The writer is the founder of Greenwich Associates, author of 19 books and a former board member of Vanguard
Surprisingly, prominent government and media figures continue to express concern, even concern, about public companies buying up their shares on the open market.
While almost anything can be done the wrong way for the wrong reasons, stock buybacks have much to commend them and should be encouraged as a superb discipline in corporate finance.
The weather is changing. A century ago, only tangible assets were considered appropriate as a basis for valuing public companies. Then earning power was recognized as a reasonable basis for public ownership and companies such as Sears Roebuck became market leaders. The Depression and World War II tightened capital and standards set in, including equity cash.
The discipline of business strategy is to maximize returns on limited resources. That’s why, during rationing, candy bar makers changed their product lines to maximize yields of their limited wartime resource: sugar. For most 20th century companies, equity was their strategically limited and limiting resource. But with the increasing importance of intangibles such as trademarks, patents or technologies, more and more companies are not limited by the necessary capital.
One way to deploy capital effectively is to develop new or improved products, or new markets, or to make sound acquisitions. Of course, as we’ve all learned in the age of conglomerates, many – if not most – acquisitions destroy value, so caution is in order. The same goes for new products and new markets. Building better businesses is not easy!
So what should a great leader do? Assume the business has been skillfully optimized and there are no major opportunities to invest? When Warren Buffett was asked why he was so successful as an investor, his answer was, “I’m rational. It is worth considering in this context.
Of course, it is rational to reduce debt to a comfortable level. It makes no sense to burden a business with too much debt, just as it makes no sense to neglect capital expenditures.
Business strategy should aim to optimize risk and reward. The financial strategy should strive to optimize both the composition and the size of the capital. When marginal earning capacity is determined by factors other than capital, an increasing number of firms will generate more capital than is needed in the business.
Then the question is whether to return capital to owners through dividends or share buybacks. The latter are, of course, much more flexible and less subject to tax. No wonder they have become increasingly popular.
In the United States, there was a particularly amusing two-part illustration of the old rule that legislatures should avoid meddling in corporate management. The first came a few years ago when Congress passed a corporate tax cut. Contrary to congressional expectations, most companies have not incurred capital spending increases. They were already making all the investments in factories and equipment justified by the economic situation.
So what did they do? They put the money where it would do the most good for their owners: they bought back shares to maintain good governance discipline in their share capital structure.
While some may laugh and say there is no direct connection, many might wonder if the recently enacted new tax on stock buybacks was motivated or “justified” by congressional grudge. The tax – bundled into a climate, tax and healthcare bill known as the Cut Inflation Act – is the second illustration of the dangers of legislative interference. At 1% on share buybacks, that’s certainly too little to alter a sensible corporate decision. Business decisions are rarely so elegant that a 1% tax on a capital decision would make the difference between going and not going.
Meanwhile, more and more companies will continue to optimize the combination of debt and equity in their capital structures, especially those that increase their profits each year largely due to marketing and technology, which are not capital intensive.
Apple – arguably America’s most successful company – is also one of the most active in stock buybacks, having repurchased more than $500 billion worth of stock over the past decade. The correlation is strong and, I believe, instructive.
Congress should reconsider the tax, especially in the national interest of making American businesses more competitive. Proper discipline in one area correlates with good discipline in other areas of business management and should be encouraged to keep America competitive.