India’s BSE Sensex, the benchmark index comprising 30 stocks, is at an all-time high. In the US too, the Dow Jones index is near its historic peak, and the more broad-based S&P 500 is within 1% of its highest-ever levels. Indeed, the US is celebrating a 10-year bull run, unprecedented in its history. There are various explanations for this, not least being the role of ultra-accommodative monetary policy, as also the most recent generous tax breaks to corporations, which reduced the US corporate tax rate from 35% to 21%. The present tax law now also gives an incentive to American companies to repatriate their mountain of cash profits, which have been parked abroad till now. What do American companies do with this excess cash? Do they invest in expanding their businesses, or in research and innovation, or do they pay out higher dividends?
One curious phenomenon is that of share buybacks by companies. This has been an increasing trend for four years, but this year marks a historic peak. American companies will dole out nearly $1 trillion in cash to buy back their shares in 2018, the highest ever. It is suspected that the share buyback is part of the reason for the buoyancy of the share market. Indeed, the correlation between the S&P 500 buyback index and the broader index is nearly perfect. So, the buyback frenzy is certainly adding to the bull run. Two months ago, Apple announced that it would spend $100 billion in buying back its shares. It is the first American company to have reached a market value of $1 trillion. Many other companies, across sectors like financial services, consumer goods and technology, are doing buybacks. When a company announces a share buyback, is it signalling that it thinks its market value can be higher? Or is it signalling that it does not know what to do with the cash, and has run out of ideas for growth? Or are managers (agents) not to be trusted with too much cash by their principals (shareholders)?
The market value of a company is based on the cash it pays its shareholders. Indeed, the value (or price) of a share is the present discounted value of future stream of dividend payments to be received by the owner of the share. Till the 1980s, share buyback by companies was basically not allowed. So, dividends were the only way to pay cash. But ever since share buyback was allowed, thanks to deregulation in the Ronald Reagan era, it has tended to overtake dividend payments. In recent years, share repurchase has dominated dividends in terms of shareholder reward. Of course, the former is subject to capital gains tax, whereas the latter is subject to income tax. If these rates are different, companies will arbitrage, and use the more tax-efficient method. But the two are not exactly identical avenues to move cash from companies to their shareholders. Dividends go to everybody, but share buyback cash goes only to those who choose to surrender their shares. Dividends do not change the share count, but share repurchases reduce the outstanding shares. Dividends are regular and sticky, but share repurchases happen sporadically, even if often.
What are the larger implications of this flurry of share buybacks? Firstly, it tends to accentuate wealth inequality. In the US, more than 80% of shares are owned by 10% of the population. In India, this ratio is much more skewed. Incidentally, the present stock market wealth itself is highly skewed. For instance, the top 5 companies in S&P 500 have a market cap equal to the bottom 282 companies. In India too, while the 30-stock Sensex is at an all-time high, more than half the stocks are below their 200-day moving average stock prices. Some of them have lost nearly 50% of their value over the past 12 months. The larger BSE 500 has hardly moved over last year, and the small- and mid-cap indices are down more than 10%.
The second issue with share buyback is the non-equivalence of cash on company balance sheet and in the hands of the shareholder. To the extent that corporations now live in stakeholder, not shareholder, capitalism, they are accountable to a larger set. Companies get an implicit licence to operate in society, in a way that does not harm the environment, or in a way that employees, vendors and supply-chain partners, and communities too, are treated decently. So, that cash in the company could have been used for corporate social responsibility, or to increase employee benefits. Indeed, a lawmaker in the US is pushing for limits on share buyback, so that some cash benefits are earmarked for employees, and not merely for shareholders.
The third issue is short-termism. Maybe the cash is being returned to shareholders to boost share price, or because there are no ideas on the table which give immediate returns. But this could be a symptom of a deeper malady of focusing too much on the next quarterly results. If managers could take long-term bets, and invest (say) on futuristic ideas, it could pay off for the company and society in the long run. Indeed, US President Donald Trump is apparently considering doing away with quarterly reporting, specially because of the ill effects of short-termism.
Corporate profitability and share prices have zoomed, but median wages and productivity in the US have stagnated for decades. The labour share of overall national income has gone down. Inequality has risen. India has not joined the global corporate bandwagon of share buybacks, but there are early signs, even as buybacks have many more restrictions than the US. It is time to pause and ponder over the larger implications.
Ajit Ranade is an economist and a senior fellow at the Takshashila Institution, an independent centre for research and education in public policy.
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