Finance professor Ken French once said about stock buybacks: “Buybacks are divisive. They divide people who do understand finance from those who don’t” Put Joe Biden and his administration in the “those who don’t” category. In last night’s State of the Union, the president proposed quadrupling the tax on corporate stock buybacks “to encourage long term investments instead.”
The concept of stock buybacks—when a public corporation uses its profits, or sells debt, to buy its own shares—may seem like a bad thing. After all, in theory, the company could have used that money to invest in its growth or to pay higher wages. But technically, a share repurchase is simply returning money to shareholders—just like paying a dividend, but more tax efficient.
AQR Capital Management’s Cliff Asness estimated that net investment did not decrease as stock buybacks became more popular. A corporation may buy back shares when it sees no profitable investment opportunities. In this case, it is better to return the money to shareholders; they can then invest that money in a company that might have better investment prospects.
Take oil companies. Biden is angry that oil companies did buybacks this year after raking in large profits. He says they should have used that money for more exploration and expanding refining capacity to boost the supply of oil. But why would an oil company invest in infrastructure to increase production when the administration has openly stated that it hopes to eliminate fossil fuels in the next decade? A rational response—one that maximizes shareholder value—is to return money to shareholders, not to make a large investment in something that may be worthless in the not-too-distant future. Biden should be delighted the profits are getting returned to shareholders, who will now invest in industries his administration finds more palatable.
True, most of the buybacks in the pre-pandemic period were financed by debt. While that sounds like a risky way to increase share prices, it’s just a way for a firm to recapitalize by switching from equity to debt, which, in a low-interest-rate environment, is a reasonable thing to do. Also, stock buybacks do not raise stock prices all that much. Research finds that they may push them up by 1 percent to 2 percent, but there’s nothing artificial about this increase. Instead, a buyback sends a signal that management thinks the company’s stock is undervalued, or that profits will improve by having more tax-favorable debt financing, or that investors are happy to hear that the firm is not chasing unprofitable investments.
Stock buybacks may make a convenient political target, but in principle and practice they’re morally and economically justified.
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