What Investors Need to Know About Stock Buybacks

Stock buybacks are deceptively complex. (Perhaps this mystery adds to their allure among CFOs!) Shareholders should be particularly concerned because a recent report suggests that buyback confusion also extends to the board room.

Ever since the SEC loosened its regulation on buybacks, companies have been changing the way they distribute cash to shareholders. By McKinsey’s calculations, share buybacks have increased to about 47 percent of the market’s income since 2011, up from both about 23 percent in the early 1990s and less than 10 percent in the early 1980s.

A recent report¹ sponsored by the IRRC Institute, highlights interviews with 44 directors serving on the boards of 95 publicly traded U.S. companies and their perspectives on stock buybacks. One concerning conclusion from this report is that directors may view share buybacks as a method of covering up the unfavorable aspects of stock options.

The report’s author, Richard Fields, shared that he was struck by how universally accepted the assumption is that equity compensation should be offset by buybacks. For example, one director reported, “I believe you always buy stock back to offset dilution that comes from granting options. You do not want to dilute the current shareholders.”

Wait—hold on. This is terrible reasoning. Buybacks don’t offset the dilution of share value (caused by granting options). Assume with me that ACME Corp. has two shares of stock before awarding its CEO one share of stock as a reward for hitting growth targets. In our overly simplified example, adding an additional share increases the total outstanding shares to 3 and reduces the value of each existing share 33%.

Here’s how buybacks work. Now assume that ACME Corp’s market value is $300 and the corporation uses excess cash to purchase one of the existing shares with the aim of destroying this share and reducing its overall shareholder count. After the repurchase is complete, there are two remaining shareholders and the corporation is worth $200 (after $100 was distributed). In this example, the remaining investors are no better or worse off than before the buyback. They still own one share of stock and each share retains its original $100 value. The purpose of the buyback is to enable ACME to slim down by distributing cash that’s not being put to productive use.

stock option and buyback

Equity compensation is a very effective tool, but it’s naive to believe that buybacks can shelter shareholders from its costs. Another director quoted in the IRRC study shared this: “If we are using hard dollars to offset stock dilution, we should treat those hard dollars as a compensation expense. Otherwise we are not recognizing what we are actually spending to compensate our people.”

Corporations have many good reasons to pursue an equity buyback strategy, but camouflaging executive pay isn’t one of them.

¹Buybacks and the board: Director perspectives on the share repurchase revolution

The Wedge

Since 2003, I’ve lived my life in two worlds. Years ago, my wife and I committed with close friends to move into the inner-city of Richmond, Virginia in a faith-inspired effort to invest in our local community. During this time, we’ve spent countless hours at our local elementary school, welcomed an after-school tutoring effort into our home, and helped start an affordable housing non-profit. While it hasn’t been an easy path, the journey has rewarded us with relationships and experiences that I wouldn’t trade for anything.

At the same time, I’ve worked in what I now look back on as an emotionally unsettled career as an investment advisor for high net worth families and institutions.

It has taken me many years to identify that my vocational angst lies not at the edges of the complex global financial system, but with its central assumptions. These central assumptions require that I ignore many of the first principles that led our family to put down roots in an economically distressed neighborhood.

I now reject the assumption that the sole purpose of a corporation is to maximize profits for the owners. In 1970, the most influential economist of his day, Milton Friedman, wrote in the New York Times Magazine that a corporation has only one purpose: to increase profits within any legal means necessary. At the time, Friedman had valid reasons to be skeptical of calls for social responsibility. He was combating many ill-conceived arguments that were contrived to pressure corporations to lower their prices to solve a monetary inflation crisis. In the process of clearing some of the dirty water, Friedman also dumped the proverbial baby. Thus, the inspirational leader and his so called Chicago School acolytes struck an academic wedge between business and personal values. The longer this wedge remains in place, the more we risk confusing future generations.

With three young boys, my challenge is to model for them the behaviors and beliefs that lead to maturity—and there’s no better place to work at this than on the soccer field. Winning is fun. I don’t need to teach them this. But if they don’t learn to carry themselves honorably on the field, they will soon find that their victories carry no enduring satisfaction.

On the “field” of finance, the desire to win never goes away, but the game gets much more complex and stretches as far as the international markets allow. Here, profit-seeking is forever running into ethical questions about ecological impact, human dignity, and property rights. Here, guiding principles become even more important. These moral and ethical principles remind us that there is more at stake in business enterprise than can be illustrated on an income statement.

In investment management, Friedman’s ideas about the purpose of a corporation directly influenced how we think about the optimal/efficient portfolio. Upon this cornerstone, all of modern portfolio theory has been built. Put simply, the optimal/efficient portfolio assumes that an investor’s only concerns are financial returns and risk of loss. In the process, morals and ethics get reduced to whatever you can legally get away with to turn a profit.

Not only does this wedge between personal and business values distort our definition of the optimal/efficient portfolio, it also perpetuates derivative concepts that have won the day in the capital markets. The most powerful child of modern portfolio theory is the now fully developed juggernaut that we know as passive (index) investing. This movement has stressed the importance of low costs and attention to broad diversification over individual stock selection. Passive investing strategies flourished by accurately noting that most highly paid active managers fail to beat an index fund that holds every stock in the target universe (e.g., S&P 500). To illustrate this, Burton Malkiel[1] preferred the punchy image of monkeys throwing darts who regularly outperformed the expensively clothed professionals.

While the movement helped investors shed unnecessary fees, it also enabled them to believe that it is possible to make money without any oversight at all. “Set it, and forget it” became standard advice. In the process, all of the responsibilities of ownership lost their meaning. If you don’t believe me, try attending a typical shareholder meeting where turnout is often just a handful of investors[2]. The very structure that was created to offer shareholders the opportunity to engage with executives is now little more than a compliance annoyance. When you consider that only 30%[3] of shares owned by retail investors get voted, you see that similar disinterest in yet another fundamental right of ownership. Concern over these trends have been noted for years but the focus on the return of an optimal portfolio leaves little energy to address issues of responsible ownership.

The emphasis on passive investing also led investors to believe there are no limits to the benefits of diversification. Most recommended investment strategies push investors to own virtually every public company in the global economy. The end result is absurd diversification and a disengaged investor.

In some cases, these companies are operating in ways that directly conflict with personal and societal values. As one personal example of the many I could cite, my own portfolio once owned an oil and gas company with a terrible track record of spills and controversial exploration practices. Without basic oversight, companies have come to believe they have our de facto blessing to maximize returns by any legal means necessary—no matter the externalities born by other parties.

At this point in my story, I think it’s worth sharing that I count Jack Bogle—the man largely considered to be the great prophet of this passive investing movement—as a personal hero. While the passive investing tsunami is fostering all kinds of irresponsible investing behavior, I believe this movement was necessary to break through to a new investor consciousness. Thomas Jefferson argued that revolutions are necessary every few decades to preserve liberty by breaking the up the establishment. Before Jack Bogle, most investors had little option other than to entrust their life savings to overconfident and overpaid money managers. The passive investing movement ushered in a creative disruption that upended the traditional investing power structures. Now it’s time to tame the dragon.

Finally, it’s time to reject the traditionally held view that a fiduciary standard is the highest form of service that the financial management industry has to offer. The fiduciary standard (which includes both a duty of loyalty and a duty of care) is a legal standard focused on financial interests. Legal standards are essential in that they ensure that our most basic rights are protected but at their best, they are also limited.

Applying fiduciary service should represent the bare minimum expectation in the financial planning profession. Fiduciary service simply ensures that a financial advisor’s recommendations are legally defensible. But I also don’t want to suggest that the step beyond fiduciary service is an easy one. Moving beyond fiduciary is a move into a universe of goals and aspirations more focused on the complexities of human and social capital than the clarity of financial capital. Moving beyond fiduciary allows investment managers to begin customizing investment advice to reflect the values of their clients. Moving beyond fiduciary recognizes that investors can get to the end of their life with only a limited balance sheet remaining and yet still have died wealthy.

Today, many have come to accept the wedge that lies between personal values and business/investment values as normative. It’s a schizophrenic mindset of honorable values on the one hand and “anything legal goes” on the other. Yet, we suffer no such confusion when we train our children. The power of living out our values never gets old—even on the soccer field.

It’s time to begin a process of aligning our principles and our business beliefs in earnest. It’s time to stop investing like passive bystanders. It’s time to figure out how to reclaim our first principles as we pursue the optimal portfolio. And it’s time to start looking for investment advisors who are willing to offer advice that moves beyond fiduciary.

1. Author of A Random Walk Down Wall Street and a leading proponent of the efficient-market hypothesis who teaches economics at Princeton University.
2. Berkshire Hathaway meeting excluded
3. SEC Proxy Voting Roundtable transcript

The Most Misunderstood Song About The Power of Money

“For The Love Of Money,” may be the most misunderstood song in all of history. Focusing on the catchy “Money, Money, Money, Muuun-nay” refrain leads many to miss all the embedded soulful consciousness. A deeper dive sheds light on why the tune was chosen as the SRI Investor’s theme song.

For The Love Of Money” (lyrics listed below) is a warning composed by R&B artists who were rapidly approaching the pinnacle of commercial music success. This song was written and produced by the famous Philadelphia Soul collaborators Kenneth Gamble and Leon Huff who also authored “If You Don’t Know Me by Now”, “Love Train” and scores of other famous R&B hits that have achieved immortality as groovy wedding ceremony staples. Gamble and Huff added Anthony Jackson as a writer of the song in recognition of the soul-piercing opening bass lines he developed which became a signature of the song.

“For The Love Of Money” was recorded by the O’Jays and became an immediate Billboard Hit in 1973. Instead of celebrating wealth, this unusually lengthy seven minute soul ballad offers seven examples of how greed entices people to do all kinds of terrible things to others and sometimes to themselves.

More wealth has been created in America in the last fifty years than in any country at any other period of history. Like Gamble and Huff, American capitalism is reaching the pinnacle of its economic success. This song reminds us that we can gain the whole world and yet still lose our soul.

The fundamental principle of the SRI Investor is this: the future is a product of the investment seeds we plant today. As investors, we hand our capital over to corporate managers for planting. They choose the seeds, the ground and the field workers. The one expectation that is absolutely certain is that their seeds are expected to produce a financial harvest. Yet, these seeds also represent a future of non-financial outcomes that impact key stakeholders.

Consider how tempting it can be to lose sight of these so called intangibles when the only question that most investors are asking is how well the stock did last quarter. It’s too easy to blame corporate America for losing their souls. Investors need to accept responsibility for the messaging they send to the planters.

“For The Love Of Money” was inducted into the Grammy Hall of Fame Class of 2016. Just as Philadelphia Soul established its place in our culture perhaps there is some room for it in our portfolios as well.

Listen to “For The Love Of Money” recording on YouTube.

Lyrics:
Money, money, money, money, money [6x]
Some people got to have it
Some people really need it
Listen to me y’all, do things
Do things, do bad things with it
You wanna do things, do things
Do things, good things with it
Talk about cash money, money
Talk about cash money
Dollar bills, all

For the love of money
People will steal from their mother
For the love of money
People will rob their own brother
For the love of money
People can’t even walk the street
Because they never know
Who in the world they’re gonna beat
For that lean, mean, mean green
Almighty dollar, money

For the love of money
People will lie, Lord, they will cheat
For the love of money
People don’t care who they hurt or beat
For the love of money
A woman will sell her precious body
For a small piece of paper
It carries a lot of weight
Call it lean, mean, mean green

Almighty dollar

I know money is the root of all evil
Do funny things to some people
Give me a nickel, brother can you spare a dime
Money can drive some people out of their minds

Got to have it, I really need it
How many things have I heard you say
Some people really need it
How many things have I heard you say
Got to have it, I really need it
How many things have I heard you say
Lay down, lay down, a woman will lay down
For the love of money
All for the love of money
Don’t let, don’t let, don’t let money rule you
For the love of money
Money can change people sometimes

The Examined Life Assesses All Three Forms of Capital

Capital is often narrowly defined as a tangible financial resource. Yet even accountants understand that intangibles have value. In fact, adding together the intangibles alone on Google’s financial statements totals over $19 billion. These brands, patents, and goodwill are harder to measure, but no less important and valuable.

Individuals also carry intangible capital on their own “balance sheets.” Taking stock of your intangible capital is an essential aspect of the examined life.personal-capital-triangle

Much has been written about material capital, so I feel little need to offer anything but a very brief summary. This category includes your house, your savings, your cars, and anything else that fits in your jewelry box, garage, or investment account.

The next two forms of capital are the more intangible types:

Human capital is the category of your educational degrees, expertise, and personal health. Unlike financial investments that require faith in the management and expertise of others, you are the primary agent in this fundamental form of intangible capital. Is your training or physical or mental health keeping your from reaching your potential? If so, there’s no time like the present to start making changes to improve.

Social capital (also known as cloud capital) is the hardest to measure, but still important. Social capital concerns the relational and spiritual connections that provide meaning and value in life and beyond. I have yet to talk with someone nearing the end of their life who felt that they spent too much time with friends and family.

Relationships are a highly transferable part of social capital. Consider how often you were helped or hindered because of your family, associations, and references. Some inherit a large starting social capital balance, while others may be disadvantaged by race, gender, sexual identity, and/or other characteristics that separate one from the norms set by culture. Before you can begin to set social capital goals, you’ll need to begin with an pragmatic assessment.

If you identify anxiety, depression, stress or burnout, your primary goals may be focused on retreat, exercise, and reflection. An examined life requires time for self-reflection. Bill Gates takes two one-week “think weeks” every year, and a personal mentor of mine recommends at least one 24-hour silent retreat per year.

When financial advisors dare to guide discussions into the more intangible forms of capital, we call this life planning. Whether you do your life planning with your money guy, a trusted friend, or alone on a mountaintop, the point is that analysis and goal setting take time and intentionality.

You can begin taking stock of these three forms of capital by asking yourself the following question: How do I feel about each of my current balances?

Material capital: Good Shape, Needs Work, or Bankrupt?

Human capital: Good Shape, Needs Work, or Bankrupt?

Social capital: Good Shape, Needs Work, or Bankrupt?

There is wisdom in assessing all three forms of personal capital at the same time because they all impact each other. This is why the arrows of the personal capital triangle (see image above) point in two directions. Too often, only one aspect of capital development is assessed at a time—if ever. Failure to consider the big picture might lead your financial advisor to make one assessment and your clinical psychologist, quite another.

Viewing your material capital in isolation from your human and social capital has also fostered an unnatural ethical tension. Material gain earned by any legal means necessary may be creating debits to your human and social capital balances. The examined life considers all three forms of capital when reflecting and setting goals.

Author’s Note: Before creating this post, I started with a conversation among friends and I want to thank everyone who shared comments (both online and in person) which all helped shape my thinking on this subject.