STOCK BUYBACKS | More Risk, Inequality

Source: IZA

Business school professors have struggled with aligning the interests of executives with the interests of company owners. It is called the principal-agent problem, or just agency problem.

One idea is stock options to reward executives when stock prices rise.

It was understood from the inception of this idea that some long-run measure of stock price should be used to avoid gaming the system. Michael Porter recommended that stock options not be exercisable for five years, and then only a portion of them. Those who have studied abuses of stock options recommend that averages of stock prices over several years be used, again to avoid executives goosing the stock price at a benchmark date.

Sadly, those who have studied the impact of executive pay on stock prices find a negative correlation. CEOs with pay that is in the top ten percent of their industry and size have stock prices that are 13 percent lower for periods up to five years after the high payouts.

OMG, how could this happen? Researchers try to explain the result as overconfidence among executives or investor mistrust of companies with high-paid executives, or both.

Now a better explanation of what has been going on has been presented by none other than Goldman Sachs. A big problems seems to lie in the timing of stock buybacks. What is going on is worrisome both from a social welfare standpoint and from the perspective of managing risks in financial markets. I am grateful to Wall Street on Parade for noting the implications.

In a research note, Goldman has compared the buybacks at high market multiples to the bad investment decisions that corporations made in this arena just before the market crash of 2008:

[B]uybacks peaked in 2007 (34 percent of cash spent) and troughed in 2009 (13 percent). Firms should focus on M&A [mergers and acquisitions] rather than pursue buybacks at a time when P/E [price to earnings] multiples are so high.

Goldman's alert picks up on an article in the September Harvard Business Review, “Profits Without Prosperity”, which notes that corporate profits have been high, but are not being passed through to workers or shareholders. The culprit? Stock buybacks.

[I]n the short term buybacks drive up stock prices. In 2012 the 500 highest-paid executives named in proxy statements of U.S. public companies received, on average, $30.3 million each; 42 percent of their compensation came from stock options and 41 percent from stock awards. By increasing the demand for a company’s shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly earnings per share (EPS) targets.

In calendar years 2006-2013, says Birinyi Associates, public corporations authorized $4.14 trillion in buybacks of their U.S.-traded stock; in 2013 alone, corporations borrowed $782 billion, almost all paid out for stock buybacks.

In the past two quarters, investment-grade non-financial companies have issued $366 billion in bonds; the $195 billion of bonds they sold in the first quarter alone was a record.  Companies in the S&P 500 are expected to spend more than $1 trillion - two-thirds of their cash - buying back stocks and repaying dividends in 2015.

The debt these companies are taking on to prop up their stock prices is diverting corporate profits to executive pay, and is making the U.S. stock market a riskier place to put money. It helps explain why the prosperity at the top of the companies is not trickling down to the 99 percent very fast.