February 24, 2022

Do Stock Buybacks Really Shrink Capital Spending?

Thanks to soaring corporate cash, capex has improved lately, but share repurchases still overshadow it.

Reported by Larry Light

CIO-022422 OSC-Capital Spending1-buybacks and dividends_Georgie McAusland-web

Art by Georgie McAusland

Is it true that stock buybacks steal from corporate capital expenditures, pleasing investors in the short term but stunting businesses long-term? There’s an interesting answer to this key question.

Among investors, buybacks are a blessing in that the repurchases usually command a premium (historically around 8%) over the market price. Plus, by reducing the number of shares outstanding, the market value for remaining shares often rises on its own. Certainly, earnings per share looks better, split among fewer shares. And for C-suite executives, whose pay packets tend to be heavy with stock options, that all means sweeter compensation.

But to numerous critics, the nice investor perk has a downside. They charge that the money would be better spent on capex, as it’s known: upgrading companies’ equipment, computer power, employee wages, and other means of gearing up for the future. It turns out that capital expenditures, while on the upswing after a pandemic-induced 2020 rout, pale before outlays for buybacks, which also dipped in the outbreak’s early days and now have sprung back.

The key question is whether a cause-and-effect exists: If so much money weren’t shunted into buybacks, would capital spending be greater? Circumstantially, that trade-off notion has an appeal. That was especially true pre-pandemic. Events since early 2020 have muddied the waters, though. We’ll address that in a minute.

No one can question that buybacks are increasingly popular among corporate leaders. For the S&P 500 in 2021, they totaled an estimated $850 billion, a big hop from 2020’s whittled-down $521 billion, and easily exceeding the record, set in 2018, of $806 billion, according to S&P Dow Jones Indices. (The companies also paid $511 billion in dividends last year, up from $483 billion in 2020.) At the same time, 2021 capital spending for the index members was $740 billion, S&P Global Ratings data show.

Philosophically, the buyback craze stems from the belief that took hold in the 1980s that companies’ primary mission was to enrich their investors, a concept known as “shareholder value.” The leading proponent of this idea is economist Michael Jensen, a professor emeritus at Harvard Business School, who started with a 1983 paper maintaining that profits should mostly be rerouted to shareholders, and company managers should maximize earnings above all.

The legal groundwork for buybacks was a 1982 Securities and Exchange Commission rule permitting companies to repurchase their own stock. Before, repurchases were viewed with suspicion as a means of manipulating stock prices and insider trading.

Boooooo, Buybacks

For some time, the fact that buybacks overshadowed capex has troubled many. The chief critic of buybacks is economist William Lazonick, professor emeritus of economics at the University of Massachusetts and president of the Academic-Industry Research Network. In numerous studies, he has contended that the buyback binge harms workers, due to stagnant wages, and the economy in general, by diverting funds to line investors’ pockets rather than to spur innovation.

For instance, he noted, for two years before its epic collapse, which triggered the 2008-09 financial crisis, Lehman Brothers spent $5 billion on buybacks. More recently, he criticized pharma giants Merck and Pfizer for spending lavishly on repurchases while struggling to develop new drugs—and Boeing for shelling out $43 billion in buybacks from 2013 to 2019, while failing to address design flaws in its 737 Max jets, two of which crashed. (The companies disputed those characterizations.)

For companies, buybacks furnish a tax-savings benefit, too. The Tax Policy Center has argued that buybacks provide a lower tax burden because they allow for greater deferral of capital gains. “Since share buybacks help avoid investor-level taxation, the buyback tax is a reasonable way to reduce the tax advantage,” the center said.

Buybacks have become betes noires to liberals, with Sen. Elizabeth Warren, D-Massachusetts, making their abolition a key goal in her 2020 presidential run. She and others like her were outraged that much of the Trump administration’s 2017 corporate tax cuts led to more buyouts instead of higher worker pay or capex.

But animosity toward buybacks is not confined to the left. Sen. Marco Rubio, R-Florida, issued a paper that knocked companies for shunting dollars to investors when they could’ve been better suited to enhancing innovation. Meantime, the Biden administration has proposed a 1% tax on buybacks, as part of his social spending plan now stuck in Congress.

Maybe Things Have Changed

So buybacks are robbing from capex, and endangering the US’s economy over the long pull, right? Well, the problem is that proving such a trade-off exists isn’t easy. Why the murkiness? Because corporate America has no shortage of ready cash able to deploy for anything—whether buybacks or capex.

This is a recent phenomenon. The counter-argument to the anti-buyback discussion coming from the likes of Warren and Rubio is that, in the slow-growth years following the Great Recession, corporate chieftains were reluctant to expand their capex, for fear that demand wouldn’t support their newly larger production capabilities. And, yes, in the process harm earnings.

Indeed, buybacks surged in 2018 and 2019, when the Trump tax cuts first kicked in, then ebbed with the pandemic’s onset in early 2020. Yet after that, buybacks came back with a vengeance, owing to the advent of massive federal stimulus and a Federal Reserve-engineered interest rate reduction to near zero. The 2020 recession lasted just two months, and the economy took off.

A big change is that corporations have been building up their cash reserves for the past several years, even predating the pandemic. The coronavirus accelerated this. S&P 500 companies ended 2020 with roughly 20% more cash and investments than they had in 2019, by the estimate of MarketSmith researchers. A lot of this cash is clustered in tech companies, with Apple the leader at $203 billion, up 4% from last year.

Proving that buybacks starve capex is tough to do. The current rise in capex, along with the parallel increase in buybacks, seems to suggest that no zero-sum game is at work. That’s where for capex to win, buybacks must lose, and vice-versa. “I’m not aware of studies that show that stock buybacks weaken capital spending,” said economist Gary Shilling, who heads his own eponymous research and investing firm.

While companies have big incentives to pump up buybacks—not the least being that executives benefit from fatter pay—slighting capex is ultimately self-defeating. Stinting on capital outlays often occurs during recessions and other slow-growth periods, and then picks up as the economy quickens its pace. Corporations “prefer capital spending since it’s usually necessary for growth in revenues and profits,” Shilling said.

For the next six months, economic growth should be sufficient to keep capex strong, said David Levy, chairman of the Jerome Levy Forecasting Center, a noted research group. What’s more, other forces are at work that could buoy capital spending beyond that.

The pandemic has created shortfalls that need to be fixed, and it has drawn attention to existing ones. Levy pointed out several of these: shortages of workers that propel faster automation in factories, shortages of semiconductors, outmoded equipment, reshoring of overseas operations to remove supply snags, and combating climate change with environmentally friendly power generation.

How much longer the mutual enlargement of buybacks and capex can continue is unknown. Regardless, the debate over the wisdom of repurchasing shares will not go away.