Redemptions are more important than ever – but is a bad ending coming?

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Share buybacks have become one of the most controversial issues in investment. Amid a 10-year bull market, companies are spending more money than ever to buy back their own stocks. Most shareholders were pleased with the trend of increased buybacks, given the positive impact on key metrics such as earnings per share and its consequent support for stock prices. Still, opponents say the money used for buyouts would be better spent on wage and benefit increases for workers.

Even as political pressure on share buybacks has intensified, companies continue to announce ever larger buyback programs. The big question remains whether Washington will take action to try to rein in the growing volume of buyouts — and whether investors should care about what legislators are doing.

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How redemptions have increased

Share buybacks have been popular for decades because they provide a key tax advantage to investors over other methods of returning capital to shareholders. When a company pays a dividend, most investors have to pay taxes on the cash they receive. However, with a buyout, only shareholders who sell their shares back to the company have an immediate tax impact. Others generally only see a rise in their share price without any corresponding tax to pay immediately.

Changes to tax laws in the early 2000s were partly responsible for a large boom in buyout activity. Among S&P500 companies, annual buybacks rose from a range of $100 billion to $200 billion in 1999-2004 to $600 billion in 2007, according to data from the S&P Dow Jones indices. The financial crisis and its fallout caused a pause in buyout activity, but in the early 2010s annual buyouts resumed and the number would reach $600 billion by 2016.

Tax reform at the end of 2017 led to a significant reduction in corporate tax rates, and companies have used much of this money to boost their redemptions. In 2018, cash-rich S&P companies repurchased $806 billion in stock, including $223 billion in the fourth quarter alone. Preliminary estimates put total redemptions in the first quarter of 2019 at around $215 billion.

The company’s biggest stock buyers

Among recent takeover announcements, Apple (AAPL 0.41% ) reigns supreme. The iPhone giant said in late April that it would allow $75 billion for share buybacksadding to the massive $100 billion takeover authorization it granted in 2018. Yet even with this move, the tech company has struggled to deploy its full free cash flow, which amounted to $113 billion according to its latest quarterly results.

Technical peers Oracle ($35.3 billion), Qualcomm ($23.6 billion) and Cisco Systems ($22.9 billion) were also among the top buyers in 2018, as was the beleaguered bank Wells Fargo ($21.0 billion).

Some small takeovers can still represent massive corporate commitments. For example, the railway company Union Pacific ( UNP 1.22% ) announced in February that it would buy back up to 150 million shares. With the stock price currently at around $175, that equates to over $26 billion. Union Pacific’s market capitalization is less than $125 billion, meaning the buyout, if completed in full, would represent more than 20% of its outstanding shares.

Lawmakers say enough is enough

Some members of Congress have looked askance at the takeover boom. Early last year, Democratic Senator Tammy Baldwin of Wisconsin sought to repeal an SEC rule which had made it easier for companies to buy back shares. More recently, the the heat on redemptions has increased. Sen. Chuck Schumer, DN.Y., and Sen. Bernie Sanders, I-Vt., argue that no company should be able to buy back stock without first enacting a host of worker-friendly provisions, including paying a minimum wage of $15, providing seven days of paid sick leave, and providing better health and retirement benefits.

Even across the aisle, Republican Senator Marco Rubio of Florida argued that lawmakers should withdraw the preferential tax treatment on redemptions over dividends. This would increase the likelihood that companies would share the wealth with all investors, although it would require no internal investment in their workforce.

What investors should watch out for

Investors generally like stock buybacks, but they haven’t always been good long-term choices. It’s easy to find examples of takeovers gone wrong, the most recent being General Electric and his bad stock purchases at far higher prices than stocks are currently fetching. Companies often have the most cash just when their stock prices are at their highest, while downturns leave them with both low stock prices and little available capital to take advantage of.

For long-term investors, a company that is taking over should not have a lasting impact. The reduction in outstanding shares makes each remaining share represent a larger portion of the business, but it also reduces the value of the business by the amount of money spent.

The only way a company can make money on buybacks is if they can buy stocks below their true intrinsic value due to market swings – and given the length of the bull market, few stocks enter. in this category. It’s those with a shorter-term mindset — such as executives whose compensation is based on stock performance over a quarterly or annual period — who often stand to gain the most from buyout-induced stock gains.

Investors who like stock buybacks are worried about what Washington might do to rein them in. But the much bigger threat to stock buybacks is the next economic downturn. If corporate earnings suddenly drop, buybacks will be the first place companies cut — and a stock market that comes to take them for granted could be in for a nasty surprise.

Colored stock certificates laid out in a pile showing several names.

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This article represents the opinion of the author, who may disagree with the “official” recommendation position of a high-end advice service Motley Fool. We are heterogeneous! Challenging an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and wealthier.

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