‘You Can Make A Reincarnated Steve Jobs The Next CEO’, And Other Highlights From Goldman’s Buyback Chat With Aswath Damodaran

Over the past two months, Goldman’s David Kostin has embarked on a veritable crusade to dispel what he calls “popular misperceptions” about buybacks.

As regular readers know, we’ve generally soured on this debate, and here’s why:

…at this juncture, the issue has become hopelessly politicized on one side (the anti-buyback push on Capitol Hill) and on the other side, it’s impossible to disentangle selfish rationalizing from honest efforts to clear the good name of share repurchases.   

That’s from a Saturday post called “Imagine A World Without Buybacks“, in which we summarized all the latest political rumblings around corporate cash usage on the way to elaborating a bit on what it would mean for markets if buybacks were eliminated.

The above-mentioned David Kostin conducted a kind of thought experiment late last week in which he laid out what the five major implications of a buyback prohibition would be. Suffice to say there are a number of potential pitfalls. You can read the linked post for the details, but one of the most dangerous unintended consequences of eliminating (or sharply curtailing) buybacks revolves around the evolution of modern market structure and the extent to which the corporate bid can serve as a helpful circuit breaker during moments when the liquidity-flows-volatility feedback loop triggers harrowing selloffs. It’s entirely possible to argue that buybacks act as a safety net (or at least help moderate the pace of declines and otherwise smooth things out) when markets get moving in the “wrong” direction (e.g., February 2018).

In any event, the buyback debate is front and center right now thanks in no small part to politics and the notion that the windfall from Trump’s tax cuts was misspent on enriching shareholders to the detriment of investment and at the expense of labor, which is destined to get the short end of the stick in a system (capitalism) named after its anti-pole.

Given how hot of a topic this is, it probably won’t surprise you to learn that the latest edition of Goldman’s “Top of Mind” series is called “Buyback Realities.”

As a reminder, these are basically expansive takes on whatever the market topic du jour happens to be. They combine interviews with Goldman’s own employees and also with outside sources in an effort to provide a balanced and comprehensive assessment on whatever seems to be the most important question on market participants’ minds (hence “Top of Mind”). The bank’s Allison Nathan conducts the interviews and generally collates all the information.

In addition to rehashing all of Kostin’s points, Nathan also chats with Aswath Damodaran. Below, find some excerpts from the interview preceded by a set of helpful charts.

(Goldman)

Via Goldman (abridged)

Allison Nathan: Why have buybacks become such a popular means of returning cash in recent decades?

Aswath Damodaran: In fact, I’m surprised that buybacks haven’t grown faster and this trend didn’t start earlier. If you look at history, part of the reason companies started paying dividends was because bonds predated stocks. So when stocks were first listed, the only way you could get investors to buy them was to dress them up like bonds with a fixed dividend basically mimicking a coupon. But dividends have never made sense as an equity cash flow. The essence of buying stock in a company is laying claim to whatever receivable cash flow is not otherwise being used. That means it should be different every year. But dividends historically are sticky. Buybacks, on the other hand, can be thought of as flexible dividends that allow companies to return more cash in years when they have more cash, and less or none at all when they don’t. Thirty years ago, I could have given you a list of hundreds of companies that had solid, predictable earnings and therefore could afford to pay a fixed dividend. But given that fewer and fewer companies can count on earnings in this period of globalization and increased competition, it’s no wonder that companies have increasingly shifted to flexible dividends in the form of buybacks.

Allison Nathan: Shouldn’t we be concerned that the trend of using cash for buybacks is reducing investment?

Aswath Damodaran: This hits on one of the great myths about buybacks: that they come at the expense of investment. Are companies investing less? The companies that are buying back stock are investing less. But the key question is where did the $800 billion worth of cash used for buybacks in the US last year go? That money didn’t just disappear; shareholders typically use their returns to invest elsewhere in the market. So it’s not that companies are investing less; it’s that different companies are investing. And so the question is not whether you want companies to invest or to buy back shares, but rather which companies you want investing: the aging companies of the last century, or the newer companies that have better investment opportunities today? Choosing the latter should redirect cash from bad businesses to good businesses, boosting the economy in the long run.

Allison Nathan: But are these cash-rich companies engaging in buybacks just not looking hard enough for opportunities to innovate?

Aswath Damodaran: You can look as hard as you want. You can make a reincarnated Steve Jobs the next CEO. But you can’t change many of these businesses. The fact of the matter is that many of the companies engaging in the largest buybacks are in the late stages of their lifecycles, and you can’t reverse that aging. Are some companies buying back stock that shouldn’t be? Absolutely, because the forces of inertia and metooism are strong in companies. Some companies buy back stock just because they have done so every year, or because other companies in the sector buy back stock. If a company buys back stock for the wrong reasons and good investments are turned down, that is troubling. But addressing that problem requires a scalpel not a bludgeon. If you ban buybacks across the board to protect yourself from the few companies that are doing stupid things, you’re going to end up with a lot of bad investments at some companies, or none at all, if these companies just sit on the cash instead.

Allison Nathan: But even if reinvestment opportunities are limited in terms of their products or businesses, can’t these companies be investing more in their employees through higher wages, better benefits, etc.?

Aswath Damodaran: That’s a fair question. But many of these companies already can’t earn a decent rate of return because they are struggling to compete with high cost structures and legacy costs. And if you pay your employees more, competitiveness will likely suffer further. This could create a vicious cycle, in which wages rise initially, but ultimately the company shrinks even faster and hires fewer people, or reduces the size of its workforce altogether. You might end up with some happier, well-paid employees who remain in the company, but a smaller number of them.

Allison Nathan: But, more broadly, shouldn’t employees be receiving a greater share of the gains of profitable companies, and how do you achieve that then?

Aswath Damodaran: I agree that labor needs to get a bigger slice of the pie. Over the last 30 years capital has acquired power at the expense of labor largely because capital is more mobile, which has been particularly valuable in the current age of globalization. But economies move in cycles, and there have been—and likely will be again in the future—periods when labor has the upper hand. I know that’s small consolation for the factory worker facing stagnant wages today. But if you try to intrude in the process and fix it, even well-intentioned legislation is likely to create a new set of problems. So I am not sure there is an easy way to give labor a larger slice of the pie by just forcing the pie to be cut in a different way right now.

Allison Nathan: It’s hard to argue with the fact that company executives are often times largely paid in stock. Could this be distorting incentives for buybacks?

Aswath Damodaran: When the method of compensation favored options in particular this was a key issue; you can make an argument that dividends went out of fashion in the 1990s in part because if you paid a dividend, the stock price typically dropped, which was not a good thing if you were getting paid in options. But these days executives are increasingly paid with restricted stock, which means that they have an equity stake, sometimes with long vesting periods and/or restrictions on selling stock once they receive it. Of course, if buybacks automatically increase the stock price, then executives that are paid in stock benefit. But there is no direct link between buying back shares and increasing the stock price. Buybacks in and of themselves do not create value, they just return cash. And even if there is an initial bump in the stock price on the announcement of a buyback, if buybacks are coming at the expense of good projects and hurting the company in the process, executives are ultimately hurt as restricted stockholders.

Allison Nathan: So what would happen if buybacks were restricted? How do you think companies would respond?

Aswath Damodaran: Companies, especially older companies, would love it, because it would be the perfect excuse for them to sit on a pile of cash without having any pressure from shareholders or activists to return it to them. This is not a hypothetical. Take a look at the walking dead zombie companies in Europe to see exactly where we’ll end up if buybacks are banned. In Europe, a myriad of factors tend to leave capital tied up in old, aging companies, leaving less capital for the younger, more exciting companies in new businesses. This is not where we want to be. You know who else would love it? Investment bankers, because now that cash would be burning a hole in the pockets of corporations, providing a greater incentive for them to pursue acquisitions—the mother lode of all deal making. In short, groups that such a policy might have intended to discipline could end up as the main beneficiaries of it. Business history is full of unintended consequences of legislation, and I can almost promise you that will occur again if Congress bans buybacks.