The Buyback Endemic

Buying back stock at unreasonably high valuations is not a good use of capital and can destroy shareholder value.

Buybacks can be a good way for companies to enhance shareholder value. Share buybacks reduce the number of shares outstanding, allowing companies to pay a higher dividend per share in the future.

But not all buybacks are good. Done at the wrong price, buybacks can actually be a bad use of capital. In fact, I have seen so many companies do buybacks recklessly and without consideration of the share price.

The problem probably arises from a few reasons. 

Wrong mindset

First, some executives do not have a good grasp of what buybacks are. Take this statement from Tractor Supply’s management in its 2024 second-quarter earnings report for example:

“The Company repurchased approximately 0.5 million shares of its common stock for $139.2 million and paid quarterly cash dividends totaling $118.5 million, returning a total of $257.7 million of capital to shareholders in the second quarter of 2024.”

The issue with this statement is that it lumps dividends and share repurchases in the same bracket. It also implies that share repurchases are a form of returning capital to shareholders. The truth is that share repurchases is not returning cash to long-term shareholders but only to exiting shareholders. If management mistakes repurchases as capital return, it may lead them to do buybacks regularly, instead of opportunistically.

Although I am singling out Tractor Supply’s management, they are just one out of many management teams that seem to have the wrong mindset when it comes to buybacks.

Incentives

Additionally, executive compensation schemes may encourage management to buy back stock even if it is not the best use of capital. 

For instance, Adobe’s executives have an annual cash remuneration plan that is determined in part by them achieving certain earnings per share goals. This may lead management to buy back stock simply to boost the company’s earnings per share. But doing so when prices are high is not a good use of capital. When Adobe’s stock price is high, it would be better for management to simply return dividends to shareholders – but management may not want to pay dividends as it does not increase the company’s earnings per share.

Again, while I am singling out Adobe’s management, there are numerous other companies that have the same incentive problem.

Tax avoidance

I have noticed that the buyback phenomena is more prevalent in countries where dividends are taxed. 

The US, for instance, seems to have a buyback endemic where companies buy back stock regardless of the price. This may be due to the fact that US investors have to pay a tax on dividends, which makes buybacks a more tax-efficient use of capital for shareholders. On the contrary, Singapore investors do not need to pay taxes on dividends. As such, Singapore companies do not do buybacks as often.

However, simply doing buybacks for tax efficiency reasons without considering the share price can still harm shareholders. Again, management teams need to weigh both the pros and cons of buybacks before conducting them.

Final thoughts

There is no quick fix to this problem but there are some starting points that I believe companies can do to address the issue. 

First, fix the incentives problem. A company’s board of directors need to recognise that incentives that are not structured thoughtfully can encourage reckless buybacks of shares regardless of the share price.

Second, management teams need to educate themselves on how to increase long-term value for shareholders and to understand the difference between buybacks and dividends.

Third, management teams need to understand the implications of taxes properly. Although it is true that taxes can affect shareholders’ total returns when a company pays a dividend, it is only one factor when it comes to shareholder returns. Executive teams need to be coached on these aspects of capital allocation.

Only through proper education and incentives, will the buyback endemic be solved.


Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Adobe and Tractor Supply. Holdings are subject to change at any time.

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