The discussion that has been taking place recently about the veracity, or even appropriateness, of share buybacks has, naturally, piqued my interest. Obviously, I’m a fan of share buybacks (please see my pen name, twitter name, hell even my entire personality). It’s a tool in the arsenal of executives that is usually not readily available to the private business owner. In public markets, large share repurchases are often an honour signal. It can indicate that managements think their shares are cheap, or that they think their business has staying and earnings power many years out. It also signals that management takes a shareholder friendly approach to capital allocation. This is not always the case, but generally speaking it’s a good sign.
Share repurchases are really a mainstay of North America (the US mostly), and parts of Europe. There’s an institutional imperative at play, but there are cultural and taxation frameworks that make them attractive in these domains too. To the point - this characteristic of American capitalism is, in my mind, the Gold Standard. This isn’t some kind of ode to American Exceptionalism, the Shining City on the Hill, or to puritanical Providence - it’s an observation.
My first premise is that it is not only expedient, but it is right that capital find the highest rate of return and thus be allocated efficiently. This is more a negative view of the alternatives than a positive view of the proposition. Governments, charities, non-profits etc etc are typically very poor stewards of capital. Furthermore, societies that use capital as a means of social and political engineering retard their long term economic prospects. Some examples, if you don’t mind.
The Commonwealth countries of Australia and Canada share many similarities. They both have similar forms of government, open societies, mass immigration, and have economies that rely on commodity production and rather long lived real estate bubbles. It’s hard to say just how inefficiently capital is being allocated in each country, but it is striking how much of it is being employed in the mass purchasing of a negative yielding asset, with leverage. No matter how sanguine you are on real estate as an investment, it’s hard to fathom how much real economic value is being created there.
Henry George, a American 19th century libertarian economist, made the observation that, without constraints, all marginal economic gains in a geography will eventually get captured by real estate values and rents. However, if there is very little true economic value being generated, how can real estate capture it?
Perhaps this happenstance exists because of the enormous mineral wealth that gets capture in these societies? It’s hard to say. My reading of events is that a complex force of social pressures, favourable policies, the interests of various agents and in the interests of taxation revenue, a tidal wave of capital has been directed toward, essentially, a form of rent seeking. Even worse, it feeds on itself overtime.
A comparatively smaller amount of capital gets allocated to new businesses and growing existing ones (which happens for other reasons too). This is expressed in the amount of actual capital investment, as well as the inversion of individual’s opportunity costs as the prospects of missing mortgage repayments makes risk seeking unpalatable.
This is simply one manifestation of a system that seeks to direct capital for non-economic reasons. In Australia, for example, there is an enormous institutional imperative for public companies to pay dividends. This reaches almost laughable extremes where a not insignificant number of ASX 300 constituents are borrowing money to pay dividends to yield hungry shareholders. On the other end of the spectrum, many companies are paying dividends in lieu of making necessary investments in their own businesses. Both policies work for a while, until they don’t.
The most egregious examples, however, of capital being subordinated to social and cultural goals are found in Asia. The stereotypical example is Japan. Even though Japan is culturally Western (broadly speaking), it has experienced a degree of central planning not seen in other parts of that cultural brotherhood. Publicly traded firms sit on piles of cash yielding next to nothing (and often less than that), as a sort grotesque ode to another time. The money never gets returned to the equities holders, and is instead lent to the government, while the monetary authorities buy every publicly traded financial instrument in sight. While there are parts of this economy that are dynamic, it’s striking how much of the business sector has been zombified by this strange financial malaise.
Then there are the state capitalists. China being the preeminent example. The central authorities keep strict control over the sources of debt financing as a way to gain leverage over the economy in general. This too (unsurprisingly) has ended in a property bubble of epic proportions. We are witnessing the aftermath of this enormous social experiment at play now.
In a world where compounding matters, these hickups have serious implications. In Japan for example, the broad based indexes have barely recaptured their 1990 bubble highs. Forget a lost decade, we’re talking about a lost generation.
So capital should be allocated properly. It won’t always be, but the ability to move quickly and address problems on a long term footing is imperative. Part of that is making sure that executives are able to make flexible decisions about what they do with corporate proceeds. In any event, money can only be wasted on share repurchases if the price paid for those shares is too high, and then only existing shareholders bare the burden of impaired capital. Exiting shareholders get cash, and then redeploy it into the economy or other investments - and the economy ticks over.
Larry.