This article appears in the February 2020 issue of Advisor’s Edge magazine. Subscribe to the print edition or read the articles online.
U.S. election primaries are heating up, and investors will be on guard for proposals that could impact Canadian portfolios.
In February 2019, Democratic presidential candidate Bernie Sanders and Senate Minority Leader Chuck Schumer re-launched the idea of banning or limiting corporate share buybacks. In a New York Times op-ed, they argued: “At a time of huge income and wealth inequality, Americans should be outraged that [various] profitable corporations are laying off workers while spending billions of dollars to boost their stock’s value to further enrich the wealthy few.”
In short, the idea is that extra money should go to employees first and not corporate owners. While easy to dismiss as vote-gathering financial mumbo-jumbo, the proposal could gain steam alongside similar populist ideas, like fellow Democratic presidential candidate Elizabeth Warren’s wealth tax on billionaires. The linkage between growing income disparity and the rise of share buybacks in recent years is more correlation than causality, but that difference is easily stepped over on the campaign trail.
The details of the idea are what could carry the day. Schumer and Sanders proposed a prohibition on buybacks unless certain pre-conditions are met, including a $15 minimum wage, seven days paid sick leave, decent pensions and more reliable health benefits. They also proposed limiting dividend increases as a way to prevent circumvention of the rules.
The bull case
The arguments in favour of buybacks are strong. The general rule is that companies should only invest funds in projects that will return more than the firm’s cost of capital. If companies produce excess cash, returning it to shareholders through dividends and buybacks means it can be put to use outside the corporation. People who elect to sell their shares into the demand created by buybacks turn around and use the proceeds in some way, often through reinvestment or spending.
If the cash is reinvested, those funds might be directed to a company raising capital to grow its business. Corporate managers can choose to spend capital on research and development, enhanced technology, capital improvements, expansion, or increased wages and benefits, all of which create and improve jobs. If an investor simply spends the proceeds from buybacks, the funds are still returned to the economy.
Workers are often shareholders, too, through pension funds and other retirement savings. Share buybacks that increase the value of investments can also benefit workers.
The bear case
Sanders and his supporters don’t claim that workers receive no benefits from buybacks; rather, they argue that the wealthy receive a much larger share of any dispersed capital, due to their disproportionate wealth.
The case against buybacks is gaining steam. Sanders’ proposal wasn’t new, but he has attracted like-minded people who have breathed life into the debate, including some Republicans.
One reignited Democratic proposal is for a “worker’s dividend” on a dollar-for-dollar basis, with buybacks equal to the lesser of either the total value of the buyback or 50% of profits above $250 million. Republican proposals lean more toward adjusting tax laws to make buybacks less attractive to shareholders (whether they elect to sell their shares or not).
One theme that seems fairly bipartisan in an election year is that the 2017 Tax Cuts and Jobs Act hasn’t done enough to support workers. Any change in legislation would need to pass through the Senate, which is controlled by the GOP but up for grabs come November.
Addressing buybacks seems more like treating a symptom instead of the cause, so focus might swing back to adjusting corporate tax rates and deductibility rules instead of setting limits, a worker’s dividend or pre-conditions on buybacks. It also might be that share buybacks are just another way to address the issue of wealth disparity, and that Democrats will use the debate to rally votes.
On the whole, it seems unlikely that buybacks would ever be banned completely, or even capped equally for all companies. They are a flexible tool that allows the economy to efficiently deploy capital where growth opportunities exist.
Al and Mark Rosen run Accountability Research Corp., providing independent equity research to investment advisors across Canada. Dr. Al Rosen is FCA, FCMA, FCPA, CFE, CIP, and Mark Rosen is MBA, CFA, CFE.