Ralph Nader steamed as stock buybacks pick up steam

Earlier this month, former presidential candidate and famed consumer advocate Ralph Nader took aim at the $7 trillion of corporate stock buybacks since 2003, declaring the phenomenon a "monster of economic waste."  Mr. Nader notes that prior to the enactment of Rule 10b-18 of the Securities Exchange Act in 1982, stock repurchases were considered unlawful stock manipulation.  But the stock buyback mania was unleashed in 1993 when President Clinton's first budget bill included §162(m) of the Internal Revenue Code.  This provision limits the deductibility of compensation in the form of salary and bonus for a company's top-5 executives to the first $1 million each in computing corporate taxes.

One apparent unintended consequence of the rule is that compensation for top executives has shifted dramatically to equity awards, the effect of which has been to drive up the overall level of pay for CEOs and others.  Although Mr. Nader singles out compensation consultants for initially pushing this innovation, the C-suite does not come off unscathed in the story.  The stock buyback mania, Mr. Nader maintains, is not motivated by a desire to benefit shareholders but to increase CEO pay by improving earnings-per-share to boost share price.  He finds a massive conflict of interest between corporate executives and their own company because stock buybacks extract capital from corporations rather than channeling it to productive corporate purposes.  But it is corporate boards, due to the deference accorded per the business judgment rule, that can authorize substantial share buybacks without seeking shareholder approval.

Arguing that stock buybacks "parasitize" the economy, Mr. Nader is hardly the first prominent figure to criticize the practice that has swept across corporate America.  He contends that the funds allocated to repurchase shares could have been invested in research and development, productive plant and equipment, raising worker pay, shoring up shaky pension fund reserves, or increasing dividends to shareholders.  Citing economics professor William Lazonick, he alleges that CEOs devise buyback programs primarily to escalate their pay to exorbitant levels, resulting in increased societal inequality and stagnant middle class wages.  Finally, he points to data indicating that the share performance of companies with excessive stock buybacks compares unfavorably with market returns, and in some cases suffered outright declines.

The intent behind stock buybacks and their effect on individual companies as well as their impact on the U.S. economy can be explored in greater depth at another time.  But in recent years the vast scale of stock buybacks in aggregate and as a proportion of equity markets is indisputable.  According to Credit Suisse, the corporate sector, by way of buybacks, has been the main buyer of U.S. equities since the market low reached early in 2009 in the aftermath of the global financial crisis.  In July, Credit Suisse strategist Andrew Garthwait wrote that "one of the major features of the US equity market since the low in 2009 is that the US corporate sector has bought 18% of market cap, while institutions have sold 7% of market cap."

Due to policy uncertainty, primarily involving interest rate levels, buyback activity slowed in the first half of 2017, down 21% compared to the first half of 2016.  Goldman Sachs estimates that buybacks will pick up in the second half of 2017 because buybacks in the Financials sector are expected to increase 60% due to improved Comprehensive Capital Analysis and Review (CCAR) results and buyback seasonality (second half buybacks usually account for 60% of the annual total).  For 2017, Goldman lowered its annual corporate demand, i.e., repurchases, forecast to $570 billion from $640 billion, implying a net decline of 9% from 2016.  Its forecast for 2018 is $590 billion, up 3% from 2017.

The modest anticipated increase in 2018 buybacks over the previous year, and below the total for 2016, is attributed to several factors:

• The equity market is at record highs with company valuations stretched.
• Rising interest rates could discourage companies from issuing additional debt to fund buybacks.
• If policy does not become clearer, management teams may throttle back cash outlays like they did in the first half of 2017.
• "Buyback stocks" have lagged broader indexes; in other words, investors appear to be bidding up share prices for companies that invest for growth as opposed to companies returning cash to shareholders.

Unlike U.S. equity markets, e.g., S&P 500 and Dow Jones Industrials, which regularly hit all-time highs these days, annual stock repurchase totals won't be breaking records any time soon.  But barring interest rates settling at a higher plateau, corporate buybacks show little sign of pulling back substantially.

Robert Stead