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CEOs are routinely bashed for their outsized pay, but companies are under intense pressure from Wall Street to produce steady, predictable gains in earnings per share every calendar quarter (i.e. 13 weeks). Pity the poor CEO who becomes the target of an “activist” investor who might have owned the stock for all of 15 minutes, but agitates for changes to end the pain by “maximizing shareholder value.”
A company’s earnings per share is calculated by dividing earnings by the number of shares outstanding. If ABC Corp. has $1 million of earnings and 1 million shares outstanding, it has EPS of $1. If ABC buys back 10 percent of its shares, voila, its EPS rises 11 percent to $1.11 ($1 million/900,000 shares).
Additionally, ABC’s purchase of a large percentage of its stock will likely drive the price higher. It’s not surprising that demanding stock buybacks is a key component of activist investors’ playbooks.
The combination of higher EPS and company buying usually provides a short-term boost to the stock. This makes Wall Street happy, keeps the activists at bay, and helps management enhance the value of its stock options and meet bonus targets.
Buybacks may be helpful or harmful in the long run, but the facts are unambiguous. According to Standard & Poor’s, U.S. companies spent more than $900 billion on buybacks and dividends in 2014, a record.
To put this in context, according to University of Massachusetts economist William Lazonick, the 454 companies listed continuously in the S&P 500 from 2004 to 2013 used 51 percent of their earnings to buy back their own stock. An additional 35 percent of earnings funded dividend payments. In total, a whopping 86 percent of earnings were used for the immediate gratification of shareholders.
Returning cash to shareholders via buybacks and dividends can be part of a responsible capital allocation strategy, but when this use of capital causes firms to underinvest in innovation, skilled workforces or capital expenditures necessary to sustain long-term growth, that can lead to big problems for the firm and our economy.
That’s the message Larry Fink, CEO of investment behemoth BlackRock, sent to each of the S&P 500 CEOs in a recent letter bemoaning the acute pressure on companies to meet short-term financial goals. Fink said returning excessive amounts of capital to shareholders “sends a discouraging message about a company’s ability to use its resources wisely and develop a coherent plan to create value over the long term.”
In Fink’s view, “corporate leaders’ duty of care and loyalty is not to every investor or trader who owns their companies’ shares at any moment in time, but to the company and its long-term owners.” He urges CEOs to “engage with long-term providers of capital,” “resist the pressure of short-term shareholders to extract value from the company if it would compromise value creation for long-term owners” and “clearly and effectively articulate their strategy for sustainable long-term growth.”
One of Fink’s solutions to combatting corporate “short-termism” is to change U.S. tax policy, which categorizes gains on securities held more than one year as “long term,” subject to favorable tax rates. He favors granting long-term treatment after three years and decreasing the rate each year until reaching 0 percent after 10 years.•
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Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Indiana. He can be reached at (812) 376-9444 or mickey@kirrmar.com.
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