The Real Reason Stock Buybacks Are a Problem

Naked Capitalism has the article The Real Reason Stock Buybacks Are a Problem.

Since the crisis, many companies have been borrowing to buy back stock.

This has been one of my complaints. I try to look for that possibility when choosing stocks to buy. One of the risks of borrowing is that it locks a company into payments that have to be made no matter what. Paying dividends is a flexible policy that a company can adjust based on business conditions. Of course, when a company cuts its dividend (or fails to increase it), its stock price can plummet. Still that’s better than going bankrupt.

The Naked Capitalism article argues against an article that they quote. Here is something from the article they dispute.

The counterargument: how are buybacks any different from dividend distributions that way? Both transfer cash from firms to households. We don’t hear people complaining about dividend distributions stealing money from workers and investment.

I have already explained why borrowing to do a buyback is bad, although some companies just use their free cash to do buybacks. However, even the idea of unlimited dividends is anathema to serious investors.

The payout ratio of dividends to earnings is an important measure to look at for every investor. When that ratio is too high, it means there is a danger that the resources of the company are being depleted. So even investors know that though dividends can be good, too much dividend payment is bad.

The investment newsletter that I use, Investment Quality Trends, has this warning about payout ratio.

Traditionally we have suggested the following criterions for Subscribers to consider in their investment considerations

A payout ratio (percentage of earnings paid out as a dividend) of 50% or less (75% for Utilities)

When a company’s payout ratio gets above 100%, the newsletter flags that company as “dividend in danger”.

I think that stock buybacks can be useful for adjusting the size of the company to better match the size of its markets. Sometimes the size of a market declines precipitously due to economic trends that are not in the company’s control. One way to cope with this without going bankrupt is to use the free cash the company has to buy down the size of the company.

I haven’t researched this, but I think IBM is a good example. IBM used to earn billions of dollars selling computer systems that sold for tens of millions of dollars. Since the advent of microcomputers typified by what powers a personal computer, the market for multi-million dollar computers is gone. There is no product that IBM could get into that could raise the kind of revenues that its expensive computers used to bring in. IBM has new products that bring in revenues, but it also has done stock buybacks.

By contrast, Digital Equipment Corporation, where I used to work, sold itself to Compaq which sold itself to HP and Intel. There is very little left of the former Digital Equipment Corporation. There is very little left of most of the computer companies that were once based in Massachusetts – DEC, Data General, Prime, and Wang to name a few.

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