Tuesday, November 22, 2011

Share Buybacks Are Good, But For Whom?

Free cash flow--when a company generates more cash than is needed in normal business operations--is typically highly valued by professional investors.  Surplus cash, when in the hands of capable management teams, can be used for debt reduction, new business ventures or acquisitions, dividend increases, or share repurchases.  All of those actions are expected to increase returns to investors.

Investors typically have cheered share buyback announcements because when a company enters the stock market to buy its stock, the additional buying demand presumably drives up the share price.  Using surplus cash for share buybacks also prevents managements from making poor capital allocation decisions--such as making expensive acquisitions of other companies--when the basic business lacks expansion opportunities.  But research by Fortuna Advisors found that over the last decade, companies that spent the most on share repurchases had significantly lower returns to shareholders than companies that spent the least.  (I would like to see more information on that, as well as corroboration by another study.)

There is a broader point as well.  What might be good for a single company--or at least its top executive--might not be good for the company's workers, investors, or the country as a whole.  The New York Times reported that as companies often continue to cut jobs and amass cash hordes, they're repurchasing stock in massive amounts--$445 billion authorized just this year.  This shrinkage of shares outstanding can increase reported earnings per share--and enable CEOs to hit bonus goals of eps--even though the underlying business is not growing satisfactorily (Zimmer is a notable example).

Such emphasis on achieving short-term eps targets is antithetical to sustainable investing.  Sustainable investing considers various stakeholders in a business enterprise, including workers and communities, and places a premium on managements who anticipate the long-term environmental and social challenges facing its industry.  Such companies tend to be better managed--period. Companies with superior managements that focus on the long term sustainability of businesses have a competitive advantage.  The evidence supports this, as companies ranked high in sustainability have produced superior returns to investors. So short-term earnings per share goals can produce a conflict between the interests of a handful of top executives and the interests of other stakeholders in the business--and when it's done throughout the economy--against the interests of the country as a whole.

Steve Lehman

No comments:

Post a Comment