In the last days of the tech bubble at the turn of the century, companies announced stock splits and the price of their stocks jumped. Services would alert day traders of splits so they could pounce on the stocks before the uninformed masses. Why would a split have any effect on the price of a stock other than a directly proportional adjustment? (e.g., A two-for-one split should reduce the price of the stock by 50 percent.) Supposedly a split represented management’s confidence in the company’s prospects, or some such rah rah. And a pizza cut into eight slices represents more pizza than one cut into six slices. It was the craziness of the time. Ultimately, all those splits did was make stocks more affordable for day-trading greater fools.
It is the craziness of our time that stocks elevate when companies take actions—advertised as “shareholder friendly”—that harm the company and its shareholders: increasing dividends and buying back shares. A company pays the corporate tax on its profits. When it pays dividends, shareholders, unless they are tax exempt, are taxed on the distribution. If the company retained the money, it could be used for productive investment. Shareholders have bought ownership in the company because they believe the company’s management will generate a return. Investors buy Berkshire Hathaway stock because they believe Warren Buffet can achieve a higher return on their money than they can.
Warren Buffet believes the same thing. Berkshire Hathaway does not pay a dividend; Buffet keeps the money and makes more investments. The many fold increase in Berkshire’s share price over the years is testament to his success. Why invest in a company if the company is going to give your money back, and you pay taxes on the distribution? Some companies even borrow to fund such distributions. The company is depriving itself of capital that could be used for profitable investment, incurring a debt that will have to be repaid from future profits, and handing many of its shareholders a tax liability.
With share buybacks, the company pays out to shareholders who are either reducing their holdings or selling out completely. The company cannot figure out anything to do with its capital, so it speculates in the stock market. Berkshire Hathaway occasionally buys back its own stock, but Buffet says it does so only when he judges that the stock price is below its intrinsic value and his record is good. The herd of corporate managers, like the herd of investors generally, buy high. After five years of a bull market, stock buybacks set a record in 2014 and may do so again in 2015. By many time-tested measures, stock valuations are stretched, definitely not the stuff of glowing returns. The criticism about funding dividends with debt applies equally to funding buybacks with debt. Bondholders get the short end of the shareholder friendliness stick, as it reduces the company’s cash and creditworthiness.
Buybacks can also create a capital gains tax liability for selling shareholders. With both dividends and buybacks, not only may shareholders have to pay taxes, they must also figure out what to do with the proceeds. Spend the money? Stick it in CDs paying near zero interest? Buy stock in another shareholder friendly company that will end up returning their money?
Notwithstanding the costs to both shareholders and their companies, dividends and buybacks have supported stocks. Short term paydays outweigh longer-term considerations. The biggest fans of shareholder friendliness are corporate executives, whose compensation is often tied to the share price. Robert Prechter has noted that many practices deemed acceptable in bull markets become unacceptable in bear markets, with punishment meted out retroactively for the newly instated sins. Spending the company’s money and incurring debt to support the share prices and the value of stock options may, when the music stops, look questionable, venal, or outright criminal, depending on the severity of the next bear market.
If executives are put in the dock, they can claim the Federal Reserve made them do it. Its debt monetization and interest rate suppression have provided so much liquidity and driven returns so low that the honchos can argue they couldn’t do anything else with corporate cash but distribute it to shareholders or speculate on their own stock. For companies sitting on mountains of cash, that defense has exculpatory merit. Why leave an asset that earns next to nothing on the balance sheet? Furthermore, the stated aim of central banks has been to drive money into riskier investments; from corporations to seniors who cannot fund their retirements from “safe” fixed-income investments offering minuscule yields. Corporate executives, their high-priced lawyers will argue, were merely getting with the program, with their own enrichment an incidental consequence. Seniors have no high-priced legal talent to argue their case, but for many, if they don’t buy stocks and junk bonds and pick up some hours at Walmart, they’re looking at cat food dinners. Unfortunately, when this force-fed equity golden goose meets its inevitable end, pâté won’t be gracing their plates or those of millions of other Americans—they’ll be savoring Scrumptious Shredded Salmon or Choice Chicken Chunks.
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