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When a buyback looks like executive pay
May 29, 2013 / 7:21 PM / 4 years ago

When a buyback looks like executive pay

(Reuters) - You know those “shareholder-friendly” stock buybacks the market is so excited about? Most of that money is going to offset options granted to executives.

Perhaps even better, much of the funding for this transfer of assets (or just reward for managerial excellence in a competitive marketplace, if you prefer) is being funded by debt.

And what is making this latest debt binge possible? Quantitative easing.

That is pretty much all you need to know as an investor, both about the state of American corporate governance and monetary policy.

Here are the facts about S&P 1500 companies, excluding financials, courtesy of Societe Generale quantitative analyst Andrew Lapthorne:

“In the first quarter of 2013, buybacks done to offset the dilution from executive stock options reached a post-crisis high. Meanwhile, the amount of buybacks done to reduce the overall share count (i.e. for the benefit of shareholders) reached a 32-month low,” he writes in a note to clients.

In other words, companies buying up shares with one hand and handing them out to employees with the other. And, at least in the first quarter, they were handing out so many that more than half of the billions being spent on buybacks was simply going to keep pace with new share issues, much of which is compensation.

While it can be tricky figuring out what companies are doing based on their disclosures, Lapthorne performs a fairly simple calculation, looking at the change in shares outstanding, multiplying that by the average share repurchase prices and then comparing to total net buybacks.

Now, nothing is wrong or unethical in this great chain of cash splashes. While the effectiveness of QE is debatable, it is at least being done to help the economy, though its effects are demonstrably of the trickle-down variety. Similarly borrowing money at cheap rates makes some sense, though perhaps companies could come up with a better and more productive use than handing much of it out as options. (And remember, buying up shares has a much more direct relationship to the value of options than do long-term investments such as plants or research.)

As well, paying executives in share options has its uses. And while anyone who has looked at the data will prefer a straight return of capital through a dividend, at least share repurchases tend to drive stock prices over the short term.

THE GREAT CHAIN OF CASH

Let’s review how this works, and how QE plays a crucial role. When the Federal Reserve buys government and mortgage bonds, investors are left with the decision of what to do with the cash, especially given low current interest rates. Many decide to buy corporate bonds, and as a result we’ve had record issuance of corporate debt, often at historic low interest rates and with few of the sorts of lender protections which were standard just a decade ago.

And what are companies doing with all of this new cheap debt? Many are using it to buy back shares, with almost $300 billion announced in the U.S. so far this year, nearly double the figure from the same period a year ago. That compares to $259 billion of new corporate debt issuance in the first quarter.

That’s an important distinction, because it makes many share buybacks look like more of a form of leverage than return of capital to shareholders.

There are two fundamental criticisms of this state of affairs.

Firstly, it illustrates how inefficient QE is as stimulus, and how unequally its benefits are distributed. Yes, some of that QE cash corporations are borrowing is going to new plants and jobs, but a distressing amount only hits the economy when investors - too often insiders who were granted shares - take capital gains.

For investors this simply underscores that too much of the money generated by the companies they own flies out the door in the form of compensation and too little regard is paid to the long-term returns of the typical shareholder. Companies which borrow funds (or earn them, for that matter) have a few choices about what to do with the money.

They can invest it in new capacity, research and products, and hopefully increase returns long term to investors.

They can return it as dividends, and let shareholders decide how to allocate the money.

They can fund share buybacks, which disproportionately benefit insiders with options.

That so many companies choose buybacks, taking on debt to do it, is reason for caution about long-term U.S. stock market returns.

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(James Saft is a Reuters columnist. The opinions expressed are his own)

Editing by James Dalgleish

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