Marion McHugh

Associate Professor, Business & Accounting, Furman University

Jonathan Handy

Assistant Professor of Finance, Furman University

Thomas Smythe

Professor of Business & Accounting, Furman University

Historically, when firms announce plans to repurchase stock, markets respond positively.  The response has been no different over the last five years. Since 2000, however, we have observed a much larger number of firms repurchasing in ever-greater amounts. Regionally, South Carolina companies are also repurchasing their stock. For example, during the 2015 fiscal year, six of the 31 publically traded companies headquartered in South Carolina made stock repurchases, with the Denny’s Corp. leading the way with more than 8.5 million shares, upwards of $92 million. With respect to repurchase growth, Denny’s repurchases have nearly quadrupled since 2012. While this activity appeases investors in the short-term, we argue that it may come with long-term costs—slower economic and job growth and a loss of future competitiveness.

There are a number of theories that help explain firm repurchase behavior. The most frequently cited is that repurchases are a way to signal the market that a firm is undervalued. (“If we’re buying our stock, so should you.”) Another theory suggests that repurchases are simply a substitute for, or in addition to, paying dividends. Both of these theories make two critical assumptions: First, managers are incentivized to look at the firm’s long-term prospects and take actions accordingly. Second, managers are adept at timing when it is most appropriate to engage in buyback initiatives.

There is reason to believe that management may not fully account for a firm’s long-term prospects when making buyback decisions. Specifically, management compensation contracts are commonly written in terms of earnings per share (EPS) growth, a relatively short-term focused metric. Buybacks increase this measure by reducing the number of shares outstanding—even if earnings are unchanged—leading to a purely mechanical increase in EPS. Further, managers with stock options have wealth directly dependent on stock price. As the stock price exceeds the exercise price of options, option values increase dollar for dollar. Finally, in recent years, managers have observed industry peers conducting buybacks at a growing rate, with a corresponding rise in stock prices. As more firms engage in the practice, it is increasingly difficult for managers to make long-term investments in capital, labor, and research, each of which negatively impact EPS in the short term.

Managerial incentives can also affect the validity of the second assumption, i.e. management can accurately time buybacks. Specifically, signaling is strongest when stocks trade at levels below historical averages, i.e. repurchase activity should only be a “signal” when equities are relatively cheap. However, when we evaluate the change in the S&P 500 since 2000, this assertion becomes hard to justify. On December 31, 2000, the S&P 500 closed at 1366.01. On December 30, 2016, the index closed at 2,238.83, an increase of 228 percent. Ironically, since 2000, the index’s return has averaged approximately 2.4 percent compounded annually through year-end 2015, while treasury stock values have risen 11.48 percent annually (2015 is the most recent year of complete data). Even when treasury stock values are scaled by assets, the annual change in treasury stock is 6.8 percent. Firm equity has become considerably more expensive; yet, managers continue to repurchase shares at a pace outpacing the return on the index.

We believe managerial incentives underlying firm repurchases are currently leading to suboptimal resource allocation. To evaluate the degree to which this may be true, we examined the behavior of S&P 500 firms from 2000-2015. Over this period, as stated above, absolute treasury stock value on balance sheets has grown approximately 11.5 percent annually. In contrast, the absolute rate of capital expenditure growth (0.9 percent), spending on employees (-1.68 percent), and spending on research and development (2.98 percent) is far slower than the increase in treasury stock. As a result, firms are not investing enough to even upgrade existing asset bases. When we scale spending on capital expenditures, employees, and R&D by total assets, these measures have all declined since 2000. Over the same period, treasury stock as a proportion of assets has risen at an annualized rate of 6.8 percent and firm profits have remained stable. In short, firms are disinvesting in physical, human, and intellectual capital and using the subsequent surpluses to fund buyback programs.

So what does the current fascination with stock repurchases portend for the future of the economy? Most immediately, relatively fewer people are working, while managers are disinvesting in order to maintain short-term stock prices. Ultimately, the lack of investment in physical, human, and intellectual capital negatively affects all citizens and the overall competitiveness of the U.S. economy and the upstate. We challenge executive teams to roll up their sleeves and focus on long-term plans to improve their firms and U.S. competitiveness.

Marion McHugh is an associate professor in the Business and Accounting Dept., Jonathan Handy is an assistant professor of Finance, and Thomas Smythe is a professor of Business and Accounting at Furman University.