatives and waiting for them to pay off. An alternative is to give stockholders the cash the company has earned. This is easy: You just buy back some shares or increase dividends. Which is the better thing to do? The answer might be different for you, the company, its stockholders and the economy.

The Situation

 JPMorgan Chase & Co. strategists estimate that gross share repurchases will reach a record of around $800 billion in 2018, up from $530 billion in 2017, a rise spurred in part by the big cut in corporate tax rates passed by Republicans in Congress in December. Along with pumping up bonuses based on stock prices, buybacks make it easier for CEOs to meet quarterly earnings-per-share targets, by reducing the number of shares. They contribute to bull markets: In some years, shares bought in buybacks have outnumbered purchases by mutual funds by as much as 6 to 1. And they mollify activist investors, who have agitated for a piece of companies' cash hoards. These bonanzas for shareholders, though, have consumed resources that companies might have put into expansion, hiring or raises. Buybacks exceeded capital expenditures over the five years through 2017, while wages stagnated and workers' share of business income remained near record lows.

The Background

Big stock buybacks are a relatively new development. As recently as the 1970s, they were effectively banned in the U.S., amid concerns that executives would use them to manipulate share prices. That changed in the 1980s. Against the backdrop of President Ronald Reagan's deregulatory drive, restrictions on buybacks were loosened and a culture of “shareholder value” was born. The idea was that the market should act as a disciplining force: Executives who couldn't find attractive projects should give money back to investors, who would put it to better use. A wave of hostile takeovers made sitting on a pile of cash seem like a dangerous thing to do. And managers' bonuses were increasingly tied to stock performance, to align their incentives with those of shareholders. Suddenly, buybacks boomed, often paid for by increased borrowing. In the new worldview, this was good: Tax breaks made debt a cheaper form of financing, and the need to make regular interest payments could focus executives' minds on generating more cash. Over the next few decades, the stock market's perceived function — raising money for business ventures — was turned on its head, as stocks became a vehicle largely for returning money to shareholders.

The Argument

Investors, academics and a number of Democrats have asserted that buybacks have gone too far. Some money managers, including Larry Fink, the CEO of BlackRock, have called on executives to place the longer-term interests of companies and employees over the short-term boost that cash payouts can give. Researchers have linked buybacks to declines in investment and employment, and even suggested that companies are contributing to inequality by enriching shareholders — who tend to be affluent already — at the expense of workers and the broader economy. Others are less concerned. Executives, the logic goes, can't be blamed for giving back money if they don't see any attractive opportunities. In such an environment, throwing cash into new projects would be a waste. Eventually, investors will reallocate the funds to other enterprises with better ideas — indeed, this is the best way for the economy to adapt and remain competitive. On the other hand, a Bloomberg Intelligence analysis suggests that many buybacks are so poorly executed — buying high and selling low — that they can leave shareholders worse off.

The Reference Shelf

• In 1986, Michael Jensen published a seminal paper on the advantages of paying cash to shareholders.
• A Harvard Business Review article makes the case for buybacks as promoting innovation.
• Economist William Lazonick assesses the economic drawbacks of share repurchases.
• Economists at the University of Illinois link share buybacks to investment and jobs.
• J.W. Mason of the Roosevelt Institute explores whether share buybacks broke the link between borrowing and investment.
• Researchers describe the history of share-buyback regulation.

First published May

To contact the writer of this QuickTake: Mark Whitehouse in New York at mwhitehouse1@bloomberg.net.

To contact the editor responsible for this QuickTake: John O'Neil at joneil18@bloomberg.net.

©2018 Bloomberg L.P.