While the stimulus bill passed this week did a lot of good things, it included one really short sighted provision that will lead to some undesirable unintended consequences. Any public company that takes assistance is banned from buying back stock (or paying dividends) for the duration of the loan plus one additional year.
This generates great headlines for politicians. I get that. Companies “shouldn’t be taking bailout funds to buy back their stock”. But let’s look beyond the soundbite and think through the ramifications.
The Immediate Issue: Negating the Stimulus
First, the biggest issue one should have with buybacks is companies buy at the wrong price. They are just as bad at buying at the highs and selling the lows as retail investors are.
If a company could truly demonstrate that borrowing from the government to buy stock at the lows was the best IRR on the cash (assuming they weren’t doing layoffs and closing stores at the same time), then they should be able to do so.
It’s highly unlikely in this environment that they could do so because most companies who will ask for government funds are worried about the state of their balance sheets. If you borrow from the government, you need to pay it back.
If you think you have the resources to pay the loan back after buying stock, then you didn’t need it to begin with (unless you were using it as a bridge loan that you expect to repay quickly). This isn’t hard.
The dividend restriction on the other hand is more onerous. If you’re having a temporary cash flow issue, you may not normally need to turn off your dividend. If you’re having a solvency issue, then the company will logically cut the dividend to stay alive. They are not going to need to be told to.
This creates a big problem. Fewer companies than expected will take the aid due to the dividend and other restrictions (no layoffs, executive comp caps). You might think this is good news, but it’s not because it will slow the recovery.
If the goal is to avoid layoffs, then don’t create reasons for companies to turn down the aid due to other handcuffs. Because they do have another option. They will max their LOCs instead.
This allows them do layoffs if necessary. Given the uncertainty over how long the economy will be depressed, guaranteeing no layoffs for the length of the loan is a difficult condition to agree to. Also, pushing companies to use their LOC instead of government loans strains the banking sector which isn’t a good outcome.
The Ongoing Issue: Misallocation of Capital
But let’s look past the short term trade off and examine the bigger issue with demonizing buybacks. Simply, it’s going to create new problems that hurt economic growth.
Let’s play this out. If companies are limited in their ability to buyback stock, what will they do with excess capital instead? Well, there are four alternatives:
- Pay it out as dividends
- Invest in the business
- Pay employees more
- Buy stuff!
Dividends
Theoretically, there isn’t much of a difference between returning capital through share repurchase or dividend. It’s really just a commentary on the value of the stock. There is a real issue where companies continue to buyback stock when it is overvalued as they don’t want to signal to the market that their stock is overvalued, but that’s a separate discussion.
The management objections to more dividends usually begin with “I don’t want to commit to a higher fixed charge”. There is logic to that. The easy solution is keep the fixed dividend low and pay special dividends. Some companies do this and, while their stocks generally trade at premium valuations, most companies violently resist when they are encouraged to pay a special dividend.
Why? The answers I have gotten over the years tend to be either a) it creates too much unpredictability (like there isn’t variability in repurchase levels!) or b) taxes, as in CEOs don’t want to pay them on their own holdings so would rather keep divs low vs. the alternative of deferred tax on capital gains. Yes, shockingly, some CEOs put their personal interests ahead of the shareholders!
So, notwithstanding the current proposed limitations, would some companies go the special dividend route if repurchases were constrained? Sure, but I predict it would be a minority.
Invest in growth
This is what the pols want: companies should do more CAPX and hire more employees! Trust me, if CEOs could find more growth projects, they would have already pulled the trigger on them.
With rare exception, any CEO who can cut his buyback to “invest in growth projects” will do it if the IRR is even barely acceptable (and sometimes when it’s not even close). CEOs love spending on organic growth. That’s where the action is!
When the CEO retires, the corporate bio never says “lead peers in buying back stock”. No, it says something about “built new markets” or “introduced new product” or even “improved margins through aggressive cost cutting”. It never mentions the buybacks.
To bring it back to theory though, encouraging companies to lower their hurdle for new investments (which is effectively the incentive here) will only hurt growth overall as it means capital is being misallocated.
Pay employees more
This is what the pols really want! Give everyone raises instead of doing buybacks. This obviously would lower margins and hurt stock prices. In a class warfare world, maybe this is appealing, but it ignores that the working class has 401ks or pensions that benefit from stock prices. Lower stock prices hurt state pensions which requires tax hikes and reduced services.
It hurts small businesses who have to match the wage hikes at larger competitors. Lower returns on investment will stunt business formation which will reduce jobs in the economy. This will increase the supply of workers which in turn will lower wages. Water finds its level! OK, let’s not belabor this one anymore and move on to where the fun is.
M&A
If we polled CEOs on what they would do with their excess capital (in a normal economy) if they couldn’t do buyback, my bet is 80% would say “I’M GONNA BUY ME SOME STUFF!!!” That’s the realistic incentive being created here.
Most companies are not going to say they’re going to lower their IRR hurdle. Nor will they say special dividends approximate the purpose of buybacks, so let’s do those instead.
No, they are going to view it as a free pass to go on an M&A bender. What makes me so confident of this? Well, look at the M&A bender we’ve been on the last several years! Do we really need to add more fuel to the fire?
M&A valuations at this point in the cycle are largely based on hope. Many deals are labeled as “strategic” M&A which is code for “I can’t justify this deal on the numbers, so let’s call it strategic so our stock gets killed less”.
If we create an artificial bid for strategic M&A because the capital is otherwise trapped, what will this do to M&A prices? Yes, it will drive them up. A lot! So now we start really overpaying for things and essentially embed future goodwill writeoffs in the balance sheet.
Additionally, any targets will see their stock prices spike ahead of selling out as investors will overweight targets and underweight acquirers. Activists will get involved and agitate for those perceived sellers to auction themselves off. We essentially encourage a mini bubble in smaller or distressed companies.
This means capital is misallocated just like in our example above with lowering the IRR on capital investments. Creating artificial incentives for M&A lowers the required IRR to complete a deal. While CEOs show some reluctance to do that with investments, they don’t tend to need much encouragement to do deals, even undisciplined ones, especially when they can sell hope that they will achieve some synergy goal or grow in some new market.
Be Careful What You Ask For!
Thus, the takeaway is an ongoing restriction of share buybacks will lead to foolish deals, irrational stock prices, and CEOs eventually losing their jobs (once the smoke clears and the deal proves to be a dud). Sounds like great policy!
Finally, there’s this great misunderstanding that if companies hadn’t bought back stock over the last five years that they would have hoarded the cash for a rainy day instead. That’s nonsense.
Companies with too much cash either spend the cash on something stupid as I’ve explained or they end up the subject of a hostile takeover. It’s sheer fantasy to think companies would have built this big pile of cash for winter like a squirrel hoarding nuts.
By the way, to the brilliant pols who haven’t thought their ideas through (or outsourced them to 24 year old aides with no practical experience), more M&A means more job cuts (synergies!) so congratulations, you are not going to create jobs with this idea, you are going to destroy them. Well done!