What Will Happen If Buybacks Are Banned?
As regular readers will know, I have spent the past several days discussing an interview given by Aswath Damodaran, a professor at New York University's Stern School of Business, that was published in a Goldman Sachs (NYSE:GS) report on corporate buybacks.
I took issue with the professor's overly academic view of the practice and pointed out a number of ways in which managers face perverse incentives to engage in unproductive buybacks. In the last segment of this four-part series, I want to examine what Damodaran thinks would happen if buybacks were banned.
To ban or not to ban?
I feel it is important to note that although I have frequently criticized the corporate buyback spree which was precipitated by the Trump administration's tax cuts in late 2017, I by no means believe they should be banned, as certain populist politicians have suggested. I do think they can function as an efficient way to return capital to investors. I have serious reservations, however, about how they are implemented today. With that being said, here is what Damodaran believes would happen if they were to be banned:
"Companies, especially older companies, would love it, because it would be the perfect excuse for them to sit on a pile of cash without having any pressure from shareholders or activists to return it to them. This is not a hypothetical. Take a look at the walking dead zombie companies in Europe to see exactly where we'll end up if buybacks are banned. In Europe, a myriad of factors tend to leave capital tied up in old, aging companies, leaving less capital for the younger, more exciting companies in new businesses. This is not where we want to be."
I feel compelled to point out buybacks are perfectly legal in Europe. In fact, some of the biggest companies on the continent have been engaging in a buyback spree of their own, from Royal Dutch Shell (NYSE:RDS.A)(NYSE:RDS.B) to Diageo (NYSE:DEO). It is true that buybacks were banned in many European countries until 2000, but I would argue that European economic stagnation has a lot more to do with central bank policy and the underdeveloped south.
Damodaran also said:
"You know who else would love it? Investment bankers, because now that cash would be burning a hole in the pockets of corporations, providing a greater incentive for them to pursue acquisitions--the mother lode of all deal making. In short, groups that such a policy might have intended to discipline could end up as the main beneficiaries of it. Business history is full of unintended consequences of legislation, and I can almost promise you that will occur again if Congress bans buybacks."
I don't necessarily agree with this either as companies would just return capital to investors via dividends, rather than buybacks. It'll be less efficient for sure, but I don't think it would result in the merger and acquisition boom Damodaran foresees.
"But I can tell you what won't occur if buybacks are banned: the return of manufacturing jobs. We already learned that from the experience of tax reform in 2017; proponents argued that allowing companies to bring back their trapped cash would lead to a surge in manufacturing. We have not seen new factories built because the underlying economic fundamentals just don't support it. But I believe that tax reform was worth it, because that cash found its way into the market, and from there, into other companies in the economy."
This I certainly agree with, but then again, manufacturing jobs aren't coming back to the U.S. regardless of whether or not buybacks are legal, so the argument is neither here nor there.
I think a core problem with orthodox thinkers like Damodaran is they see the world as they believe that it should be, not as it is. Yes, in an ideal world, we would have sensible interest rates and honest management and buybacks that were implemented correctly.
But this is not what is happening in practice. This should be glaringly obvious to anyone who has been watching the financial markets for the last 10-plus years. Ignoring the problem only makes it more likely that a populist legislator will come along and implement the thing that Damodaran says he doesn't want: a ban on buybacks. That is something worth thinking about.
Disclosure: The author owns no stocks mentioned.
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This article first appeared on GuruFocus.
