Examining the corporate governance implications of share buybacks

When companies announce share buybacks, are they returning value to shareholders, propping up earnings per share statistics, or responding to perverse incentives in executive remuneration?

Since the US government passed significant corporate tax cuts in December 2017, US listed companies have increased the pace of share buybacks – media outlets cite figures including with $171 billion of stock buyback announcements by February 2018, according to this CNN article.  CNN notes that at the same point in 2017, US companies had announced US$76 billion in corporate buybacks.

There is not a lot of research on a link between share buybacks and total shareholder return or long-term corporate strategy. MSCI has recently conducted an analysis of US listed companies to determine if there is a correlation between share buybacks and quality of corporate governance.

“Prior to the financial crisis in 2007/2008, the focus was on building bigger companies, so you saw a lot of M&A activity,” said Ric Marshall, executive director, MSCI ESG Research. “One of the things you could do with money if you weren’t investing in R&D, you could build a bigger company buying up smaller companies. That trend seems to have been replaced by the new emphasis on returning value to shareholders. That’s the current rubric. One of the things we found in looking at US large caps was that since ’97, share repurchases as a percentage of total company assets has exceeded dividend payouts in every single year. Prior to ’97, this was not the case.”

Whilst MSCI has not conducted research on Australia for this piece of work, Marshall had some observations.

“From an Australian perspective, ’95 was the year that buybacks started to become a factor,” he said, “with the introduction of new regulations that make buybacks more feasible. In the US that transition happened much earlier, in 1982, but they really took off in the late 90’s here as well.”

MSCI examined more than 600 companies for their share buyback activity.

“When companies decide what to do with their extra cash, they have two main options besides investing in capital improvements, R&D or M&A, and that’s either dividends or repurchases,” Marshall said. “One of the reasons for the decision to go for share buybacks versus dividends is that when a company pays out dividends, it’s on a regular schedule, and it’s considered a negative if they have to can’t meet that schedule. Whereas with buybacks, if they have a strong period or two, they can buy back more shares this year, then fewer the next year – buybacks are a more flexible form of capital return.”

Marshall noted that there has been a decline in capex spending and an increase in share buybacks during the period of analysis, pointing out that in 2015, a higher percentage of money was spent on buybacks than capex in the US listed companies they analysed.

“There are several concerns that investors have when it comes to buybacks,” Marshall said. “The most basic is whether a company that is buying back a lot of shares, not spending on the long term future of the company, are they not making capital expenditures, are they not spending on R&D?”

But there doesn’t seem to be a clear correlation between this decline in capex spending and the simultaneous increase in buybacks, Marshall said.

“We found that while the overall decline may be of concern, at the individual company level there doesn’t seem to have been this sudden ‘ok, we‘re not spending money on the future of the company, it’s all on buybacks.’”

The question raised by buybacks is whether there is a link between executive remuneration and increased share buybacks.

“The biggest area of concern is the relationship between share buybacks and executive remuneration,” Marshall said. “In the US especially, long term incentive plans are comprised of equity awards, which are intended to align the interests of the executive with shareholder interests We have previously published two pieces looking at that very question – is higher CEO pay aligned with long-term performance? In both cases we found poor alignment between pay levels and long-term investment returns, and in fact, the companies that set the highest incentives awards, and where executive take-home pay was highest, are not the strongest performers.”

These reports on executive pay and performance did not examine the impact of share repurchases, but Marshall has compared the data from the current study on share buybacks and executive remuneration and come up with some initial conclusions.

“An initial assessment is that there is something similar here – companies that are paying their CEOs the highest, but returning the least to investors, are also amongst the highest share repurchasers,” Marshall said. “That’s a potential problem, as it suggests that the equity awards that are being paid out to CEOs and other executives, and based on share price performance, are also linked to the company’s share repurchases.”

While investors engage with companies on issues relating to executive remuneration and share buybacks, they tend to be on a company-by-company basis, rather than an economy-wide concern on strategy.

The Australian Council of Superannuation Investors (ACSI) has spoken with boards at times over the structuring and timing of share buyback schemes on the ASX, said Ed Johns, executive manager, governance, engagement and policy.

“Buybacks are something we look to boards to oversee, as are all capital management directions,” Johns said. “Historically, a buyback was seen as a loss of face for executives – as if, why are executives buying back shares and not investing or acquiring?”

However, there can be justifiable reasons for a buyback, Johns noted.

“It’s a capital allocation question that we want boards to oversee,” he said. “Buybacks are the starting point, and any allocation of the same capital obviously has to meet a return objective, whether that’s reinvestment in the business, brownfields or greenfields M&A, etc. As you run along those actions, you’re running up the risk curve, so you have to ask the questions, what the likely results from those issues are, you want boards to be really challenging executives on that.”