Are Buybacks Really Shortchanging Investment?

Jesse Fried is the Dane Professor of Law at Harvard Law School and Charles C.Y. Wang is the Glenn and Mary Jane Creamer Associate Professor of Business Administration. This post is based on a recent article authored by Professor Fried and Professor Wang, recently published in the Harvard Business Review.

In an article recently published in the Harvard Business Review, Are Buybacks Really Shortchanging Investment?, Charles Wang and I use data to challenge the widely-held view that U.S. firms distribute too much cash to shareholders through stock buybacks and dividends, reducing these firms’ ability to innovate and invest for the long term.

Payout critics focus on the high volume of dividends and repurchases, often pointing to shareholder payouts routinely exceeding 90% of net income. For example, during the decade 2007-2016, S&P 500 firms distributed $7 trillion to shareholders, mostly via repurchases, totalling 96% of net income. These figures have led Larry Fink, CEO of Blackrock, to warn corporate leaders against seeking to “deliver immediate returns to shareholders, such as buy-backs… while underinvesting in innovation, skilled workforces or essential capital expenditures necessary to sustain long-term growth.” Vice-President Joseph Biden, reportedly mulling a run at the White House in 2020, claimed that the high level of buybacks “has led to significant decline in business investment” with “most of the harm …borne by workers.” Biden’s view is widely shared by prominent politicians in Washington, D.C. Just last week, Senate Democratic Leader Chuck Schumer, who claims buybacks “crowd out investment” that would benefit workers and firms, joined Senator Tammy Baldwin in introducing an amendment to the banking deregulation bill that gives the SEC the authority to block a stock buyback it deems to harm the corporation.

We begin by examining corporate investment levels. If shareholder payouts were excessive, corporate investment should be declining. However, across all S&P 500 firms, we find that the absolute amount of R&D spending ($274 billion in 2016) and R&D intensity (R&D spending as a percentage of revenues) are both at record highs. Similarly, a broader measure of investment, CAPEX plus R&D ($885 billion in 2016), has risen steadily over the past two decades. In fact, both in absolute and relative terms, CAPEX plus R&D are at levels not seen since the late 1990s boom period.

A payout critic might argue that investment in the S&P 500 would have been even higher if firms had retained more cash rather than distributing it to shareholders. But we find that corporate cash stockpiles are huge and growing. In 2007, S&P 500 firms held $2.8 trillion in cash plus cash-equivalent short-term investments. Over the next decade, they accumulated significantly more, ending up with $4.3 trillion in 2016—an increase of about 50%.

What accounts for the apparent disconnect between the large volume of shareholder payouts, on the one hand, and soaring investment and cash levels, on the other? The main reason is that buyback alarmists look at shareholder-firm capital flows going in only one direction: from firms to shareholders. They ignore capital flows going in the other direction, from shareholders to firms, via equity issuances. Across all S&P 500 firms, equity issuances from 2007 to 2016 totaled $3.3 trillion—about 79% of the $4.2 trillion in repurchases over this period. As a proportion of net income, shareholder payouts for the S&P 500 totaled 96%, but net shareholder payouts totaled a much more modest 50%.

A second reason for the disconnect is that, net income, against which shareholder payouts are often compared, is a poor measure of the income available for internal investment. It assumes the expenses deducted to arrive at net income are entirely unrelated to future-oriented investment, but one of these is R&D, which by its very nature is future oriented. At most, net income indicates the amount available for CAPEX and additional R&D. When we add R&D expenses (net of tax effects) back into net income to arrive at R&D-adjusted net income, and compare it to net shareholder payouts, the overall picture looks very different. From 2007 to 2016, net shareholder payouts by the S&P 500 constituted only 41.5% of R&D-adjusted net income. That left the S&P 500 with $5.2 trillion available for CAPEX, R&D, and other investments, which explains why investment levels can be at record or near-record highs while cash balances are increasing.

We also explain that buyback alarmism reflects a very myopic view of the U.S. economy, as it implicitly assumes that there is little economic activity outside S&P 500 firms and net shareholder payouts by these firms are thus wasted. But net shareholder payouts by the S&P 500 free up capital for productive use elsewhere, both in non-S&P 500 public firms and private firms. Consider non–S&P 500 public firms. In every single year of the 2007–2016 period, they experienced net shareholder inflows (that is, negative net shareholder payouts), absorbing capital to fuel investment, innovation, and job creation in those firms. Getting capital to private firms is even more important, as these firms account for more than 50% of nonresidential fixed investment, employ almost 70% of U.S. workers, generate nearly half of business profits, and historically have been important sources of innovation and job growth in the United States.

We also address the argument that stock buybacks increase income inequality by favoring wealthy executives and shareholders at the expense of middle-class workers. We explain why there is little reason to believe that shareholder payouts transfer value from workers to shareholders, or have much effect on nation-wide income inequality. Executives can and do sometimes use repurchases to improperly benefit themselves at the expense of shareholders, a real problem that should be addressed through better regulation of stock buybacks, but one that is unlikely to have a perceptible effect on income distribution in our society.

In short, buyback alarmists’ claim that buybacks are draining public firms of investment capacity or causing other social ills does not stand up to the data.

The complete article is available here.

The data and the methodologies behind the analyses reported in the article can be found in the February 2018 version of our SSRN working paper, Short-Termism and Capital Flows.

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