“When you are told that all repurchases are harmful to shareholders or to the country, or particularly beneficial to CEOs, you are listening to either an economic illiterate or a silver-tongued demagogue (characters that are not mutually exclusive).” – Warren Buffet, Chairman of Berkshire Hathaway, “Letter to Shareholders” in 2022 Annual Report (here)
Warren Buffet raised the issue of stock buybacks – alluding to the new 1% excise tax on such transactions[1] – in his letter to shareholders in Berkshire Hathaway’s 2022 Annual Report, released over the weekend. According to SPG Global, repurchases of stock are expected to top $1 trillion for the first time ever in 2023. The growth of share repurchases by S&P 500 companies is depicted in the graph below from a recent Yardeni Research report (here):
Many companies have ongoing stock repurchase programmes and / or have recently increased their stock repurchase authorisations as part of their corporate financing strategies, including Apple, Meta Platforms, Microsoft, P&G, Exxon Mobil, Alphabet (Google), Chevron and Lowes Cos. The return on stocks in the S&P 500 Stock Buyback Index[2] has been 10.11% over the last 10 years, according to S&P Global (as of Feb 24, 2023), meaning that such repurchases are positive generally for shareholders.
I view the imposition an excise tax on share buybacks similar to the way I view actual (or proposed) windfall taxes on “excess profits” of companies that experience a usually brief period of abnormally high profitability[3] – both are populist-inspired measures for governments to raise revenues that are over-reaching. Taxes on stock buybacks could affect financial decisions that companies make on how to deploy their excess cash, even if such excise taxes might be considered modest. According to Howard Silverblatt, analyst at S&P Global, in an article written late last year:
"The 1% tax that we're going to have next year [meaning 2023] is not really that much. It's less than half a percentage point on the earnings. The bottom line is it's no more than a trading error on buybacks. A half a percent is 'what time did I buy it?”[4]
Nonetheless, I view the imposition of government-mandated taxes like this as unfair to shareholders. Perhaps more importantly, these sorts of excise taxes can result in less efficient decision-making by companies as to how to best deploy “excess” cash.
Management teams and their Boards have plenty of options to consider when they have the luxury of profits or strong cash flows, including: 1. Hold “excess” cash at a bank or in short-term risk free investments
2. Invest the cash in financial instruments like corporate bonds or equities of other companies
3. Repay existing debt
4. Invest the cash in new plant or equipment or invest in R&D
5. Make an acquisition
6. Pay higher wages to employees
7. Increase (or begin paying) dividends
8. Repurchase stock
Let’s look quickly at these in more detail.
Hold cash – Equity investors seek returns that are significantly more than what a company can earn on over-night deposits and similar risk-free investments. Perhaps some modest amount of cash makes sense as “rainy day money” or in anticipation of budgeted investment needs, like capital expenditures or acquisitions.
Invest is stocks or bonds (of other companies) – This is not generally what investors expect unless they are buying shares in an investment company. However, some companies – and Berkshire is an example – do take minority positions in public companies as part of their well-defined business strategy. Repay existing debt – Choosing to repay existing debt is a decision that a company should make based on the fundamentals of its business and its cost of capital. Astute financial management teams of most companies normally target a mix of debt and equity that they think is both appropriate for the business (given, for example, its cyclicality) and results in the lowest blended risk-adjusted cost of capital. Also, keep in mind that companies raised significant amounts of long term debt at incredibly low all-in rates during the year or so following the onset of the pandemic, thanks to the Fed’s (overly)accommodative monetary policy. It is hard to imagine a scenario today when it would make sense for companies to refinance such low-coupon debt. For example, Apple (Aa1/AA+) raised 10-, 20- and 30-year bonds in February 2021 with coupons of 1.65%, 2.375% and 2.682%, respectively. Repaying this debt would be value-destroying for shareholders, in that Apple can earn significantly more on this money in a variety of ways compared to what the debt costs. Also, remember that the US government is paying nearly 4% to borrow 10-year money at the moment! Invest in capital expenditures and/or R&D, or make acquisitions – Considering reinvesting in the business is logical in order for companies to achieve their growth targets. This growth can be achieved either organically or through acquisitions, and both involve investment decisions which require existing cash (and often, incremental debt or equity). Using cash to invest in projects or to make acquisitions makes perfect sense when the expected gains from such investments are expected to meet the threshold objectives of the company as far as hurdle returns. Similarly though, it makes no sense for a company to invest in mediocre projects or to make overly risky acquisitions just to deploy existing cash. Plenty of mistakes like this have been made by a myriad of companies in the past, akin to “letting money burn a hole in your pocket.”
Pay employees more – Like all operating costs, wages are subject to competitive dynamics in the marketplace. Being overly generous to employees, meaning paying more than the market requires for wages, is rewarding employees at the expense of shareholders. For example, if a management team manages its (non-wage) operating expenses particularly well, such that its margins (and bottom line) are better than its peers, this money rightfully belongs to the company’s shareholders, not to its employees. Having said that, management teams need to ensure that employees are rewarded for the part they play in generating the savings in operating expenses, a decision that should rightly be left entirely in the hands of management. Increase dividends or repurchase stock – Dividends and stocks buybacks are both ways a company can return money to shareholders. The issue with the more conventional method of paying dividends is that shareholders become dependent on them, and for companies to radically alter their historical dividend policy comes at their own peril. Stock buybacks are different, in that they are viewed as non-recurring and not necessarily reliable, enabling companies to change their stock buyback programmes to reflect the normal eb and flow of profitability and cash flow. Companies often set price thresholds for repurchasing their stock that reflect their view as to when the stock is undervalued based on the company’s outlook and business fundamentals. No one should know this better than management. Other advantages of share buybacks relate to reducing shares outstanding (i.e. increasing EPS) and allowing shareholders to decide whether or not they wish to sell into a stock repurchase programme (whereas they have to take dividends as they are paid). In conclusion, stock buybacks are a corporate financing technique that companies should be permitted to consider and ultimately employ without the prejudice of a supplemental excise tax, which can alter the decision-making and overall economics of how a company manages its cash. I am inclined to agree with Mr Buffet when he provided the very interesting quote in his recent Letter to Shareholders.
[1] A 1% excise tax on share buybacks was included in the Inflation Reduction Act of 2022 passed by Congress last year. Here is a discussion of the excise tax on share repurchases from Mayer Brown, and if you really want to get into the trees for some reason, here is the entire Inflation Reduction Act of 2022 from the Congressional website Congress.gov.
[2] See description, including factsheet and methodology, from S&P Dow Jones Indices here.
[3] You can find my views on windfall taxes in an article I wrote in E-MorningCoffee.com here: “Windfall taxes are a stupid idea”.
[4] Here’s more from S&P Global: “On a proforma basis, the new 1% excise tax on net buybacks, which will start in 2023, would have reduced the Q3 2022 S&P 500 operating earnings by 0.46% and as reported GAAP earnings by 0.52%; for 2021 it would have reduced operating [earnings] by 0.45% and as reported GAAP [earnings] by 0.47%.”