🔋Insider Scheme

How corporate share buybacks are affecting your stocks.

Nov 20, 2024

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The Fireworks Over Share Buybacks Are Duds - WSJ — WSJ

Last week, in Passive Aggressive, I discussed the drastic rise in passive flows into the equity market rather than an actively managed approach. This has caused the market to be less efficient, more fragile, and more richly valued. In the conclusion, I showed that while the type of flows into equities matter, on net they have been negative over the past 10 years. This alone should give you pause as to how the stock market performance has been so good over this time if there is less money flowing into stocks.

First, let’s think about companies. Not all companies make money, and those in the news like Apple and Nvidia are the most successful. When they bring in profits there are a few options; save a stockpile for future hard times, re-invest in the company, issue dividends to return capital to shareholders, pay off debt, increase wages, and more.

As seen below, corporate profits are booming with an explosion higher and above long-term trend since 2020. One popular strategy is to return capital to employees and executives as thanks for helping the company succeed. This seems fine, but people and legislators have been worried that C-suite executives are too greedy and give themselves multi-million dollar salaries that they do not need. That changed in 1994 when the IRS capped how much salary could be deducted from corporate taxes to 1 million dollars.

**Corporate profits after tax** (without inventory valuation adjustment or capital consumption adjustment)

The issue however is that all this rule did was change how executives got paid. While this law was touted as sticking it to the greedy capitalists, it only moved that compensation from the form of a salary to stock-based compensation and stock performance awards.

Even when adjusted for inflation, the compensation of top U.S. executives has doubled or tripled since the first half of the 1990s, when it was already widely viewed as excessive. - Harvard Business Review

If all this did was alter how a few billionaires got paid on technicalities and tax documents, that’s probably just the boring end of the story. Unfortunately, it’s not. We are not in the realm of corporate share buybacks, where the company uses cash holdings to re-purchase publically owned shares on the open market. Taken to the natural end, this would mean eventually these public companies would go private once again (remember that there is a reason companies go public in the first place).

Only the largest companies in the world can do this squirrely tactic owing to their outsized corporate profits compared to small and mid-cap stocks. Further, the passive investing engine contributing to the outperformance of top companies serves only to embolden this action through more profits relative to smaller companies. Apple, Google, Meta, Microsoft, and Exxon were the 5 companies with the most share buybacks in 2023 (Nvidia is up there as well). This is another key point to the dangers of the passive investing engine.

Over the years, share buybacks have been increasing.

Share buybacks are marketed as a return of capital to shareholders by reducing shares outstanding and boosting the stock price. The issue is that the shares aren’t sold/distributed equally and it is used to enrich executives at a disproportionate amount. The higher stock levels allow executives to achieve better stock compensation awards (earnings per share (EPS) bonuses). Furthermore, Insiders are able to time sales. Instead of dividends which are distributed equally, buybacks only really benefit the stock sellers. Insiders know when buybacks are taking place which merely emboldens C-suites even more than before.

While the trend of share buybacks has been increasing due to the benefits it causes the companies and executives, it more importantly affects asset markets as a whole. Last week I mentioned how mutual funds/pensions had a negative net demand for equities which could be puzzling how the stock market could perform so well. Including all other monetary flows in and out of the stock market shows that on net every flow cancels except for the large inflow through corporate share buybacks.

Below you can see the net flow is ~$5.2 trillion which dwarfs the other category. This means that as long as this trend continues to provide flows, it will boost asset values.

From a company perspective, it would be most prudent to buy back shares when stock prices are low to capture the most possible value for the company. Instead, what we see is the exact opposite which is a very strong indication that the purpose is to sell insider shares to capture more value for certain individuals. While touted as a return of capital to shareholders, the company would be better positioned if it did more useful things with the money like re-investing in the company, issuing a dividend, increasing wages, or at the very least buying back shares at lower prices for better value. This trend favors short-term asset price performance over long-term company health.

I’m not concerned whether corporate executives enrich themselves through this scheme like some, and it seems to happen regardless of the rules surrounding corporations. Further, placing stifling regulations on companies could drive them away. To conclude, this trend of corporate share buybacks is not healthy for companies long term, yet again raises asset valuations to ever-expensive levels, and adds fragility to the stock market. This is yet another reason to be skeptical of asset prices and a place to keep an eye on for potential market disruptions. Until next week,

-Grayson

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