To reignite growth: ban share buybacks?

Kaveh Pourvand, 16 May 2013

Admittedly, the topic of share buybacks, when companies repurchase their shares to return money to investors, may not immediately set the pulses racing. However, if William Lazonick is right, cracking down on this practice may be crucial to getting investment rates back up and the economy back on track. Lazonick’s research has focused on the American stock markets, but there are lessons here for the UK.

The practice of buying back shares was popularised in the 1980s and 1990s, when the ‘shareholder value’ ethos took hold in America and the UK. The rationale was simple. Many large companies had lots of cash generated from successful investments in the past. However, they also operated in saturated markets with few investment opportunities in the future. If the cash wasn’t returned to shareholders it would be wasted on things like big corporate offices and jets for the CEOs. The proposed solution was to incentivise CEOs to return ‘free cash flow’ to the shareholders. This, among other reasons, was why the executive pay became linked to the share price. If the CEO wanted more pay, she would have to please shareholders by buying back shares when the company had ‘free’ cash flow.

The problem now, as Lazonick points out, is that executives often buy back shares simply to inflate the share price in the short-term (and consequently their pay) even when there are potentially profitable investments or that cash definitely had uses in the company. Three (American) examples he gives:

• In November 2007 Citigroup secured $7.5bn in equity investment from the Abu Dhabi Investment Authority. Yet it spent almost as much on buybacks in 2006 and 2007.
• Pharmaceutical firms spend more on buybacks than R&D while arguing against regulation of drug prices on the basis that they need the profits to invest in drug research.
• Exxon Mobil spent $163.7 billion on share buybacks between 2000 and2009, more than any other company during the period, even though there were investment needs for large-scale energy alternatives.

This problem is not just limited to America. Between 2001 and 2010, the S&P Europe 350 index, which includes 86 of Britain’s largest companies, made €882bn in net profit, of which 63% was paid out in dividends and another 26% to buy back their own shares. British gas supplier Centrica announced a £500m share buyback scheme last year, even while it’s been raising consumer prices. In his submission to the Kay review of equity markets, Civitas director David Green pointed out that BAE announced £500m worth of share buybacks in July 2011 and then announced the redundancy of 3,000 highly trained staff two months later. ‘why’, he asked, ‘did it not use its reserves to develop new products to take advantage of the proven capabilities of its workforce?’

Were those 86 British companies to invest more and return capital to shareholders less, we would be back on the way to growth. Maybe it’s time to consider, as Lazonick argues, banning the practice of share buybacks.