Buybacks are a Capital Structure Decision not an Investment Decision

As the stock market raced ahead of the real economy in recent years, the increasing volume of buybacks was criticized by those that felt that firms were channelling funds away from productive investment into seemingly wasteful financial engineering. Now that they have passed a peak, the decrease in buybacks is being interpreted as a signal that management believes its stock is overpriced, and therefore not worth buying. Buybacks are not deserving of this double-edged rebuke, nor the confusion that surrounds what they represent.

Buybacks are first and foremost a capital structure decision and they are much more similar to dividends than is often suggested. Furthermore, the supposed trade-off between investing to grow and investing in one’s own stock confuses the sequence of decisions in the capital allocation process and needlessly adds complication.

Buybacks and dividends both take cash from the company and give it to shareholders. Dividends treat all shareholders equally; buybacks on the other hand change the composition of the shareholder base and in doing so increase leverage only for continuing shareholders. Buybacks are better than dividends for continuing shareholders if the market value of the firm subsequently increases, which is more likely to happen if the market value is below intrinsic value. But buying back stock when the market value is below intrinsic value, though often lauded, is not necessarily a good capital allocation decision. The firm may have capital investments that would have created even more value for shareholders.

A good capital allocation process looks first at opportunities to invest in projects that are sufficiently likely to earn a return in excess of the firm’s cost of capital. The correct cost of capital to use is market implied, not the theoretical (and, almost always, wrong) one that comes from a spreadsheet in Canary Wharf or Wall Street.

Next, the process turns to how these capital investments should be funded. If funded entirely from profits (ie equity), then leverage will fall. This is good only if leverage was too high to start with. If funded with a mix of debt and retained profits, firm leverage can be held constant or adjusted to a closer-to-optimal level. Only if there is excess cash flow following this, should the firm look to return these to shareholders.

It can use dividends or buybacks to do so. Dividends are more likely to be used if there is a long term decision to return a percentage of profits. Buybacks are seen as more flexible. This is convention and need not be the case. Of course, shareholders can decide to create a synthetic dividend during a buyback or use proceeds from a dividend to buy additional stock.

Separately, the idea that buybacks signal a cheap stock is flawed. If a company’s stock is trading at a relatively low multiple, it may be that the market’s estimate of the cost of equity is high, rightly or wrongly. Or it could be that growth prospects are low. Mixing these up and using the outcome to justify buybacks is bad for shareholder value creation. A high multiple may be a sign of growth opportunities with high returns so you are less likely to see a lot of cash left over for buybacks/dividends. But the stock may still be cheap.

As stock prices go up the hurdle rate for internal projects comes down and firms channel more into investment projects, leaving less to return to shareholders. If the hurdle rate subsequently goes up (ie share prices fall) it doesn’t make the previous decision to invest a bad one, but may mean it is harder to justify investing additional cash into the same project. All projects should be NPV positive at the time of funding, decisions to increase or decrease the size of the project at a late date should similarly be NPV positive.

So, capital returns to shareholders should naturally be low when valuations are high and vice versa. The reduction in capital return that has been noted after the rise in share prices is what one should expect, all else equal. The fact that a peak in buybacks didn’t happen earlier as the market advanced, probably reflects executives being too conservative in estimating IRRs on projects and being paid for non-productive activities such as reducing the number of shares outstanding.

Buybacks are not an investment in one’s own shares; they are a means, just like dividends, of reducing the amount of shareholder equity and hence changing the capital structure of a company. Constructive discussions about the role of buybacks should take this as a starting point and, with some hope, buybacks will shake off their unjustified reputation as a dark force in the capital markets.

The Truth about Maximising Shareholder Value

In the post, I want to challenge an assertion made by the naked capitalism website on the topic of maximising shareholder value.  There is an ostensible incompatibility at the micro level between maximising shareholder value and keeping everyone else happy, but only in the short term. At the aggregate level and over time this dissipates – competitive markets are at the core of capitalism and, despite its flaws, this is the system that works best at allocating resources and aligning with human interests.

The author correctly states that “[l]egally, shareholders’ equity is a residual claim, inferior to all other obligations. Boards and management are required to satisfy all of the company’s commitments, which include payments to vendors (including employees), satisfying product warranties, paying various creditors, paying taxes, and meeting various regulatory requirements (including workplace and product safety rules and environmental regulations).”

But the author uses that statement to back up the incorrect assertion that boards and management teams are not obligated to maximise shareholder value. I believe that this claim fails to appreciate the ownership and organisational structure of a firm.

The shareholders own the company. Because there are many shareholders with conflicting demands on their time, they elect a small group to represent their interests. This is what the board of directors does. Boards oversee the actions of management and delegate to them the power to make decisions about the running of the business. Shareholders can change the composition of the board and the board can change the composition of management. Ultimately, the responsibility of the nominated representatives is always to the owners.

Nevertheless, the owners of the business have responsibilities that range from paying creditors to abiding by regulations, and these have precedence over the claims of the shareholder over the revenue the business generates. But, these actions are perfectly compatible with the objective of maximising shareholder value for the following reasons:

  1. the value of the firm to shareholders is the sum of all future cash flows accruing to the owners, doing anything that reduces that stream of cash flows, such as not paying a supplier or failing to adhere to environmental regulations, reduces shareholder value
  2. it would be senseless to try maximise the value of the claim of any other stakeholder, companies that overpay their suppliers or undercharge their customers will go out of business – everyone involved, not just the shareholders, will lose out in that case.

We can debate whether any single decision is right or wrong in terms of achieving this objective (and this is what analysts and shareholders do on a regular basis), but ultimately the guiding principle of maximising shareholder value is what keep managements in check. This works. And will keep working as long as enough people don’t want to ditch capitalism and democracy and revert to some fiefdom approach that promises a subsistence-level standard of living.

Wheeling and Dealing

What does a BMW M4 have in common with a BMW share? To the owner, both are assets that can be turned into cash at a known price. While I reckon you’d have more fun in the M4, you would fully expect to sell it for less than you paid. Not so with the share. This distinction between a tangible asset and a financial asset is clear. Other differences are a source of confusing and meaningless statements. For example, articles claiming that there is a stock of cash/bonds being “rotated” or about to “flow” into equities, gives the impression that the market for shares is like the market for the M4 – money being “rotated” into BMWs means that there will be more BMWs on the roads and BMWs will represent a greater share of total cars in use.

Applying this way of thinking to stocks is misleading since for every buyer of a share there is a seller, and on a net basis issuance of new shares is minuscule and possibly negative. The important factor to consider is not the amount of cash that a particular group may decide to invest in equities, instead it is the willingness to pay of that group relative to the willingness to receive of the prevailing owners of the asset.

If the new group has a higher willingness to pay for some structural reason, then the fact that they are “rotating” out of cash and into equities is an indication that prices will probably rise. But, markets are never segmented to that degree (even in the case of a short ban – see here). Perhaps retail investors have a reputation for being less discerning in the price they are willing to pay, but more often they delegate to a professional who is. So, an increase in flows into mutual funds from retail investors does not mean that, in aggregate, mutual fund managers (who operate in a competitive market) are going to change the price they are willing to pay for a particular security.

Ultimately, the prices of equities depend on discount rates and expectations of cash flows. Talking about those committing more of their money to mutual funds, for example, is not informative, since it is always only one side of the story. Similarly, statements claiming to explain why prices moved higher such as “there are more buyers than sellers” are equally useless. There could be hundreds of buyers willing to buy all shares of a company at $10, when a stock is priced at $11. Buyers and sellers have to be equal in terms of volume, always, and the price is a function of the willingness to pay/receive of each group. Price changes because the willingness to pay changes.

Willingness to pay is not an easy concept to think about. But it sits at the core of investing. It’s another way of thinking about the cost of capital. Vague concepts such as the “Great Rotation” and “net flows into mutual funds” are not instructive in determining the cost of capital and add little value to the capital allocation process.

Utterly Styleless

As in a number of other disciplines, investors groups themselves according to some (often arbitrary) criteria. It goes with the in/out tribal nature of humanity. Are you a liberal or a conservative, a frequentist or a Bayesian, a value investor or a growth investor?

Value investing means buying stocks that appear cheap on current multiples and growth means buying those that seem cheap on future multiples. Regardless of which so-called “style” an investor follows, the objective of active management – to outperform passive alternatives – remains in tact. So why do investors pitch their tent in one of the two camps?

The origin of the distinction between growth and value can be traced to a paper written over 20 years ago by two of the most respected academics on the topic of asset pricing. Fama (a 2013 Nobel prize recipient) and French argued that the CAPM failed to accurately price the risk on smaller companies (the “size effect”) and those with low price to book (the “value effect”).

This gave a boost to an already-blossoming line of literature examining various anomalies, or breaches of the predictions of the CAPM. Some demonstrated that buying stocks in January and selling in May outperformed, others showed that buying stocks just before they reported results paid off over time. But the most pervasive, from the point of view of the design of the asset management industry as we know it today, is the idea that most stocks fall into one of two categories, value or growth, and managers should behave differently depending on the category they are involved with.

Commentators like James Montier have argued that investor overpay for growth and that value is the only discipline the sensible investor should follow. This line of reasoning extends an approach to investment analysis that can be traced to Graham and Dodd’s Security Analysis textbook. Published in 1934, well before the formulation of the CAPM, the approach advocated by Graham and Dodd has been spliced with the results from Fama and French to give an ostensibly credible lineage to value-investing. But Graham and Dodd neither coined the term “value-investing” nor did they draw a distinction between two styles of investing. Graham and Dodd simply laid out analytical tools for determining whether a stock was cheap given the risks – this is what investing is and should be about, regardless of style.

Value investors expect a specific trajectory in earnings (or cash flows) much the same way as growth investors. Getting this right is more important than being in the right camp to start with. More often stocks don’t fall cleanly into either category and crude criteria such as price to book and price to earnings brush over accounting differences, leverage and the organic sustainability of earnings at the expense of the efficient pricing of risk.

So, there’s nothing fundamental to the style distinction. The two categories exist due to the flaws in a now-debunked theoretical framework, the CAPM. If the theory was better to start with, Fama and French would not have found these exceptions. But we would still stick to the principles laid out by Graham, Dodd, Buffett, Marks and a host of other successful investors – we would just call it “investing” and we would do it without style.


Some people take risks. Investors and traders take uncertainties. This awkward turn of phrase draws on the distinction between risk and uncertainty made clear by Frank Knight over 90 years ago. Only when the precise probability of a random event occurring is known can we call something a risk. Otherwise it is an uncertainty.

The strap line for the website mentions uncertainty for exactly this reason. If pricing capital in the face of risk was all that there was to finance, this website would be as useful as running a regression on a bus timetable.

In one of the best papers I have read in recent years, Professor of Finance Andrew Lo and Physicist Mark Mueller, explore different levels of uncertainty. While they acknowledge that certainty and uncertainty lie along a spectrum, the categories they propose are useful in framing discussions about what we can and cannot know and predict.

Level 1 is Complete Certainty. In the context of this discussion it ‘s quite uninteresting – but it is useful to keep such things as the effects of gravity in mind when going about your daily life.

Level 2 is Risk, and is consistent with how Knight thought about it. Probability distributions are known (with certainty). It is debatable whether this exists in reality, but it is most useful in serving as a base for Level 3.

Level 3 is the first of the “uncertainties”: Fully Reducible Uncertainty. With enough data and knowledge of statistical methods, events in this category can be “rendered arbitrarily close to Level 2”. This makes working with them quite straightforward. Examples include games of chance, heights of people and train arrival times. For practical purposes, events in this category can be called risks.

Level 4 is Partially Reducible Uncertainty. Here the data generating processes can, for example, have stochastic parameters, complex non-linear functional forms or other properties that greatly reduce the utility of statistical methods. This is the level with the most relevance for financial analysis. We can understand processes up to a point, beyond that we use a incomplete mix of tools and techniques to figure out what’s going on. But this opens up an intricate web of signals and noises. We can back-test hypotheses that work well in sample but don’t out of sample. We can convince ourselves and others of crazy rules governing the cost of capital. Ultimately, though, being aware of the nature of Partially Reducible Uncertainty and formulating and sticking with a good strategy is the best way of dealing with it.

Level 5 is Irreducible Uncertainty. This has relevance for financial analysis too but it is much more difficult to work with. If you can develop an investment strategy that is not built on trying to guess the answer to unknowable states you’ll be better off. Lo and Mueller describe Irreducible Uncertainty as a “polite term for a state of total ignorance”. But that doesn’t stop us from getting having strong views on topics in the fields of philosophy, religion and politics (in fact Darwin argued that ignorance is a good starting point for having immovable opinions). Beware of the investor who only talks in unfalsifiable terms.

A lot of people working in finance seem to behave as if the world stops at Level 3. Risk managers spin elaborate models which portfolio managers latch on to in an effort to reduce cognitive dissonance. Some investors look for patterns and trading rules, others buy into the latest fad from the brains of rocket scientists. Lo and Mueller have set out a lexicon and framework that (1) can be used to make people aware of the shortcomings in a variety of financial tools and (2) lays the foundation for a more informed discussion of risk and uncertainty in financial markets.

Winning a Loser’s Game

In 1975, Charles D. Ellis explained that active investment managers are destined to lose, on average. This point is unequivocal, but it led people to ask questions about the role of active management rather than how we define winning and losing in this context.

Rightly, the job of the active manager has not been made redundant, as some (Fama-followers, mostly) have erroneously predicted. Markets cannot function properly with purely passive participants – Grossman and Stiglitz (1980) lay out an elegant counterargument to the Fama line of reasoning. There will always be a role for analysts and active managers. But they will continue to lose, as judged with reference to a benchmark. Beyond the injuries it inflicts on the egos of a majority of fund managers, this focus on benchmarks is not healthy for the important role investment management plays in allocating capital and pricing risk.

Firstly, benchmarks unfairly favour the big and punish the small. Companies in consolidated industries have a higher likelihood of being included in a widely-followed benchmark such as the S&P 500 or FTSE 100. In industries with a large number of small companies, raising external capital is more expensive in aggregate; even if the businesses are less risky, the inefficiency of pricing that comes about through a lack of attention makes this so. It is harder for these companies to grow, so the size issue is somewhat self-fulfilling.

Secondly, benchmarks reduce the cost of equity for inferior companies and can counteract the efficient pricing of risk when it matters most. If a stock with the potential for a lot of volatility (for example, a company that is close to bankruptcy) is in an index, a manager that is measured against that index may feel compelled to hold it. If he or she does not and the price jumps, investors who interpret the manager’s underperformance as a lack of ability will take their money and walk. But, given the choice, the manager would not invest.

Finally, benchmarks amplify market crashes. Following them encourages momentum in prices. Stocks that do well represent a bigger percentage of the index and it becomes harder for those that are on the sidelines to justify staying there. While this can lead to investors befriending trends, sustained runs that are not grounded in fundamentals are often tantamount to a mispricing of risk, and a crash typically follows at some point.

To what do we owe the obsession with benchmarking? To a large extent the answer lies in our inconsistent relationship with the (largely debunked) Modern Portfolio Theory, which argues that the best way to invest is passively in “the” market portfolio. That has many different interpretations. In the strictest sense, holding the market portfolio means buying some of every investable asset. But, in the real world, that’s not feasible, so we arbitrarily combine the biggest 100 or 500 companies into a substitute for the market, or for subsets thereof.

This substitution creates a distortion between the insiders and outsiders which sits at odds with the theory that inspires the process. The perfunctory attempt to use a reference point inspired by a flawed theory as a yardstick for active funds should not sit at the heart of the capital allocation machine.

The best investors in the world are not bound by the constraints of a benchmark, by design. They invest in businesses, not in the market, and through intelligent analysis try to understand the risks, which the MPT wrongly assumes are known. Most will not reference portfolio theory in what they do and you will, therefore, find proportionally fewer of them among Ellis’ losers.

What Investors Don’t Get About Buybacks

Shareholders trust the management teams of companies to make sensible use of the profits generated. Investing those profits wisely can greatly increase future profitability and, hence, shareholder return. Overpaying on an expansion project, for example, will do the opposite. Recently there has been increased focus on companies using their cash stacks to buy their own shares rather than looking for good ways to invest to grow. The question I am going to address is (and it’s an important one) is Does it matter at what price a company buys its own shares?

The intuitive answer, and one that many professional investors and commentators would give, is “of course, buying at a lower price is always better”. The reasoning is that companies that buy their stock before the price goes up get more bang for their buck than those that buy before it goes down. As a result, investors scold companies that buy at or near peak levels in their share prices (this article from Fortune is one of a very large number I found online).

But it actually does not matter. In fact, I can reverse the intuitive answer with two simple arguments:

(1) The shares the company buys get cancelled. The company is not investing in its own shares. Shareholders have no claim on the shares that are bought back and so do not gain or lose if this is done at a high or low price.

(2) When a company buys back its shares, it is buying them from shareholders. Shareholders always prefer to sell shares at a high price and therefore should thank any company that buys from them at such a lofty level.

Argument (1) is pretty solid but I think it’s worth digging into (2) in more detail. Shareholders as a group should prefer the “buy high” approach, but at the individual level those that sell to the company at the peak are better off (following a subsequent fall in price) than those who choose to hang on. That the latter group did not sell at the peak is not the fault of the company or in any way linked to a buyback or lack thereof.

Here’s another way to think about it: if companies had perfect foresight on their share price would they still buy back shares today if they knew the price would be lower in a week?

This is not just a theoretical exercise since companies do have inside information that can give them a sense of the short term trajectory of their share prices.

The answer, again, is that it does not matter. Neither the shareholders nor the company is better off if the buyback is delayed. The company can buy more with a fixed pot of cash if it waits, but the total value of equity following the buyback will be the same regardless of the timing.

However – and here’s where the intuitive answer starts to look (somewhat) good again – the share price will actually be slightly higher in the case when the company delays the buyback (let me know if you want proof of this). Any shareholder who would not sell regardless of when the buyback takes place is better off if the company waits a week. But, shareholders on average will not gain from this “buy low” strategy and, if the company does not buy at today’s higher price, shareholders miss out on the option of cashing in at a better price.

The discussion should not focus on whether timing buybacks in a certain way creates shareholder value (it does not), but how the decisions of individual shareholders to sell or not seem better or worse as a result of the timing. The actions that a subset of the shareholder base might take should not determine the way in which companies divvy out the spoils, so shareholders would be better off redirecting their attention to monitoring the use of the cash that actually stays in the company.