In defense of stock buybacks
Stock buybacks are suddenly controversial, with critics arguing that they are hurting the American economy, killing jobs, and manipulating stock prices and therefore must be banned. Bernie Sanders, the Vermont senator running for president, has made slamming buybacks a theme of his campaign. And William Lazonick, an economics professor at UMass Lowell, has asserted that banning buybacks is key to reviving the middle class.
Is this ordinary corporate tactic really so bad? Actually, buybacks are both useful and benign — and in no way warrant restriction. Let’s start with the basics: stock buybacks are a converse operation to stock sales. Companies issue stock — that is, they sell slices of equity — to raise capital. They buy back stock to retire capital. These buybacks occur for two reasons.
Sometimes, a firm accumulates more capital than its business can profitably employ. Believe it or not, overcapitalization can be just as harmful as undercapitalization. Companies with an overabundance of capital tend to do stupid things. They become lazy about operating efficiently, or build a vanity headquarters, or make a foolish acquisition. Such pursuits may make the CEO feel important, but (often) they waste the shareholders’ capital. Retiring excess capital is smart business.
The other common reason for repurchasing shares is that executives believe their stock is cheap — and indeed, cheaper than possible alternatives. This is not “manipulating” the stock. As with an investment you make in your 401(k), buybacks will pay off if — and only if — the executives’ calculation about value is correct. Suppose you had a 50-50 partner in a private business worth $1 million; one day your partner, feeling gloomy, offers to sell his half for only $250,000. Buying him out would increase the value of your equity. In just that way, buybacks of inexpensive stock raise the value of the remaining shares.
If the executives are wrong, however, and the stock is overpriced, no amount of stock repurchases will raise the share price (except perhaps in the very short term). Indeed, with every overpriced share the company acquires it becomes that much poorer.
Decisions about selling and retiring stock are part of the process of “capital allocation,” one of the most important functions of the capitalist system. It is the market’s way of directing society’s capital where it is most productive.
There are many things the capitalist system cannot do well — or doesn’t do at all. There is no market mechanism for restricting pollution or for prohibiting monopolistic mergers or for setting a reasonable floor on wages. We need government for that. But allocating capital is far better done by the private sector. No government office can decide how much capital each firm should work with, or where it should be deployed — and none should try.
Protesters of corporations such as McDonald’s have charged that buybacks represent a “theft” from the employees. However, the capital that a McDonald’s uses in share buybacks isn’t diverted from employees any more than it is diverted from beef producers, or ketchup distributors, or any of the company’s other vendors. Capital belongs to the shareholders. McDonald’s has a fiduciary duty to employ that capital profitably, hopefully at competitive rates of return. Lazonick has written that the idea that profits belong to shareholders “is true only according to an ideology that defies common sense.” I would like to see him devise a system in which investors put up capital without being entitled to the profits.
Roger Lowenstein is a writer in Newton. His next book, “America’s Bank: The Epic Struggle to Create the Federal Reserve,’’ will be published in October.