Stock buybacks—i.e., a company repurchasing shares of its own stock—have been targets for praise and criticism through the years. So, which are they: good or evil? We agree with The Wall Street Journal columnist Jason Zweig, who once wrote:

“Buybacks are neither bad nor good. They are simply a tool. Just as you can use a hammer either to build a house or knock one down, buybacks are useful in the right corporate hands and dangerous in the wrong ones.”

In other words, a stock buyback can help you, hurt you, or be a neutral event, depending on the particulars. Today, let’s embark on a balanced look at stock buybacks.

Part I: How Do Stock Buybacks Work?

Big Picture: Diversification Is Still Our Best Friend

Before we dive into any details, let’s answer a bigger question: No matter how you may feel about stock buybacks, what should you do about them as an investor? If you’re familiar with our general investment strategy, our answer will come as no surprise:

Stock buybacks give investors yet another reason to prefer widely diversifying their investing across myriad asset classes around the world, rather than trying to get ahead by deliberately picking or avoiding particular stocks or industries.

As with any stock bid, even a well-devised buyback can backfire if the future doesn’t unfold as hoped for. It can be even worse if the buyback motives were shaky to begin with. Because we can’t predict, we advise investing across a globally diversified portfolio of low-cost mutual funds or ETFs, using fund managers who avoid engaging in market-timing or stock-picking. That way, you’ll continue to capture long-term market growth—including any returns generated by stock buybacks—without needing to assess each one as it occurs.

In this context, let’s look at how buybacks generally work. Even if you’re not actively participating in individual stock buybacks, it’s worth being informed about them—especially if you’re employed at a company that may periodically offer them.

How Do Stock Buybacks Work?

In general, you and other traders can buy or sell any publicly traded stock on an open exchange like the NASDAQ or New York Stock Exchange (NYSE). Similarly, a company can participate in these same exchanges, using its retained earnings to buy back or extend a tender offer to repurchase some of its own stock.

However, just because a company wants to buy back shares, does not mean you have to sell any of yours. A stock buyback offer is just like any other trade on the open market. Before a trade occurs, would-be buyers and sellers must agree on a fair price.[1]

There is also one noteworthy difference between a stock buyback versus simply selling stock to another trader. In a “regular” trade, one of you is the seller, and the other is the buyer. End of story. But when you own a company’s stock, you own a piece of its capital, making you a co-owner. Thus, in a stock buyback, you may have vested interests on both sides of the trade.

And that’s where things get interesting. How do companies use (and occasionally abuse) stock buybacks to deliver sustainable value to its shareholders? We’ll explore that next.

Part II: Sustaining Current and Future Value

Striking a Balance: Buy Back or Plow In?

Broadly speaking, stock buybacks are meant to deliver value to a company’s shareholders in two potential forms:

  1. A bump in share value: Removing shares from the public exchange increases the per-share worth of remaining shares. As one of the world’s best-known business owners Warren Buffett described in his 2022 Berkshire Hathaway shareholder letter: “The math isn’t complicated: When the share count goes down, your [shareholder] interest in our many businesses goes up.”
  2. An opportunity to sell: Those on the sell side of a stock buyback presumably profit from the trade, or at least have some incentive to sell shares.

At the same time, your company (if you’re a shareholder and/or an employee) must spend some of its retained earnings during a buyback, or potentially even take on debt. Clearly, this leaves less cash in the company coffers for other purposes.

As such, a stock buyback represents a trade-off between two opposing forces: enhancing shareholder returns, versus preserving enough capital to continue delivering solid value moving forward.

A company’s management, its employees, and its investors should typically want to strike an appropriate balance between sustaining current and future value. Stock buybacks can (but don’t always) help make this happen.

Why Do Companies Repurchase Their Own Stock?

How and when does a company decide a stock buyback represents shareholders’ best interests, and the best use of its capital? There are a number of reasons a company may embark on a buyback offer.

[1] If you are invested in a mutual fund or ETF, rather than directly in individual stocks, the fund manager decides on your behalf whether to accept company buyback offers. But the principle remains the same: The buyer and seller must agree on a fair price at which to trade.

Distributing “excess” capital: If a company is thriving, with what feels like a cash surplus on its books, its board may decide to reward shareholders with the aforementioned boost in stock value. If the buyback offer is appealing, current shareholders may also take some of their gains off the table by selling shares back to the company.

One argument goes: If a company has more cash than it really needs, a buyback may make more sense than spending the money mindlessly, at the ultimate expense of its shareholders. Here’s how Zweig has described it:

“Expecting oodles of surplus cash not to burn a hole in the typical CEO’s pocket, however, is like putting a pile of raw meat in front of a lion and expecting it not to disappear. My favorite examples come from the 1970s, when—just like now—giant oil companies had vastly more capital than they could plow back into their existing wells.”

Creating tax-efficiency: You may have noticed a similarity between stock buybacks and dividend distributions. For both, the company pays out capital to shareholders … with a tax twist. Dividend distributions are taxable when they occur. In a stock buyback, your shares increase in value, but you’re only taxed on a gain when/if you sell them. Thus, stock buybacks are considered a more tax-friendly way to distribute capital to company shareholders, at least in taxable accounts.

Managing share dilution: If a fast-growing startup (for example) has leaned heavily on stock options to recruit and retain employees, these options can start to dilute the stock’s per-share value once employees begin exercising them. If the company has thrived, it may choose to buy back some of its “excess” shares, to maintain good value on the remainder.

Fighting a takeover bid: A stock buyback is expected to increase share value, as described above. Obviously, the higher the share price, the more expensive it becomes to snatch up new shares. Thus, a stock buyback is one way a company may try to prevent a hostile takeover.

So far, we’ve summarized the ways stock buybacks can be an effective tool in the right hands, delivering powerful, tax-efficient value to shareholders, without necessarily stunting future growth. Next, we’ll look at how this same power tool can end up being weaponized in the wrong hands, and why the government is keeping an eye on the practice.

Part III: Risks Amidst the Rewards

Bad Apples in a Big Cart

First, it’s worth emphasizing that evidence in the U.S. and around the world suggests that most stock buybacks function as hoped for; the bad apples are exceptions to the norm.

For example, a study published in a 2019 Journal of Financial and Quantitative Analysis looked at some 9,000 stock buybacks across 31 countries, from 1998–2010. The authors also compared their results to past U.S. and global studies of similar focus. Describing their work as, “to our knowledge, the most extensive analysis of buybacks around the world,” the authors concluded:

“On average, share repurchases are associated with significant positive short- and long-term excess returns.”

However, not every stock buyback is a beautiful thing. The authors also observed:

“While, on average, buybacks are beneficial for long-term investors, when we dissect the cross-section of buybacks around the world, we find evidence supporting a more nuanced view. Not all buybacks are created equal.”

Price vs. Worth

Warren Buffett offered a similar caveat as he extolled the virtue of stock buybacks in his Berkshire Hathaway 2022 shareholder letter:

“Every small [buyback] helps, if repurchases are made at value-accretive prices.”

What did Buffett mean by “value-accretive”? He was talking about whether a stock’s price accurately reflects the company’s true earning power. In other words, given the risk/reward tradeoffs the company faces, is there enough “there” there to warrant the asking price?

Volumes of evidence suggest that the collective wisdom of the market’s crowds creates among the most rational price-setting around. But this does not mean the price is continuously correct. If price-setting mechanisms run amok, such as if a company tenders an unrealistically high buyback offer, efficient markets have a way of eventually correcting the imbalance. But in the meantime, there may be immediate winners and losers in the resulting trades. As Buffett notes:

“[W]hen a company overpays for repurchases; the continuing shareholders lose. At such times, gains flow only to the selling shareholders and to the friendly, but expensive, investment banker who recommended the foolish purchases.”

Managers, Shareholders, and Everyone Else

Again, if a going enterprise truly has more cash than it can use for value-added purposes, it can make good sense to direct some of its profits back to its shareholders at a fair price.

But who gets to decide it’s time for a buyback, at what “fair” price? Often, the company’s managing stakeholders—the same individuals who usually stand to benefit the most during a buyback offer—are the ones weighing in heavily on these calls.

Can you smell the potential conflicts of interest? No wonder there are some ill-advised buybacks. Sometimes, a few appear to have pilfered company reserves to fatten their own purses with pumped-up prices, at the ultimate expense of many others—including, potentially, the general public.

In his aforementioned column, Zweig offers some telling examples on this front. He cites Lehman Brothers, and its $4 billion in stock buybacks within six months of its 2008 collapse. There was also Citigroup’s $20 billion in 2004–2008 repurchases “right before it needed a roughly $45 billion government bailout during the financial crisis.”

Whether a buyback is ill-fated due to excessive greed or simply unintended consequences, the negative repercussions can be equally unpleasant to those left holding the proverbial bag—especially if we, the people, end up spending public funds to clean up a mess.

Government Initiatives

Again, evidence strongly suggests injurious buybacks are the exceptions to an otherwise healthy norm in a productive, relatively free-market economy. But given the stakes involved, perhaps it’s no surprise that the government has been keeping its eye on stock buybacks.

There are also those who feel stock buybacks are receiving an unfairly sweetened tax deal compared to dividend payouts. Both methods distribute company capital to shareholders. But where dividends are taxable in the year incurred, any post-buyback bump in stock value isn’t taxable until shareholders sell their stock for a realized gain.

These concerns have spurred two avenues of government activity: taxes and regulations.

For example, in July 2023, the Federal Reserve proposed raising capital requirements for at least the nation’s largest banks. In other words, banks would have to increase the amount of capital they’re required to keep on hand, reducing the amount they can use on buybacks. As reported by The Wall Street Journal, many banks have halted buyback programs for now, pending resolution of the proposal.

On the tax front, efforts have been aimed at reducing the perceived incentive to favor stock buybacks over dividends, as well as potentially generating an even higher tax windfall from buybacks.

Specifically, the Inflation Reduction Act of 2022 has imposed a 1% excise tax on companies making stock buybacks after December 31, 2022. In July 2023, the IRS released transitional guidance, effectively putting the requirement on hold, pending “forthcoming regulations.” However, the IRS has also instructed companies to maintain detailed records on any buybacks they perform in 2023 and beyond.

Time will tell how this tax tale ends. Largely along party lines, there have been efforts to pass an even higher excise tax of 4% “to help reinvest in the economy, while also preventing abuse and reducing tax avoidance” (as described by proponents of the higher rate).

On the flip side, others feel any excise tax is unfair, unnecessary, and harmful to American business interests. For example, financial author and podcaster Meb Faber has bluntly expressed:

“Dividends and buybacks are already taxed twice: when the company makes money and again when the investor receives payment. Taxing buybacks three times [through an added excise tax] is obviously insane!”

Where Do We Go From Here?

As Americans, each of us is entitled to our opinions on how our government should proceed in taxing and regulating corporate stock buybacks. As financial advisors, our opinion isn’t as important as how we advise you to integrate the information into your personal investments.

As we expressed at the outset of this report, the trickiest thing about investing in any single stock is the infinite number of ways its future can surprise us—for better and for worse. Company- or sector-specific news, government action, global socioeconomics … all of these influences and many others can alter whether any given stock buyback plays out in your favor as a shareholder.

For a long-term investor, your best course is to capture market-wide sources of return according to your willingness, ability, and need to take on accompanying market risks. By holding a globally diversified portfolio, you’re highly likely to benefit from an ongoing stream of return-generating stock buybacks, without being overly harmed by the occasional failures.

If you work for and hold stock or stock options in a company that engages in stock buybacks, you may not be able to diversify away all of the concentration risks involved. But there are ways to manage them more effectively. Please be in touch for a personal conversation.

Beyond that, at least in your role as an investor, you’re probably best off leaving the politics of stock buybacks to the politicians. Vote according to your preferences when the time comes and stay the course with your diversified investments.

Please let us know if we can answer additional questions you may have about how stock buybacks work, and how to make best use of them in your own financial planning.

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