Recently, stock buybacks—the widespread practice of public firms repurchasing their own shares in the open market—have been targeted as a cause of income inequality, with some Democrats on Capitol Hill calling for restrictions or even a ban on such transactions. Companies, they say, should use the cash to invest in R&D or pay higher wages to workers, rather than put money into buybacks to enrich shareholders and senior executives. Harvard Law Professor Jesse Fried ’92 first became interested in the use and misuse of repurchases as an Olin Fellow at HLS in the mid-1990s. He has recently co-written several articles on the topic, including “Are Buybacks Really Shortchanging Investment?” with Charles C.Y. Wang in the Harvard Business Review. Here, Fried offers perspective on a complex, and increasingly political, topic.
There has been quite a lot of media attention—most of it unfavorable—for stock buybacks. Why?
For the last decade or so, the U.S. has been experiencing sluggish growth and growing inequality. Many claim both problems are due to large payouts by public firms to shareholders, mostly via stock buybacks. These buyback critics often point to a 2014 study finding that S&P 500 firms have been distributing over 90 percent of their net income to investors through repurchases and dividends.
The cash used to repurchase shares, it is claimed, could have been used for growth-stimulating investment or to pay higher wages. As buybacks soared in 2018 due to the 2017 tax reform, this criticism intensified, and legislation in the Senate was introduced to ban them altogether.
While both dividends and buybacks move cash from firms to shareholders, repurchases tend to attract the most criticism because they are more easily abused to enrich executives.
Your research challenges the notion that buybacks are preventing companies from investing for the future. Can you explain?
If increasing levels of buybacks were actually depriving firms of cash needed for investment, we’d expect to see this effect in the data. But my research with Charles Wang shows that R&D spending by public firms is at a record high, both in absolute terms and relative to revenues. A broader measure of investment—R&D plus capital expenditures (CAPEX)—is at record levels in absolute terms and near-record levels in relative terms. And public firms are not cash-constrained from spending more. Indeed, over the last decade cash balances have risen from about $3.5 trillion to a record $5 trillion. Of course, we don’t know whether investment is at optimal levels; maybe R&D and CAPEX should be even higher. But if investment is insufficient, cash-draining buybacks cannot be the cause.
Such high levels of investment and cash holdings seem hard to square with the finding that buybacks and dividends by S&P 500 firms total over 90 percent of net income. But that’s because this ratio—buybacks and dividends to net income—actually tells us very little about how much of the value that is available for internal investment goes to shareholders. First, the numerator reflects gross payouts to shareholders: repurchases and dividends. But marketwide, about 80 to 90 percent of buybacks are offset by equity issuances, which move cash from investors back to firms. Net shareholder payouts—repurchases and dividends, less issuances—are only about 40 percent of net income. Second, the denominator— net income—is not a good measure of resources available for investment, as it reflects what’s left after a company invests in R&D. Across all public firms, net shareholder payouts as a percentage of income available for investment are only about 33 percent, with plenty left to be invested or stockpiled for a rainy day. This explains why we can observe both high levels of buybacks and rising investment and cash balances.
How would you respond to the argument that companies should be paying higher wages with that money?
Profitable corporations are not the right vehicle for redistributing wealth, in my view. It’s important to remember that not all firms turn out to be profitable. Many fail, generating losses for investors. However, investors expect that gains from those firms that are profitable—some of which go public—will more than offset these losses. If we start taking a portion of the profits generated by successful firms and diverting them to non-investor constituencies, investors’ now-reduced gains from winners may no longer offset their losses. The incentive to finance new and growing companies would decline, impairing investment and job creation throughout the economy. If redistribution is desired, the appropriate vehicle is tax policy.
You noted that buybacks can be abused. How does this occur, and how can it be addressed?
Executives whose bonuses are based on earnings per share, or EPS, may be able to trigger a bonus by aggressively repurchasing shares to shrink the share count. There’s evidence of such undesirable manipulation. Repurchases can also be used to exert buying pressure to push up the stock price before executives sell their shares. That’s not a good thing either. Finally, stock-owning executives with inside information suggesting that a firm’s shares are underpriced can increase the value of their own shares by having the firm buy back cheap stock. It’s like insider trading, but via the corporation.
All of these abuses could be mitigated by improving disclosure requirements for repurchases. Right now, a firm buying its own stock in the open market need not disclose these transactions until several months after they occur, and must only report monthly averages. I have proposed subjecting firms trading in their shares to the same disclosure requirements imposed on their officers and directors: requiring disclosure of each individual trade within two business days. Such fine-grained real-time disclosure would quickly reveal abusive buyback transactions to regulators and investors, enabling them to take appropriate action.