When a talking head, on CNBC, proclaims that Company X has announced a stock buyback, it is unfailingly hailed as good news for shareholders. After all, in the world of high finance, cash is trash, leverage is good, and stock buybacks can boost earnings per share and the price of the stock itself. When stock buybacks are executed judiciously, shares are purchased when management recognizes that the stock is undervalued — as it is preferable to buy while the price is low (at least that’s the theory). All of this is done, of course, under the guise of enhancing shareholder value. Hence, what is good for the shareholder (i.e., a stock buyback) must be good for the company itself. This is exactly what the charlatans, of Wall Street, want you to believe; and it is a lie.
The financial distress, besieging America’s largest financial institutions, exposes the pernicious nature of stock buybacks. Call me old fashioned and financially conservative as I have never agreed with the idea that weakening a company’s balance sheet is beneficial for the company and its shareholders — yet, it does benefit a very select group of shareholders and this will be covered below. Repurchasing shares weakens a company’s balance sheet in three key ways in that cash, working capital, and equity are diminished by the dollar amount of the shares repurchased. When a company’s stock-buyback program, over time, adds up to billions of dollars, the negative financial impact can be staggering.
The stock prices, of America’s largest banks and brokerages, have been getting hammered. Yet the declining stock prices fly in the face of the "wisdom" of buying back shares in that a scarcer number of shares should lead to higher stock prices. The following table, comprised of seven high-profile American financial institutions, neatly exposes the falsehood that stock buybacks increase shareholder value.
From 2001 Through 2007
From fiscal-year 2001 through fiscal year-end 2007, these seven companies have repurchased $127.3 billion of their common stock. I would argue that each company’s stock-buyback program actually intensified the downward pressure on the price of their respective common shares.
It is well known that there is a global credit crisis and that investors are nervous about which financial institutions will or will not survive through these uncertain times. Top-notch financial strength, consequently, is viewed as a virtue. Thus, it stands to reason that had each of the above-mentioned companies not engaged in such reckless stock buybacks, each company would possess a dramatically stronger balance sheet. In turn, better financial strength provides a company with a greater chance of surviving difficult economic circumstances and, accordingly, would be reflected favorably in the price of its common shares. Return, to any one of these companies, the money it squandered on stock buybacks and you’d see a company with a higher stock price than currently bestowed by the marketplace.
Let’s test, a little more, Wall Street’s "logic" with respect to share repurchases. If a stock buyback is good for a company, shouldn’t buybacks take place when times are tough? After all, during tough times, shouldn’t management do good things for a company? Moreover, if stock prices have dropped precipitously, shouldn’t management be repurchasing shares hand-over-fist? The actions, of the seven aforementioned companies, speak volumes about such questions; and exposes stock buybacks as nothing more than a Wall Street scam.
Through the first five months of 2007, these seven financial institutions bought back $14.4 billion of their common stock. Through the first five months of 2008, the same exact companies repurchased only $786 million of their shares — a reduction of nearly 95%. It is painfully clear that each company’s management team has determined now is not the time to further weaken their respective balance sheets. Corporate survival may be at stake. After all, share repurchases would further erode the balance sheet and the share price may suffer even further. So, when is it ever a good time to weaken a company’s balance sheet?
In Berkshire Hathaway’s 2005 annual report, Warren Buffett criticized executive compensation schemes in his letter to shareholders. In the following example, Mr. Buffett makes it quite clear that a company’s top executives and managers can be compensated handsomely even if the company’s performance is mediocre or poor. At the epicenter, of such a compensation scheme, is management’s control over whether or not to engage in stock repurchases. Read it and weep:
Too often, executive compensation in the U.S. is ridiculously out of line with performance. That won’t change, moreover, because the deck is stacked against investors when it comes to the CEO’s pay. The upshot is that a mediocre-or-worse CEO — aided by his handpicked VP of human relations and a consultant from the ever-accommodating firm of Ratchet, Ratchet and Bingo — all too often receives gobs of money from an ill-designed compensation arrangement.
Take, for instance, ten year, fixed-price options (and who wouldn’t?). If Fred Futile, CEO of Stagnant, Inc., receives a bundle of these — let’s say enough to give him an option on 1% of the company — his self-interest is clear: He should skip dividends entirely and instead use all of the company’s earnings to repurchase stock.
Let’s assume that under Fred’s leadership Stagnant lives up to its name. In each of the ten years after the option grant, it earns $1 billion on $10 billion of net worth, which initially comes to $10 per share on the 100 million shares then outstanding. Fred eschews dividends and regularly uses all earnings to repurchase shares. If the stock constantly sells at ten times earnings per share, it will have appreciated 158% by the end of the option period. That’s because repurchases would reduce the number of shares to 38.7 million by that time, and earnings per share would thereby increase to $25.80. Simply by withholding earnings from owners, Fred gets very rich, making a cool $158 million, despite the business itself improving not at all. Astonishingly, Fred could have made more than $100 million if Stagnant’s earnings had declined by 20% during the ten-year period.
Indeed, stock repurchases benefit a narrow group of corporate insiders. Not only can such insiders benefit while the company remains stagnant, they can financially benefit while simultaneously demolishing the company’s balance sheet. A perfect example can be found at Citigroup.
As you saw above, Citigroup was the most aggressive company when it came to repurchasing shares. Over the past three quarters, Citigroup has suffered a cumulative net loss of $17.4 billion. To be sure, these losses were "baked in the cake" ten to fourteen quarters ago when Citigroup was speculating in mortgage-backed securities, extending shaky loans, entering into risky transactions with the monoline insurers, and participating in speculative leveraged buyouts. Credit standards were set irresponsibly low so that revenues and net earnings would go sky high. And, in order to goose Citigroup’s stock price and executive compensation, Citigroup engaged in nothing short of an orgiastic stock buyback program. It worked for a while with the stock peaking at nearly $56 per share in December of 2007. Now, the chickens have come home to roost as Citigroup’s share price has collapsed by approximately 65%.
Since Vikram Pandit became Citigroup’s CEO eight months ago, he has been instrumental in raising $40 billion in new capital for Citigroup. As stated in this July 15, 2008 International Herald Tribune article, Mr. Pandit "…is trying to turn around Citigroup as the banking industry struggles through one of its most challenging periods since the Depression. His task is particularly difficult because many Citigroup bankers, paid with stock and options for years, have seen their fortunes vanish. Morale is low." I have no sympathy for these demoralized Citigroup executives and managers as their "fortunes" were built upon a financially destructive stock-buyback program pyramided upon intellectually bankrupt business and credit practices.
The next time you hear a CNBC talking head gush over a company’s stock-buyback announcement, think of Fred Futile and his self-dealing management style. To praise the weakening of a company’s financial condition reveals the vapid nature of financial reporting. More importantly, the incredible amount of stock repurchased by the seven above-mentioned financial institutions exposes the intellectual and moral rot of countless business managers and their Wall Street enablers. Not a single analyst has cried "foul" and questioned the grotesque balance sheet mismanagement of any of these financial powerhouses (or, more accurately, former powerhouses). To me, this further reinforces my core belief that Wall Street exists to redistribute wealth from the poor and the middle-class to the wealthy. To deny this is to remain comfortable dealing with liars and thieves.