The Compound and Friends - Exposing The Big Lie About Stock Buybacks (with Michael, Barry, and Ed Yardeni)

Episode Date: November 15, 2019

Ed Yardeni, of Yardeni Research, joins Michael Batnick and Barry Ritholtz at The Compound to explain why we're looking at the wrong data all wrong, what the real data is, and what it means for the current narrative surrounding share buybacks. 1-click play or subscribe on your favorite podcast app   Subscribe to the mini podcast on iTunes or Spotify    Enable our Alexa skill here - "Alexa, play the Compound show!"   Talk to us about your portfolio or financial plan here:  http://ritholtzwealth.com/   Obviously nothing on this channel should be considered as personalized financial advice just for you or a solicitation to buy or sell any securities. Please see this 3,000 word terms & conditions disclaimer: https://thereformedbroker.com/terms-and-conditions/ Hosted on Acast. See acast.com/privacy for more information. Learn more about your ad choices. Visit megaphone.fm/adchoices

Welcome to Live from the Compound. My name is Michael Bannick. I'm here with Barry Ritholtz and Ed Yardeni of Yardeni Research. Buybacks have become the topic du jour, not just for Wall Street, but also for Main Street. Correct. And one of the things that people use to make arguments is data. And I was flabbergasted where last week I read in Barron's that you said that some of the data that we're using might not be correct. What did you mean? How did you find this out? Well, the Federal Reserve puts out flow of funds data on a quarterly basis.

Is that the Z1? That's the Z1. Okay. And it's very detailed. I really love that data set. It's been very good at understanding with a little bit of a lag what the financial system's doing. with a little bit of a lag what the financial system's doing. And everybody uses the table that shows who's buying equities and who's issuing equities. And what that data has been showing for a few years is that nobody's buying stock other than corporations buying back their own shares.

And I've been staring at that for a while, and just something just didn't make sense to me. Because when you look at the S&P 500 earnings per share, and then you look at aggregate earnings of the S&P 500, it's not that big a difference in terms of the growth rate. It's about 1% per year from 2011 to 2018. So if they're buying hundreds of billions of dollars of their stock back, why aren't the numbers much bigger? And I think the answer is, with regards to the flow of funds data, is that they forgot to include a category called employee stock plans. In other words, a substantial amount of these buybacks by corporations are actually for the employee stock plans to avoid dilution rather than to increase earnings per share.

So this is really fascinating because I understand all the pro and con arguments. From a policy perspective, I've said for a long time I would prefer a dividend to a buyback because, A, the dividend eventually works its way through the economy. But more importantly, I don't want to provide a tax-free incentive for companies to pay management a lot of stock options, to dilute themselves at the expense of the shareholder. And the pushback has always been, oh, no, no, that doesn't happen. You're suggesting it really does happen. Well, what I'm suggesting is that the right way to understand what's happening is that about two-thirds of the buybacks are probably related to stock employee

plans. And those stock employee plans are not just limited to the top four executives. They're actually fairly democratic about it. There's a survey data from 2014. That's the earliest I could find, the latest data I could find. And the data shows that about one third of employees working for companies that have public stock are stock owners through plans. Wow, that's a lot. So that's a really important point because people have this idea that it's only C-suite executives that are getting these options. Well, look, I wish we had a lot more data and a lot better data, but a lot of this is urban legend. A lot of this is just people talking without looking at the data. So let's get into the data a little bit. So you wrote that shares outstanding fell from a peak of $297 billion in 2011 to $275 billion at the end of 2018.

That's only a decline of 1.1% a year. That's correct. Yeah. And again, we sort of reversed engineered because the buybacks data is in dollars. And we thought, well, it'd kind of be interesting if you could actually look at a number of shares. So we reversed engineered and took the market cap of the S&P 500, So we reversed engineered and took the market cap of the S&P 500, and we divided that by the S&P 500 index to get an average price of the stock. I'm sorry, divided by the basic shares, which we calculated. And then we took that and compared that to the buyback story. And so here's what we got. We got 70 million shares of gross buybacks

and 22 million shares of net buybacks, leaving 50 million shares for employee stock plans. So the data we get from the S&P is the gross number. And the gross number is hundreds of billions of dollars. But by the way, from 2011 to 2018, and I take that period because that's when the share count started to come down, what you see over that period is that stock buybacks gross totaled $4.3 trillion. Okay, now that's, wow, they're buying all the stock back, it's at the expense of employees. But the reality is compensation over that same period was $70 trillion. So

if a lot of this is actually being paid as stock compensation, it's actually a pretty small component of employee compensation. So if you're saying $70 trillion, $70 trillion is compensation. $70 trillion, yes, is compensation. What chunk of that $70 trillion, $70 trillion is compensation. $70 trillion, yes, is compensation. What chunk of that $70 trillion is employee stock issuance? Well, take the gross buybacks as $4.3 billion, if all of that. $4.3 billion or trillion? Trillion, trillion. Okay, $4.3 trillion.

Yeah, $4.3 trillion, correct. Billionaire, trillion there. All that trillion. Okay, 4.3 trillion. Yeah, 4.3 trillion, correct. Billion here, trillion there. Right, all adds up. But it's kind of important. So let's say that's all stock plans. So that's like around 4% of compensation. And if it's really only two-thirds, not all of it, then maybe we're talking about 3% of compensation over that period since 2011 has actually been attributable to stock compensation.

So that's about $2 trillion in stock compensation to all the employees. All I'm saying is when you look at the big numbers on buybacks, you've got to put it in the context of what is driving it, and it's compensation. And compensation is a lot bigger than that. Well, so that's a key point is that we hear these giant numbers and we fall prey to denominator blindness. It's very normal. But in the second quarter,

buybacks as a percentage of market cap, if corporations are the only one buying back stock, how do you explain the fact that buybacks were just 0.67% of market cap? Well, I mean, from my story, you know, buybacks are being blamed and compared to a lot of concepts that just are not really relevant. So as if they're the cause of income inequality. And maybe they are exacerbating it a little bit, but—

Well, I'm not going to say that they— First of all, income inequality is welcome to capitalism. I mean, that's the way it works. And you get some of your worst income inequality when the economy is doing best, because the rich are getting much richer than everybody else, but everybody else is doing pretty well. And if the stock compensation plans are relatively democratic, maybe the top four people are getting the big chunk of it, but lots of other employees are also getting a chunk and enjoying the bull market. So the problem with the income inequality equation is that the bottom 50% of America

doesn't own any stocks. They don't have a 401k. They don't have an IRA. And so when the stock market does well, the top half does much better. The bottom half gets left behind. And that's driving a lot of the politics and the policy discussions we see. Totally. So obviously, people's minds don't change with this data because it's emotional. It's political. It's political. It's emotional. So in terms of some of the story that we hear, I thought you made a really good point. You wrote, to a large extent, the bull market in stocks has been boosting buybacks rather than the other way around. Yeah. And a bull market, employees would love to get paid some of their compensation in stock

and be a party to the party. And employers would definitely love to pay their employees with stock. Everybody's happy. So you look at a chart of the S&P 500 versus the kind of the quarterly buybacks data, it looks like it's correlated. And so a lot of people look at a chart of the S&P 500 versus the kind of the quarterly buybacks data, and it looks like it's correlated. And so a lot of people look at that chart and say, therefore, buybacks have been driving the stock market, which when you think about it, it's the reverse. Not only that, but does it really make sense that corporate management are so dumb that they do most of their buybacks near the top of bull markets?

Well, that's true. Well, I mean, at least that's what's the urban legend. The urban legend. That's what the progressive politicians are saying is that politicians are saying we're smarter than these corporations because they're dumb. They're just buying all these by buying back all near the top. And my point is it doesn't have anything to do with that. What it has to do with is the longer a bull market lasts,

and this one's lasting a long time, you pay more and more of your employees and it's vests and it accumulates. And it gets expensed. The companies expense that. And that's where the cash comes from for the buybacks, not all this urban legend stuff about borrowing all this money to buy back shares.

So talk about that. Are companies piling on debt? Because you wrote the ultimate source of funds for most stock buybacks is the employee compensation expense on the income statement, not bond issuance, as the bears contend. Well, again, the bond issuance looks huge, but you've got to put everything in perspective. You know, the critics of buybacks keep pointing out that if you add dividends and buybacks, they're eating up 100% of after-tax corporate profits. What a disaster. How awful that companies are, you know, using this for, you know, share to benefit their shareholders. Why don't they spend this money on their employees? Well, the answer is that it's not just profits that matters to corporations, it's corporate

cash flow. Corporate cash flow is huge because there's something called depreciation allowance, which is a tax shelter for corporate income. And that's no longer seven years. Now you could do all of that in year one. That and I, you know, I've looked at the corporate spending cycle in nominal terms and it looks about the same as previous cycles. In other words, the notion that we're, corporations are not spending anything to expand

and they're not spending on their employees. Just again, I'm kind of data dependent as the Fed says. Well, if you're, if we're not looking at the denominator, we're just looking at, say, R&D numbers, you could say, oh my God, they're spending hundreds of billions of dollars on R&D. What a waste of money. Most of it goes down the toilet. Why are so many people claiming that R&D is suffering at the expense of dividends and buybacks?

Beats me. Again, you go to the data that the government provides with GDP, and R&D a few years ago was included as part of capital spending, and it's doing fine. As a matter of fact, if you take R&D and software and high-tech equipment, it's about 40% of capital spending. So if you're going to compare capital spending today to what it was 10 years ago, and you've seen more and more capital spending going to technology, which is cheaper and cheaper and more powerful and does more for more kinds of business models than you put it all together.

And I think the capital spending is absolutely fine. I mean, companies aren't being managed by greedy fat cats that all they care about is getting rich today. I mean, a lot of them really are managing their companies very, very well. So let me push back a bit because we know that a lot of people despise buybacks. And here's the pushback that has some resonance, that it's not that they're greedy. They're just profit maximizers. And the problem is that corporate executives are terrible

timers and they tend to over buy back stocks when their shares are cheap. Look at 08, 09, nobody was buying back stock when it was cheap. They tend to overbuy it when it was expensive. Oh, and here's an anecdote. Look at GE. They bought all this stock at 30 and 40, and now it's 10. So the anecdotes always come up as an example. But as we know, anecdotes and data are not the same thing. Exactly. There's the anecdotes, and then there's the data. And the data just doesn't support that narrative, that story.

Well, it's an easy story to tell and get riled up over. But if you look at the alternatives to buybacks, what else can companies do? They can sit on cash, they can pay more dividends, or they can invest for the future. But you're falling into that trap. But wait, hold on. However, but the point is our friends at Alpha Architect did a study and showing that companies that tend to invest heavily in R&D, their stocks don't do very well because to invest and get a return on your capital is very difficult. So the point is, sometimes the best way to return capital or just to spend your capital is to buy back shares. See, but I don't view buybacks as

mostly aimed at returning capital to shareholders. I view it as providing about two-thirds of the buyback as part of compensation. And that compensation has to be expensed. And that expense then is cash that companies can use to buy back their shares in the market to avoid dilution from the employee stock plans. So maybe a third of that story that you just told maybe is about a third right. Two thirds of buybacks are anti-dilutive to offset stock issuance. That's what the data shows. But I guess when do these, so people have this misunderstanding, I believe, that they think that management is saying, hmm, should we buy back stock or should we invest or should we do that? Buybacks come after everything else is done.

It's almost locked into your compensation plan. If you've got a stock compensation plan that provides workers with a certain percentage of their compensation in stock, it's just, you know, once you program it into the computer in the payroll department, that's what happens. And so it just happens automatically. And the decision that the management needs to make is, do we want to just do nothing and let this dilute our earnings per share? Or do we want to take that cash that we didn't pay the employee as cash, but as stock, and use that to buy back the shares that we are eventually going to give the employee when it fests. I guess maybe a good place to leave this is the idea of banning buybacks.

Well, you ban buybacks. And sadly, a lot of employees that kind of liked getting some of their compensation in stock are going to be told we can't do this anymore because we can't go into the market and buy back our shares. Or the companies will have to say, okay, so we'll let that dilute the earnings per share, which doesn't make any sense. And they're not going to do that. So the idea that, oh, you could still issue shares to employees and they would just get dividends. Yeah, but how much are they going to do with their existing shareholders? They're not going to do that. The reality is that you pay your employees stock as part of their compensation. You know, it's not

something that you just give on top of the compensation. And so there are a lot of urban legends about all this. But when you look at the data, it suggests that that's exactly what they are, just urban legends. Ed, thanks for coming in. Let us know what your thoughts are on buybacks. Should we ban them? Should we increase them? What should we do?