Stock Buybacks are not the Enemy

Posted by Alex Frey (@alexhfrey )
What some investors would like to see done to cash-hoarding compoanies

Activist investor Carl Icahn's recent purchase of Apple shares and his subsequent lobbying for a larger stock buyback has brought a wider question back into the news.

Namely, why are so many large companies, particularly ones in the technology field like Apple, unable to find profitable growth projects to invest in? It seems particularly unusual given that by many accounts we are in the midst of a tech bull-market (/bubble) and entering a second machine-age. Now, it would seem, should be the time when companies are furiously scrambling to invest in the next new thing. Instead, many companies have billions sitting in bank accounts earning .2% interest, and they don't seem to be able to do much other then spend it buying back their own shares.

On the surface, this certainly seems wasteful. When technology could be applied to alleviate so many human problems, shouldn't there be worthier uses of this money?

And indeed, an explanation that seems to winning support from some of the VCs that I follow on twitter* is that it is wasteful: a market inefficiency is at play. Companies may indeed have profitable long-term investment opportunities, but they are unable to take advantage of them because their short-term oriented shareholders are demanding that they return cash to them instead.

This argument is not without its logic. In particular, investors who face career risk might be unwilling to ride it out with a company that is making an investment that will only pay out fifteen years from now, given that it is going to decrease earnings and cash-flow and make the company optically seem more expensive until then.

If this story is true, it would be a real tragedy. The whole point of the developed modern financial system is suppose to be to allocate capital most efficiently. If we are placing a greater value on financial engineering then on real engineering, then something is badly broken.

But before drawing too sweeping of conclusions, we should examine the facts in a little more detail.

For a start, it's not quite so clear that investors don't have some valid reasons to like companies that buy their shares back. Namely, giving cash back to shareholders just works! If you run the backtests (I have), investing in solely the companies that are buying back the most number of shares has been a market-beating strategy. This is also true for a host of related measures from free-cash flow yield, to earnings quality, to shareholder yield (dividend yield + share buybacks), to capex / depreciation.

More interesting still is the story behind this empirical observation. Much research shows that companies, as a whole, tend to over-invest because their management teams face incentives to "empire build" given that management's power (and likely salary level too...) is more directly related to market share, revenue, and overall market cap then it is too driving positive shareholder returns. We know, for instance, that the average major M+A deal is value-destroying to the acquirer. Avoiding empire-builders and purchasing humbler dividend-payers turns out to be a profitable strategy.

Of course, what is true in the aggregate is not necessarily always true in the individual. It would be silly to argue that companies that do have profitable opportunities are better off not taking them just because of what some backtest says.

But when companies prove that they can drive profitable growth, there is ample evidence that investors will give them the right to invest as much of their earnings as they want. You can see this in Amazon, which has had a high-flying stock for years despite making huge investments in new productions, distribution plants, and low prices that drive market share gains. Companies might have to earn their right to be like Amazon (through demonstrating that they can execute), but once they do the market is willing to play along.

So if it's not investor demands that are causing tech companies to hoard their cash, what is it? There are several possible explanations that have nothing to do with the stock market.

One is that technology companies just might not need to make large financial investments anymore. Put differently, the constraint on future growth might no longer be physical capital, but instead be human capital, or some other kind of capital.

Compare a company that manufactures patio furniture to a modern-day software / SaaS company. If you are making patio furniture, it certainly makes sense that you can increase your growth rate (provided the demand exists), by building a bigger factory and producing more patio furniture. If you feel particularly bullish about your market, you build a bigger plant. This kind of business is where our accounting notion of "capital expenditures" as additions to property, plant, and equipment comes from.

But when we're talking about modern software products, property, plant, and equipment don't much matter anymore. The reality is that this kind of physical capital might be one of the least important constraints to a modern technology business' growth.

More important than property, plant, and equipment for modern tech companies is the ability to find talented engineers, product managers, and designers and convince them to spend their days sitting in the same room and tapping away at keyboards next to each other. And capex doesn't make additional software engineers appear out of thin air (and won't anytime soon without some serious advances in 3D printing).

Of course companies could choose to use their cash to acquire startups that already have teams in place (the VCs would love that, since they are probably invested in many of the targets). And to be clear, they are doing this, if not in the size that some VCs would like them to be doing.

But for these types of acquisitions to be value-creating for shareholders of public companies, the acquiring company must have economies of scale that result in the business it is acquiring being worth more inside of it than outside of it. This might be the case if the acquiring company is quickly able to feed the acquired company's new product into its existing distribution channel, for example.

But there are a lot of reasons to suspect frequent diseconomies of scale in integrating a new company as well. History and basic business logic suggest that management has a finite amount of attention and is generally best-served by focusing on a core business. Cobbled together empires of various different businesses become difficult to manage and foster the kind of large company bureaucracy that has proven so hostile to innovation.

When you get to be the size of Apple (or HP), there is also a simple law of large numbers effect. It's just hard from several standpoints to put tens of billions of dollars to work every year. And there is probably a practical limit to how big any single company can become (if nothing else, regulators may become less friendly at some point).

It's no wonder then that it is easy to think of so many examples where acquisitions, mergers, or large capital expenditures did not work. For every youtube, there is a once promising business that was forgotten and shut-down inside its new parent, or a culture clash that turned out poorly for everyone involved.

As a society, we all have an interest in promoting more investments in technology. So let's by all means build an education system that will increase human capital. Let's build crowd-funding systems that provide an alternative funding mechanism to the traditional routes, so that anyone with a vision and the team to execute on it can get access to the capital that they need to do it, no matter where they are located or who they know. Let's fund basic science and engineering research to create the knowledge that will form the foundation of tomorrow's technologies.

But let's be careful what we wish for when it comes to meddling with the capital markets. Buybacks are part of a well-functioning market, and sometimes they are also the best mechanism to get cash back to those that are best positioned to invest it in the companies that will drive the future.

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By Alex Frey