The Globe and Mail

  Share buybacks often help employees with stock options more than public shareholders, our contrarians say


Saturday, July 8, 2000

During this mighty bull market, it’s not just investors who crave stock -- public companies have been big buyers too. Many companies have exhibited a voracious appetite for their own shares.

Traditionally share buybacks have been viewed with a jaundiced eye. After all, firms are supposed to use their capital to expand the business and move on to bigger and better things. Buybacks were also tainted by their frequent use as a public relations ploy to prop up a weak stock. With no regulatory obligation to follow through on their stated target, many firms buy back far less stock than initially indicated, or wimped out altogether.

But the popularity of buybacks has skyrocketed in the past 15 years or so. The dollar value of stock repurchases has been more than three times larger than that raised by initial public offerings in the Unites States since 1985. In 1998 alone, corporations announced they would buy $209 billion (US) worth of stock.

What changed? For starters, the boom in corporate profits has generated large sums of excess cash to be deployed. Though this might have fuelled a big rise in dividends, many investors favour buybacks because they create no immediate tax consequences for shareholders. A capital gain is only realized after the shares are sold, and then at a reduced tax rate.

Aside from increasing demand for stock, buybacks also spruce up some key ratios. With less stock outstanding, share earnings are enhanced. Less cash on the books raises return on equity and return on assets. This is important because these yardsticks are used as screening parameters for stock selection.

The No. 1 reason for the growth of buybacks is the proliferation of employee stock options. Instead of paying a cash bonus, which would decrease net income, the company awards employee stock options to buy stock at a designated price. When these options are in the money they can be exercised and the holder can then sell them and pocket the gain.

But observe how this sale of company stock at a below market price affects the books. The money received goes into the plus column for cash flow, and the money lost to the company -- the difference between the market price and the employees price -- doesn’t show up at all! Nor does it have a negative affect on earnings because it is not considered to be an expense. In fact, the company receives a tax benefit because the tax the employees pay on their windfall is deducted from corporate taxes. No wonder options are so popular.

The fly in the ointment is the increase in the number of shares floating around. In order to offset this dilution, share repurchase programs are often set up. They also increase demand for stock, making the price rise and these options programs even juicier. And as mentioned, they improve growth in share earnings and return on equity, the very benchmarks that are often used in the granting of options to management.

But do buybacks really pump up share prices? There is evidence they do, though studies suggest the effect is more prominent for value stocks than for growth stocks. That’s probably because growth stocks are already fully priced so a buyback isn’t likely to push the price much higher, while value stocks have room to appreciate.

Another key factor is the level of debt. Companies that borrow to repurchase shares rather than using internally generated cash flow are going out on a limb. For example, debt-laden Laidlaw Inc.’s buyback of its shares last year has been disastrous, given their current problems. The company could desperately use that capital now as it teeters on the brink of bankruptcy with a stock price around half a buck.

So the main things to look for in a buyback program are affordability, good cash flow and a net reduction in the number of shares outstanding. A great example is one of our Contra stocks -- Utah Medical Products Inc. In the past year its share count decreased from 7,939,000 to 6,469,000 while debt was simultaneously paid down. Instead of cashing options, insiders were buying. At some point, this company will likely soar.