An Open Letter To BlackRock Regarding $7 Trillion Of Stock Buybacks
By: Arne Alsin
Are you doing everything possible to protect your investors from excessive stock buybacks?
The bread and butter of BlackRock’s business is the index fund. Index fund investors own every stock in an index, which means they end up owning companies that engage in unnecessary and risky buybacks.
In my opinion, and as I’ll show below, index fund investors represent a specific class of investor that suffers real, measurable harm from misguided and ill-advised buybacks.
First, let’s take a step back. Earlier this month, in November 2017 at the DealBook conference in New York City, you noted that BlackRock is “the ultimate long-term holder” of stock. On stage with Kenneth Chenault, the CEO of American Express, you said, “We want to be engaged and working with our large companies…I believe we can play a very long-term, systematically positive role.”
Our question: Why not start with pushing CEOs to rein in buybacks? You’re clearly aware of the problem—you’ve been writing about it for years. In your annual letter to CEOs earlier this year, you warned against the “furious pace” of buybacks. Back in 2014, you bemoaned that “Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.”
An investor in an S&P 500 index fund ends up owning each and every stock in the index, for better or worse. This makes Blackrock’s vigilance so critically important. Index fund investors are passive – they must rely on their manager to defend their long-term interests.
This is a real problem—and it needs to be addressed now. Capital spending has declined significantly since the early 1990’s, coupled with a rise in buyback spending. In fact, a 2017 survey of 7,000 global firms by Boston Consulting Group found “capex levels relative to revenues at a 20-year low, having dropped almost 20% between 1995 and 2015.” This is troubling for long-term investors. BCG researchhas also shown that “outperformers”—i.e. companies in the top-third of market valuation relative to their peers—“invest approximately 50% more in capex than their peers and achieve approximately 55% higher returns on assets and approximately 65% higher sales growth.”
Index fund investors need CEOs to protect their long-term interests by reinvesting profits into research and development, pioneering new projects, and other growth initiatives. But too much is being spent on buybacks—and it’s hurting index fund investors. We believe BlackRock could be doing a lot more. Further down, we have a specific example—a case study of buyback disaster at Bed, Bath, and Beyond—but it’s first worth pointing out that most buybacks can be even more dangerous for long-term investors than people realize.
This past summer, economist Robert Ayres and researcher Michael Olenick published damning evidence that the more companies do buybacks—the more those companies decline in value. Of 1,839 firms studied, Ayres and Olenick concluded that the firms that repurchased the least amount of stock (in proportion to their market value) saw their market value increase an average of about 250% over five years.
But the 64 companies that bought back the most stock, saw a nearly 22% decline in value over the same time period. What does this mean?
“For one thing, it means that firms that have “invested” in buybacks (to support the price of the stock and to keep the senior executives happy) have actually wasted money that should probably have been invested in the business, especially in R&D,” the authors conclude.
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Isolating and identifying index fund investors as a “harmed class” is an important distinction to make. That’s because it’s possible to calculate damages for index fund investors—something that’s tough to do for active investors, who can simply say “no thanks” to companies engaging in questionable buybacks. They can avoid such stocks altogether. As you said yourself in November 2017 at the DealBook conference, “If you're an active manager, and you don't like the company, you can sell the company…I can’t sell.”
Clearly, index fund investors have no such freedom. And it’s possible to measure “buyback damage” for index fund investors because there is a specific point in time when a company is added to an index, and a date when it is removed. In other words, there is a buy date and there is a sell date. Buybacks also involve cash and stock, making it very easy to calculate investor losses from buybacks each time a company is removed from the index.
Who is advocating for long-term investors, anyway? Is anyone?
On behalf of their customers, hedge funds make all sorts of noisy demands of CEOs and boards. They demand board seats, for instance, and they pressure corporate leaders for action on restructuring, large cost cuts, and company-wide reorganizations. Hedge funds even push for more buybacks in support of their customers, who have more of a short-term orientation than index fund investors.
Hedge funds are also not shy about promoting the interests of their customers. With just 1 or 2% ownership of a stock, they’re often able to bulldoze their way into board seats, and frequently have their way with corporate leaders.
BlackRock has far more girth than any hedge fund in the world. As you pointed out last month,BlackRock typically owns “5, 6 percent” of an S&P 500 company’s equity valuation. In our opinion, BlackRock clearly has the ownership muscle it needs to get things done on behalf of long-term investors.
For example, Blackrock could (and should, in our opinion) offer an emphatic “No!” to companies which do buybacks when funded by increases in debt. BlackRock could pressure management to stop buybacks when the business is obviously shrinking. Spending cash on buybacks at shrinking companies can help meet quarterly earnings targets, but it can also destroy shareholder value, and increase risk for both the business and the shareholder.
We recently completed an exhaustive multi-year study of buyback behavior at the thirty companies that comprised the Dow Jones Average from 2014-2016. Among many alarming findings: Businesses that were plainly and consistently shrinking continued their buybacks in robotic fashion.
How to calculate damages for index fund investors
This will not come as a shock to you: There’s no free lunch with buybacks. When executives screw up and a buyback goes bad, somebody loses. There is real, tangible harm when a CEO pays $60 per share in a buyback—and the stock tumbles to $30.
Consider the case of Bed Bath and Beyond. The retailer entered the S&P 500 on September 30, 1999. Back then, the company had a market cap just shy of $5 billion and the stock traded around $17.30 . Over the next 17 years, BBBY management spent $10.3 billion of cash on buybacks at an average price of $52.64, according to our calculations from SEC filings.
Then, in July, 2017, Bed, Bath and Beyond was booted from the S&P 500 at a stock price of $28.31. Damage to index fund investors was severe. Cash of over $4 billion had been squandered in buybacks during the time the stock was in the S&P 500 index, from 1999 to 2017. As a result, index investors suffered a loss holding BBBY (dividends are included in our calculations) while a no-buyback strategy would’ve generated a total cash return in excess of 100%.
If, instead of buybacks, BBBY executives had simply accumulated cash or paid out cash via dividends, we estimate index fund investors would have enjoyed a return of over 100%.
Somebody has to pay, and that “somebody,” of course, is the long-term shareholder, the one stuck holding the stock after an ill-advised buyback. The harm, however, is not evident at first. When a buyback takes place, it may appear that all is well, as the stock might be helped by a temporary surge in demand. A debt-fueled buyback might look beautiful for a year or two or three. But not forever.
The fact is, Bed, Bath and Beyond is an early warning shot for index investors—the tip of the iceberg. We predict that other buyback abusers—including Macy’s, Ralph Lauren, and specifically many other retailers—are at risk of being removed from the index. Since 2013, for instance, Macy’s management has spent $6.2 billion of shareholder cash on buybacks, more than the company is now worth (about $5.6 billion). Macy’s has accumulated large paper losses due to excessive buybacks. When Macy’s is inevitably removed from the S&P 500 those paper losses will be realized losses.
Another, bigger example of the looming damage of buybacks: General Electric.
Over the five-year period from 2012 to 2016, GE’s Jeffrey Immelt spent $42.8 billion buying GE shares at an average price of $26.24, according to GE’s SEC filings. Today, as of late November 2017, the stock trades around $18, a 30% loss to shareholders. Of course, GE’s stock price could miraculously recover, but more likely, the market has rendered judgment onto Immelt’s buyback binge: It was a lousy way to spend cash, given massive disruption throughout the energy complex. The world is shifting from fossil fuels to renewables, and instead of leading the revolution, GE is focused on the wrong things, like how many shares it needs to repurchase to make next quarter’s earnings per share target.
Meanwhile, a hedge fund led by Nelson Peltz is calling for more buybacks at GE, and recently won a board seat at the firm. Trian owns just a 0.82% stake in GE. Where is the pushback from long-term investors? It’s troubling that Vanguard, State Street and BlackRock, who own a combined 17% of General Electric, do not have a single board seat to advance the interest of long-term shareholders. Why not?
BlackRock could demand that companies at high risk of obsolescence due to disruption immediately halt their buyback activity. Sophisticated investors like Blackrock are fully aware of how buybacks put shareholders at increased risk. (Buybacks involve spending cash, which increases shareholder leverage. See our report for more detail.)
In addition to pushing back against excessive buyback activity, BlackRock could help long-term investors by demanding a lot more disclosure—including full disclosure of management conflicts of interest. It’s a dirty little secret about buybacks: The C-Suite is frequently and materially conflicted when making buyback decisions.
It should be noted that CEOs and boards are able to hide behind SEC Rule 10b-18, which grants safe harbor to buyback purchases. Companies are not required to disclose conflicts. And so they keep it a secret. But what if a large, boisterous long-term investor stood up and said, “Enough!”?
Full disclosure of conflicts is long overdue. It is the shareholder who pays the cost of buybacks, and it is the shareholder who takes on the risk. Since shareholders pay for the party, they have every right to know how many millions of extra dollars CEOs make because they choose buybacks instead of investing in innovation or paying down debt.
Larry: We know you are aware of the buyback problem and its negative effect on the American economy. In 2016, you wrote that the buyback binge was the result of companies “succumbing to the pressures of short-termism in place of constructive, longterm strategies.” And in 2015, you again railedagainst buybacks, saying they “extract value from the company” while compromising “value creation for long-term owners.”
So again, what is BlackRock doing to protect long-term shareholders from risky buybacks?
Your letters and anti-buyback commentary make us believe that you’re aware of the scope of the problem. Earlier this year, you even expanded your corporate governance department to respond to shareholder concerns. You have the corporate muscle to respond. So is there any action planned?
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