AP Photo/Mark Lennihan, File
The debate on the role of stock buybacks in the performance of the U.S. economy is heating up. There are executives, journalists, and academics who, like us, argue that corporation’s repurchases of shares on the open market —the vast majority of buybacks—do great damage to the economy because they undermine stable and equitable growth. On the other side is a growing chorus of executives, journalists, and academics who insist that buybacks, like dividends, improve U.S. economic performance because the shareholders who receive these distributions inevitably put them to use “somewhere” in the economy. In a recent New York Times op-ed, Joshua Bolten, chief executive of Business Roundtable, and Ken Bertsch, executive director of the Council for Institutional Investors, sang buybacks’ praises.
So let's compare these two very different perspectives on corporate resource allocation. Our view is founded on the conviction that, to compete successfully on a product market, a company must invest in productive capabilities: not only in plant and equipment, but, more important, in its employees’ collective and cumulative learning. It is organizational learning that enables the company to improve its products, which in turn enables it to expand its market share and achieve economies of scale. This process, through which employees create value, results in higher productivity that shows up in increased profits. The corporation’s reinvestment over time of a substantial portion of profits in the productive capabilities of its employees has always been, and remains, the financial foundation for the growth of the firm.
The abilities and incentives of the senior executives who determine how to allocate their firms' resources are critically important to this value-creation process. It cannot be taken for granted, however, that these senior executives will have the abilities and incentives needed for making value-creating investments.
By retaining earnings, these executives can reward participants in the value-creation process as well as reinvest in productive capabilities that may enable the company to grow and prosper in the future. As value creators, the company's employees should be first in line for those rewards, which take the form of sustained employment, higher wages, and better benefits. The company can also use a portion of its profits to invest in upgrading the employees' productive capabilities. On the basis of such a “retain-and-reinvest” regime, the corporation can remain competitive for long periods of time while raising the living standards of its employees. Adoption of a retain-and-reinvest allocation regime by most of a nation’s leading business corporations is what provides the foundation for stable and equitable growth—or what we call “sustainable prosperity”—in the larger economy.
A very different view of the corporation and its role in the economy emerges from Bolten and Bertsch's recent op-ed. Their assertion that “companies are always looking for ways to invest profits to increase their future growth” indicates that they assume senior executives will have the abilities and incentives to engage in a retain-and-reinvest allocation strategy. As we have shown, however, U.S.-style stock-based compensation in the form of stock options and stock awards gives senior executives a personal incentive to distribute corporate cash as dividends and buybacks in order to boost stock prices. Rather than focus corporate resource allocation on value creation, these executives favor value extraction. Their self-interest may lead them to avoid uncertain, but potentially important, value-creating investments.
Indeed, our company-level research suggests that once senior executives adopt a value-extracting approach to corporate resource allocation, they lose the ability (if they ever had it) to envision opportunities for new types of value-creating investments that their company could and should make. Instead they will look for opportunities to cut operating costs—for example, through wage suppression and employee termination—and raise product prices to augment profits for the purpose of distributing more cash to shareholders. In the process, a once-successful company will transition from a retain-and-reinvest allocation regime to a “downsize-and-distribute” regime, with negative impacts on its competitive capabilities and its contributions to sustainable prosperity.
Bolten and Bertsch contend that the reason senior executives distribute corporate cash to shareholders is that “at some point, they may run out of investment opportunities with enough growth potential to justify an investment.”But it is nonsense to argue that the largest stock repurchasers—a list that for the decade of 2008-2017 is topped by Apple with $166 billion in buybacks; Exxon Mobil, with $147 billion; Microsoft, $105 billion; IBM, $101 billion; and Walmart, $68 billion—have, with their accumulated capabilities, run out of investment opportunities. Corporate executives who make this argument as an excuse for distributions to shareholders are admitting that they are not doing their jobs as strategic decision-makers.
Bolten and Bertsch note that many of the largest repurchasers also are among the biggest spenders on R&D. “It is a myth,” they say, “that buybacks and dividends displace investments that companies would otherwise make to grow or develop innovations.” They argue that S&P 500 companies “that repurchased stock in the first three quarters of 2018 tended to engage in more capital expenditures and research and development investment than those electing not to do buybacks.”
But making capital expenditures and funding R&D will not necessarily result in innovation if those executives who exercise strategic control over corporate resource allocation have neither the abilities to conceive nor incentives to implement the visionary organizational-learning processes that innovation requires. Our research on innovation and competition in the global pharmaceutical and communication-technology industries supports this hypothesis.
- According to our findings, leading U.S. pharmaceutical companies such as Merck and Pfizer that practice large-scale buybacks along with ample dividend payments have had little success in originating and developing innovative medicines, despite spending over 15 percent of their revenues on R&D. For the decade of 2008-2017, the 17 U.S. pharma companies included in the S&P 500 Index spent $300 billion on buybacks and $290 billion on dividends, equivalent to just over 100 percent of their combined profits. Notwithstanding the expenditure of $526 billion on R&D (16.6 percent of sales) by these 17 companies over the decade, and their access to $30-$40 billionper year in U.S. taxpayer-funded life-sciences research through the National Institutes of Health, the U.S. pharmaceutical industry is losing out in global competitionto European companies such as Roche, which has done minimal buybacks, and AstraZeneca, which has not done any since 2012.
- Although Apple has distributed $325 billion to shareholders since the death of founder Steve Jobs in 2011, it has also put $58 billion, or 4.2 percent of sales, into R&D. It has focused its R&D spending, however, on annual launches of new versions of the iPhone at premium prices, and has fallen behind both Samsung and Huawei in global smartphone unit sales. Meanwhile, under CEO Tim Cook, the world’s richest company has failed to use its formidable position to invest in technologies of the future.
- In the 1990s, Cisco Systems was the fastest-growing company in history as it rose to dominate enterprise-networking equipment, and in March 2000 it had the highest market capitalization in the world, without relying on boosts in share value from buybacks. Since 2002, however, Cisco has devoted 136 percent of its net income to shareholder distributions ($129 billion in buybacks and $33 billion in dividends), while spending $89 billion on R&D (13.3 percent of sales). By the decade of 2008-2017, it had become the seventh-largest stock repurchaser among U.S. corporations, and from 2002 through the second quarter of its fiscal year 2019 it averaged $7.4 billion in buybacks per year. In a forthcoming paper our research group documents how Cisco was poised at the turn of the 21st century to become a world leader in communication infrastructure equipment, but since its buyback binge began, it has eschewed the investments in organizational learning needed to transition from enterprise networking to the more technologically complex service-provider market.
- Another U.S. communication-technology company that could have been a global competitor in infrastructure equipment was Motorola, which definitively sabotaged its accumulated capabilities when, between 2005 and 2007, it spent $7.7 billion on buybacks and $1.3 billion on dividends, and then had a devastating loss of $4.2 billion in 2008. In a world that is being revolutionized by the Internet of Things and 5G, the global leaders in communication infrastructure equipment are Huawei, Ericsson, and Nokia. These three global competitors are retain-and-reinvest companies: Huawei is 100 percent employee-owned and not listed on a stock market, while Ericsson is controlled by Investor AB (the Wallenberg family) through dual-class shares and only repurchases a small number of shares for its employee stock-purchase plan. As for Nokia, it was among the leading repurchasers in Europe from 2003-2008 (71 percent of profits went to buybacks, another 36 percent to dividends) en route to losing its global lead in smartphones. Between 2009 and 2013, however, Nokia did no buybacks and cut dividends as it transitioned to become one of the leaders in infrastructure equipment.
Bolten and Bertsch legitimize buybacks by assuming, in line with the doctrine of “shareholder primacy,” that corporate profits belong to shareholders. Rooted in the common misconception that the prime function of the stock market is to provide corporations funds for investment, this view—a triumph of ideology over empiricism—overlooks a key fact: The overwhelming majority of shares are acquired on the secondary market rather than from the corporation itself, and the money paid for them adds nothing to the corporation’s resources.
In fact, the history of stock markets in the United States shows that the most important function of the stock market has been to separate control over corporate resource allocation from the ownership of the company’s shares, thus giving professional managers power over strategic decision-making. Similarly, the listing on the stock market of a new venture funded by private equity, whether directly through an IPO or indirectly through an M&A deal, is referred to as an “exit strategy” by venture capitalists, who use the stock market to monetize their stake in the company. The continued growth of the listed company is then dependent on the abilities and incentives of its executive team to invest in the firm’s productive capabilities.
From that point on, the company's shareholders, be they individuals with a handful of shares or institutions with millions of them, are simply portfolio investors who buy shares in the hope of realizing dividend yields while they hold them and capital gains from stock-price appreciation if and when they sell. Nonetheless, in the name of “maximizing shareholder value,” corporate executives make it their top priority to reward those shareholders. Since 2013, for instance, under its “Capital Return Program,” Apple has paid out 106 percent of its profits, with $75 billion in dividends and $247 billion in buybacks. Yet, Apple has raised funds from the public stock market only once in its history, in 1980, when it netted $94 million in an IPO—a fact that calls into question whether Apple, or any firm, can “return” funds to entities that never provided it with funds in the first place.
Bolten and Bertsch speak of companies' needing “investors' confidence” if they are “to flourish,” but secondary stock issues that come from publicly listed firms are far more the exception than the rule. What public shareholders see as “flourishing” is the stock price rather than anything intrinsic to a firm's operations, and the “confidence” to which Bolten and Bertsch refer is the fund manager's expectation that corporate executives will boost shareholder yields by extracting value from the companies they run.
In line with most defenders of buybacks, Bolten and Bertsch proclaim, “Money returned to shareholders through buybacks and dividends does not disappear from the economy.” Hyperlinking to our own New York Times op-ed, “End Stock Buybacks, Save the Economy,” Bolten and Bertsch contend that “some critics of buybacks miss this point.” They argue that “[i]ndividual investors can use [buybacks and dividends] to purchase something they’ve been saving for. The money can be lent to other companies that are hiring and growing. It can be invested in new businesses as seed money for start-ups or financing for emerging technologies.”
These three claims for the salutary effects of buybacks do not stand up to scrutiny. We know that in 2016 just 10 percent of U.S. households possessed 84 percent of all U.S.-held corporate shares. Because a highly disproportionate allotment of the gains from distributions to shareholders go to the richest households, it is extremely misleading for Bolten and Bertsch to contend that these gains enable households “to purchase something they’ve been saving for.” Many if not most of the households that buybacks enrich already have more disposable income than they can spend. As billionaire buyback critic Nick Hanauer has put it: “I already earn about 1,000 times more per hour than the average American, but I couldn’t possibly buy 1,000 times more stuff. I only own so many pairs of pants. My family and I can only eat three meals a day. We enjoy a luxurious lifestyle, but we already own several houses, a private jet and one too many yachts (turns out, the optimal number is two).”
If we want masses of Americans to have more disposable income that they can spend, then corporations should cut their distributions to shareholders and pay their U.S. employees higher wages and provide them with greater employment stability.
These U.S.-based companies should also allocate resources to producing more innovative products in the United States so that less of the income of U.S. households is spent on imports. Under a retain-and-reinvest allocation regime, it would be possible for U.S. workers to have higher incomes on a sustainable basis because they would have the capabilities to produce a wider range of high-quality, low-cost goods and services in the United States.
In arguing that the money shareholders receive “can be lent to other companies that are hiring and growing,” Bolten and Bertsch assume that the growth of the economy is constrained by financial resources and that lending money to businesses is simply a market transaction. But in a developed economy such as the United States, finance is in abundant supply: The problem, rather, is determining how that finance can be invested in productive capabilities that can generate products that customers need or want at prices that they are able or willing to pay. Distributions to shareholders from productive companies have increased the size of the financial sector, one function of which is to make loans to other companies. Currently, however, billions of dollars in corporate bonds are being used by companies to finance buybacks, rendering the whole economic systemall the more fragile. Meanwhile, billions of dollars in gains from buybacks are flowing into the ever-growing war chests of activist shareholders who routinely use their financial clout to press companies to increase the size of their repurchases.
Bolten and Bertsch also assert that distributions to shareholders “can be invested in new businesses as seed money for start-ups or financing for emerging technologies.” But there has been no shortage of venture funding in the U.S. economy since July 1979, when the Department of Labor permitted pension-fund managers to allocate up to 5 percent of a fund’s assets to risky investments such as venture-capital funds, with a safe harbor against litigation for mismanaging other people’s money. If there is a venture-capital problem, it centers on whether those funds are invested in productive capabilities that can deliver an innovative product to market. More often there is too much venture finance looking to fund too few productive opportunities, resulting, for example, in the dot.com bubble of the late 1990s.
Toward the end of their op-ed Bolten and Bertsch write: “Stocks are owned by thousands of pension funds and mutual funds, and millions of Americans benefit from asset price increases or when shares in those funds receive a dividend.” But do retirees benefit from the asset-price increases that result from buybacks?There is a fundamental difference between shareholders who gain from dividends and those who gain from buybacks. Dividends are paid to all shareholders, while the gains from buybacks done as open-market repurchases go to those share sellers—senior executives, investment bankers, and hedge-fund managers—who are in the business of timing the buying and selling of shares. Under its Rule 10b-18, which encourages buybacks, the Securities and Exchange Commission (SEC) does not require companies to report, even after the fact, the precise days on which buybacks are done. But senior executives have insider knowledge of when the company’s broker is executing a repurchase, and professional traders are able to detect—and game—this activity.
The trillions of dollars that have been distributed to shareholders as open-market repurchases over the decades since the SEC promulgated Rule 10b-18 in November 1982 amounts to nothing less than the legalized looting of the U.S. business corporation. As Jang-Sup Shin and one of us (William Lazonick) argue in a forthcoming book, Predatory Value Extraction, institutional investors have acted as value-extracting enablers, working in combination with corporate executives in the role of value-extracting insiders and with shareholder activists in the role of value-extracting outsiders. In functioning as enablers, managers of pension funds and mutual funds are helping to diminish the retirement incomes of the very people they are supposed to serve. Pension funds and mutual funds should seek a stream of tax-deferred dividend income from companies that can afford to pay dividends after they have provided wage increases and employment stability for their workers, and after they have invested in the value-creating processes required to keep them competitive in the future.
It is the combination of employment stability and sustainable dividend yields that helps retirees save for old age. According to economist and pension expert Teresa Ghilarducci, “Even the highest income workers—those earning over $200,000 per year who are in the top ten percent of the income distribution—do not have enough money to retire and maintain their standard of living.” Ghilarducci notes that households cannot count on working more years of their lives to help overcome a shortfall in retirement income because the employment instability that has come to characterize the U.S. economy makes the availability of additional years of gainful employment highly uncertain.
We have become critics of buybacks as our research has revealed that the looting of the business corporation, carried out by piling buybacks on top of dividends, is a major determinant of employment instability and insecurity. The first step toward getting the U.S. economy on a path to stable and equitable growth is clear: Rescind the SEC's ill-conceived Rule 10b-18.
