The corporate buyback is a deceptively simple thing, one whose very name suggests the act of buying something back, when in reality, it's much more complicated than that.
In the wake of Sept. 11, companies have been engaging in more of these buybacks for a wide variety of reasons. To help clarify what this rise in buybacks means, we talked to David Ikenberry, an associate professor of business at the Jesse H. Jones Graduate School of Management at Rice University.
TSC: Let's start with a really basic question -- is a buyback just when a company goes into the open market and buys shares of itself? And why do companies do buybacks?
There are two formats by which companies repurchase stocks. One is through the open market. The second is through some kind of an exchange offer, where the company shouts a price and the quantity that they're interested in.
An exchange offer is just like a hostile takeover, as if another company was bidding. But in this case, they're taking over themselves. Those programs tend to be larger than in the open market and tend to happen very rapidly. And they tend to be done in a shorter period of time. A fixed-price tender offer or a Dutch auction tender offer might be completed in a handful of months. Open market programs tend to be completed in a handful of years.
TSC: Why would a company want to do a buyback?
There are four motivations for why a company would buy back stock. One of them is what I call dividend substitution. There's an increasing trend in the last few years for companies not to initiate cash dividends but to do something else. As companies mature, they tend to pay off dividends. There's a trend in the last decade of companies that skip the dividend initiation phase and skip straight to the share repurchase stage. A company like
, for example, is one of these new companies.
Additionally, you have companies that, rather than increase their cash dividends on a year-over-year basis, tend to hold their dividend flat. And what would have gone into a dividend increase is now being plowed into share repurchases. So, that's one big reason.
TSC: And the others?
The second big reason deals with distributing excess cash and returning that to shareholders. There's a traditional story that companies create value for shareholders by investing in good projects. And as companies mature and as those projects begin to become less and less prevalent, companies that are generating excess cash flow need to distribute that back to shareholders, and let them put that back into the economy. That's how the economy works. That's Adam Smith's invisible hand at work.
A couple of years ago, this was precisely the activity that liberated capital from the Old Economy and put it into the New Economy. In short, repurchases are part of the natural death and natural birth process. They're critical to the functioning of our capitalistic system.
The third reason why companies buy back stock is to alter their capital structure, which is the relationship between the amount of debt financing and the amount of equity financing they have within the firm. When a company buys back stock, it's increasing the amount of debt relative to the amount of equity, by definition. And so, companies that are in need of that kind of maintenance activity are more prone to repurchasing their shares. This is extremely common for companies that have a great deal of exposure to stock options.
TSC: Such as?
There are many companies that are very aggressively using stock options as part of the executive compensation system. A stock option has the effect of essentially expanding the equity base of the company, and therefore changing the capital structure of a company. On Wall Street, they call this expansion the run rate. Year over year, the run rate on many companies is on the scale of 2% to 3% a year. For high-tech companies, the run rate can be as high as 7% to 10% a year. And that's a very serious expansion of the capital base. And when left unchecked, that could dramatically alter the capital structure of their companies.
In many cases, stock repurchases are used as a balancing mechanism. That's the third big class of factors.
The fourth big class of factors is a mispricing story. And this is what most people probably have in mind when they think about stock repurchases. If the stock becomes depressed in price, companies may look at buying back their own stock as a very attractive use of capital. And there's a real signal embedded in that story. While the other three reasons are all potentially good reasons and helpful to shareholders, this is the most intriguing one. It suggests that the stock price may be cheap and may be a good value for investors and we actually find some support for this idea.
Of course, not all companies who buy back their shares do it because it's cheap.
TSC: Is this why analysts come out and say that buybacks are good. That they're eating their own cooking, so to speak?
Right. It's a very positive sign. Some people take a rather dim view of these things but I think those people tend to underappreciate the dynamic of what's going on. For example, they'll say, "I don't think the company should because if it does that it's shrinking its own capital base and that's an un-American, communistic idea." This is nonsense.
If companies didn't repurchase shares, our economy would be set back quite a bit.
TSC: In the last 10 months or so, we've seen a lot of capital head into nontechnology investments, like hospitals and gold stocks. So what are we seeing now on the buyback front? Is it more prudent to do a buyback in a recession?
We've seen a dramatic increase in the number and frequency of share buybacks. Up through Sept. 10, repurchase activity was comparatively modest, due to the general economic downturn/recession we've been going through since the market peak. And you find that when companies are going through cash-flow strains and stretches, there's actually a shrinkage in the number of repurchases and announcements of repurchasing activity.
But in the last few months, starting in the third quarter at about July, we began to see a dramatic increase in the amount of repurchasing activity. And we don't have too much in the way of numbers for the recent history, but there's a lot of indication that in just the past three months, repurchasing rose a lot.
In the week following the tragedy, we had close to 300 buybacks. I don't have the exact figures on hand, but it was a significant increase. And since then, we've had a lot more.
TSC: Is 300 a significant number over and above what is normal?
Yes. I think we had like 700 up through September and I may have that number wrong. But then, in the span of three weeks after the attack, we had like 300. One of the real drawbacks of repurchases is that the disclosure of repurchases is miserable -- in effect, nonexistent. The company CEO, if he buys 100 shares for his granddaughter, has to disclose that 10 days into the next month. And then that information is beamed around the world.
But the same CEO on the same day can execute a 100 million-share order and there's no law that prohibits that activity. The only law that governs repurchase activity is called Rule 10B18, but it's essentially a guideline. There are no -- and underscore the word no -- there are no disclosure requirements aside from the very modest disclosure buried in the cash-flow statements.
Many companies don't even report raw repurchasing activity. For example, in many of the common electronic media you look at, the line item that goes for share repurchases includes not only common stock, but preferred stock. And it's not only repurchases, it's also net of issuances. So the company may have a lot of executive stock options, but you'll never know they were in the market repurchasing shares. There's a huge number of disclosure issues.
Getting a clear picture with U.S. disclosure policies is very difficult. It's very difficult to see some very huge liabilities laying around. Now you've got me on my soapbox.
TSC: Getting back to the previous issue, it's clear that American disclosure may be problematic, but from what we can see, buybacks are up post-Sept. 11. Some people may be surprised by that, thinking that in a recession, companies wouldn't want to spend money on buying back their shares. What's going on?
There's a couple things going on. Stock prices for many companies have come way down. While the market, overall, is still relatively expensive, there are many companies in the market by historical standards that are historically cheap. And so when a manager announces that they intend to buy back stock, they're sending this signal and a vote of confidence that their stock is mispriced.
I heard a number this morning that said something to the effect of, if you took all the companies that announced a repurchase in the week after 9/11 in the
and compared that to the S&P 500 overall, then the S&P is essentially flat to up 2%. And the companies that repurchased are up 10% or so. I don't know if that's a valid number or not. But it isn't surprising to me.
When we look at the crash of 1987, when the typical stock lost 20% of its market cap in a short period of time, we saw a flood of repurchase activity in the days following that. Those stocks outperformed their peers in the quarter following that and in the next four years.
TSC: So companies do buybacks during recessions because there is value in there?
Absolutely. Because they're looking forward. If they were focused on the short run, logic would hold that they keep their powder dry and be less willing to buy back stock. What the evidence seems to suggest is that the companies are willing to look beyond the near-term stresses and strains.