Pressure to provide buybacks can also lead to underinvestment in the business and downward pressure on wages, write Allen He and Sarah Keohane Williamson
Buybacks have undergone a meteoric rise since the turn of the 21st century, overtaking dividends as the preferred means to return capital to shareholders in many countries. In 2019 alone, firms spent more than $1.2 tn globally on buybacks. Buybacks are controversial, however, with academics, practitioners and politicians all maligning their use.
At its most basic level, buying back shares can be a technical capital-allocation tool and an attractive alternative to dividends. Buybacks are more flexible than dividends for both companies and shareholders, can recycle excess cash to growth areas of the economy and provide tax advantages in certain jurisdictions.
But while buybacks can be an attractive method of returning cash to shareholders, care must be taken that they are not used to manipulate earnings per share, hit quarterly targets or inflate compensation metrics. Pressure to provide buybacks can also lead to underinvestment in the business, downward pressure on wages exacerbating income inequality, or employee insider knowledge vis-à-vis selling their own shares.
When considering a buyback, it is critical to be able to tie the buyback program to the company’s strategy and performance. Corporate boards can assess whether the buyback plan supports the overall capital allocation strategy. For an apples-to-apples comparison, expected buyback ROI can be compared with the discounted future ROI from other uses of cash – including investments in R&D, capital expenditure and M&A.
Actual buyback ROI can be tracked and evaluated to determine the success of the program. To avoid compensation gaming, plan structures can eliminate the potential effects of buybacks, stripping out or minimizing links to earnings per share.
Finally, boards have started to recognize the need for resilience when the unexpected happens and the need to stress-test balance sheets when contemplating buybacks.
But the onus is not solely on companies; investors should encourage buybacks only when they actually create long-term value. Investors can evaluate whether buybacks are the most efficient use of capital in the long run and make their views known. In some countries, shareholders approve buybacks directly; in others, the board is responsible for that approval.
Regardless of location, however, shareholders have a strong say in the company’s approach to buybacks through their votes, their engagement and their investment decisions.
Likewise, policymakers have a role to play in mitigating buybacks’ potential harm. In many jurisdictions, buybacks receive preferential tax treatment, leading many shareholders to choose them over dividends. It is ironic that buybacks enjoy favorable tax treatment in the US while also being a practice that American policymakers frequently disparage. Leveling the tax treatment so that shareholders are truly indifferent would solve this problem.
To ward off insider trading, mandatory blackout windows on employee stock trading could be strengthened around buyback announcements and execution. Policymakers and regulators can also consider adopting stricter disclosure requirements around share buybacks.
Companies, investors and policymakers could each take steps to mitigate the potential pitfalls of buybacks. While buybacks are a valuable capital allocation tool, they are also a potentially dangerous one, and boards must use them only thoughtfully and in specific circumstances that support and build long-term value.
Allen He is associate director of research and Sarah Keohane Williamson is CEO at FCLTGlobal, a non-profit organization that develops research and tools that encourage long-term business and investing. FCLTGlobal’s report, The dangers of buybacks: Mitigating common pitfalls, highlights the drawbacks and strategic use of corporate buybacks.
