What Does Shrinking Equity Supply Mean?

My friend Brian Reynolds, chief market strategist at MS Howells & Co., has long said that Buybacks have been a driver of stock prices, with the shrinking float the key reason why. Econ 101 says that reduced supply with the same demand equals increased prices.

There are some caveats: Companies always could add shares back by new issuances, so equity is not quite like a commodity with a finite supply (Oil and Gold come to mind).       

We were discussing this in the office yesterday, and the example I used was Paul Kasriel’s recent chart. It showed up in Barron’s today, with an interesting spin, and that’s kismet enough for me:


catchy head of "Off a Cliff" on this page comes to you courtesy of Paul
Kasriel, Northern Trust’s crack economy watcher. What it shows is the
dramatic shrinkage in the supply of equities; all told, a record $548
billion worth was "retired" in ’06. As Paul explains, rather than using
their vast profits to fund capital spending, corporations have been
buying in their own stock, hand over fist. Further soaking up the
supply of stocks has been the explosion in private equity. It’s hardly
a surprise, then, he says, that stock prices moved up as smartly as
they did.

Paul also points out that the massive corporate
buybacks and scarfing up of shares by the acquisition-hungry private-
equity types have had another effect: Together with mortgage-equity
withdrawal, they’ve helped fund the $503 billion deficit that
households ran last year. Said households, either directly or
indirectly via mutual funds or pension funds, he reckons, were net
sellers of stocks in 2006.

Which suggests, according to Paul, that unless
corporate buybacks or personal income steps up sharply, with
mortgage-equity withdrawal (MEW) likely to slow further this year, Jane and
John Q. will have to clamp down on their spending. The stage seems set,
in other words, for the end of the great consumer buying binge."

A few things worth pointing out:

• If MEW slows, that would potentially engender either more stock selling to fund a certain lifestyle — or decreased consumer spending.

• There is, according to Barron’s, a "sizable build-up in pending new issues. By one savvy estimate, the number of IPOs in ’07 could shoot up a formidable 50%."

• Share repurchases are heavily dependent on corporate profits. If the earnings deceleration trend continues, so too might buybacks.

One last thought: Late 1990s saw a similarly large net share decrease. As prices rallied to new highs, we saw a return to trend. Once the market cracked, buybacks went away.

In other words, the psychology of the financially engineered buyback is a double-edged sword. If either the market seriously corrects or the economy slows (or both), we should expect buybacks to drop too.


Barron’s, March 12, 2007      

Corporate Equities: If the Supply goes down, the Price is Likely To Go Up (PDF)
Paul Kasriel
Northern Trust Global Economic Research, March 8, 2007

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What's been said:

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  1. MarkTX commented on Mar 10

    “Kismet” ? Hadn’t heard that word used in a long time.

    Googled the word, interesting what turned up.

    To me, it pretty much looks like stock buybacks have replaced dividends and/or capital funding.

    Long Term that has to be a disaster for workers(maybe even business in general) if paper gains become the only future economic growth for the US.

    and then you have to wonder what happens when that well runs dry too?

    Have a good weekend

  2. Fullcarry commented on Mar 10

    Well personal income is up sharply!

  3. SINGER commented on Mar 10

    KISMET appears to be related to the Hebrew work “KESEM” which is usually translated as MAGIC.

    “Outside the Housing and Auto Industries the U.S. Economy is strong.”

    -Bies – FRB (See Article on Bloomberg)

    “Except for Food and Oxygen, I have everything else I need to survive.”


  4. Bluzer commented on Mar 10

    Will a significant drop in consumer spending cause the crisis everyone’s expecting? Or will a crisis, in some form, cause a drop in consumer spending?

    Given how deeply ingrained ‘shopping’ has gotten in the fabric of American ‘culture’ I would bet on the latter.

    First he eats his home equity, then his stock portfolio then…? Makes for a good version of PacMan does it not?

  5. lurker commented on Mar 10

    MEW ending along with the dead cat bounce? Maybe that’s the noise a dead cat makes when the force of gravity takes hold once more of the overleveraged markets.

  6. Winston Munn commented on Mar 10

    It is good to find out that the Law of Supply and Demand is still functional; it seems that demand has hit a peak, though, if the only way to add value is to reduce supply. Without a fresh money infusion, it will be difficult for demand to increase substantially, and for the past two weeks repurchase agreements have ebbed.

    From where will new money come to create increased demand?

  7. lurker commented on Mar 10

    Winston-from the sky and Ben’s dollar-dumping choppers….ahhhhhh I love the smell of fresh currency in the morning!!!!

  8. Polly Anna commented on Mar 10

    I know a lot of people bash him, but I heard Ken Fisher say this EXACT thing early last year on Bloomberg with Suzy Assad and suggested the market would do very well because of it. I wasn’t sure whether to believe him at the time, but the chart is very illustrative (and it comes from Paul Kasriel). I was having a tough time believing companies and private equity could take so much issuance out of the equity market that it would acutally drive up stock prices. Now I know.

  9. seminole commented on Mar 10

    the homebuilders and lenders have bought back tons of stock the past five years but that is unlikely to continue.

  10. wcw commented on Mar 10

    I tend to see buybacks as tax-advantaged special dividends. Tax-advantaged for obvious reasons, special since they likewise tend to be more volatile payment streams. What’s going on with the market is simply that profits really have been that high as a percentage of GDP, and so corporations have been spitting out money. Check the charts I did based on the S&P data, especially the second one.

    Now, if buyback activity stops going up like that, or if rates go up, or both, there will be less payout supporting market valuations. For now, though, the S&P 500 still represents a pretty good value proposition vs bonds, which is why I stayed net long through the recent market downdraft and actually went slightly levered long last week.

    The market and the economy are vulnerable enough I took off that bet before the NFP came out, and I added back a couple select shorts on Friday in some of my target sectors, but I can’t see being anything but net long while profits and payouts are high and rates are low so long as the ‘soft landing’ stays soft.

  11. curmudgeonly troll commented on Mar 10

    interesting, but stupid.

    scale by the stock of equity outstanding, then come back and talk.

  12. gorobei commented on Mar 10

    I’m with wcw here: buybacks are easily 2x more tax efficient. Also…

    If a firm, ahem, aligns managment and shareholder interests by paying management with long-term stock and option grants, there is a big incentive to pay with capital gains rather than income: the tax situation is better, and the resulting comp doesn’t appear in the company’s financials.

  13. Winston Munn commented on Mar 10

    There is an interesting discussion of buybacks in an old but valuable book: “Quality of Earnings”. (Not hyping the book – it’s publication date was 1987).

    “There are only two ways to increase earnings per share – earn more money, or shrink the number of shares….the latter is resorted to only when all else fails.”

    According to this source, the huge buyback bonanza we have seen bodes poorly for the future of earnings.

    What’s that whump, whump, whump I hear in the distance – could it be a the blades of a helicopter?

  14. Estragon commented on Mar 10

    One more thing worth considering…
    “If MEW slows, that would potentially engender either more stock selling to fund a certain lifestyle — or decreased consumer spending”

    Slowing MEW also necessarily means a reduced supply of MBS related debt securities available for both domestic and foreign investors. The current account deficit continues to be financed, and the capital account surplus has to go somewhere. All else equal, this suggests an increase in demand for corp debt and/or equities, which could support buybacks for some time yet.

  15. wcw commented on Mar 10

    ct’s tone may have been annoying, but it’s a good suggestion. Here’s the chart as percentage of outstanding (PNG).

    Looks like there has been one (1) period that competes with and in fact bests the current one: the late-’80s LBO boom time.

    OK, ct — get to talking.

  16. Paul Stanton commented on Mar 10

    Historically many/most Fortune 500 firms used “buy backs” to avoid dilution due to large stock option grants (MSFT, CSCO, etc.). Any analysis of the volumes of stock buy backs would have to be analyzed against the stock option grants to judge whether the buy backs were in fact reducing the outstanding stock of traded shares. Historically the buy backs resulted in no net reduction in shares.

  17. Aaron commented on Mar 10

    I have to say – you guys are wonderful. I love these discussions. I only partially understand them, but gimme time.

    The emotional me sees these buybacks and thinks why aren’t they paying employees more? Isn’t buying an employee like buying a car?

    Then the rational me thinks, is this in fact a comment on the American worker? I guess this would be supported by the comment that buybacks are a last resort.


  18. Wcw commented on Mar 10

    Net equity issuance

    Net issuance of corporate equities as percentage of outstandingfour-quarter-trailing issuance over trailing average

    I do like Paul Kasriel for reminding me of data at which to look, but he has a habit of not normalizing historical series. Tipped by Ba

  19. David Merkel commented on Mar 10

    In the short run, this is bullish. In the intermediate term it is neutral-to-bearish. What to watch for:

    1) Low IPO quality. (Does Clearwire count as a start? Perhaps it gets balanced out by Employers Holdings.)

    2) Problems at private equity firms from low returns.

    3) Declining gross margins at firms doing buybacks. Buybacks aren’t magic; they only help firms that buy back stock below their intrinsic value.

    4) Consumer spending is a red herring here. It doesn’t affect the supply of stock. The most it does is change the motivation of a wealthy person short on cash to lift the bid, rather than wait at the ask.

    Good post, though.

    long EIG

  20. S commented on Mar 10

    There may be alot of IPOs on the forward calendar, but the bankers may have screwed themselves if the price action in a couple of large high profile deals this past week is any indication.

    CLWR raised $600 million on Wednesday. It broke price the first day of trading. By close of business Friday, it was down 10% from it’s offering price.

    XFML raised $300 on Friday. It broke price during the first two hours of trading, and closed the day down 13%.

  21. wcw commented on Mar 10

    Don’t forget my favorite fruit, FIG.

  22. Greg Alton commented on Mar 10

    One other way to look at this is a straightforward trade-off between the cost of debt and the cost of equity, otherwise known as WACC optimisation. As the cost of debt goes down, expect fewer issues. If it goes way down, it makes sense for companies to reduce their equity outstanding. As borrowing rates go up, firms will slow or stop the equity repurchases.

    The only tricky part of applying this is figuring out how the risk-weighting between asset classes plays out, but not many would disagree that issuing even risky debt has been extraordinarily cheap. Equity risk (volatility) may also be low, but nowhere near the massive compression in spreads between debt classes.

    As noted elsewhere here, issuances as a percentage of outstanding is low, but at the margin can have a large effect. But this is all probably just a sideshow compared to the movement of money to a different asset class and the effects there: e.g. housing.

  23. JKH commented on Mar 10


    Buybacks are a use of corporate cash (e.g. from retained earnings). Cash generated and retained reduces the average risk level of assets, which reduces the cost of capital, with corresponding enhanced effect on PE valuation. Buybacks reduce such corporate cash levels, thereby increasing the average risk level of assets, compared to that had cash been retained. Increased risk then mean increased cost of capital, with corresponding depressing effect on PE valuation. The degree to which buybacks actually increase share price, compared to that had cash been retained, is debatable.


  24. Frankie commented on Mar 10

    That corporations prefer to buyback shares instead of investing for the long term would have surprised me 2 days ago.

    Now I am underwhelmed. Why? Because of a conversation I had yesterday with a retired very senior executive of one of the Fortune 100. The reason I stay vague about the gentleman ID is simple: he still does a good amount of consulting on the side, and is a rather private fellow.

    What he told me was downright scary; essentially, very few public corporations engage the capital they used to in R&D. Anything that is not applied research deemed to generate marketable results as fast as possible is just shunned. Some private ones do have a time-honored tradition of NEVER skimping on R&D (Bose is a great example of that; SAS come to mind too) but publicly traded companies have markedly decreased their mid-long term R&D. It’s a trend that scares the heck out of him.

    At first, I was very skeptical and let him know it: How in the world did these guys expected to stay competitive in a knowledge economy without innovating? C’mon! Innovation takes TIME and resources. Plus, there are numerous studies that show how corporations that invest steadily in meaningful R&D end up beating the market in the long-term.

    Aaaah! “Long-term” That was the key word. In his regular conversations with deciders, a dominant theme (“fixation” came into the conversation) is “efficiency”. How can we extract the maximum value form our assets in the shortest unit of time? Some of his clients even have “efficiency experts” deployed in teams that scan every conceivable corner of their turf to scrub any behavior, process, physical stuff, you-name-it thing that is not “efficient”.

    Yes…but how are you going to innovate? ask the consultant to the execs. “We can always buy what we need, can’t we” is a common answer. How’s that for efficiency?

    With such a mindset, it is not surprising that corporate purse wardens will go for what “works” in the most “efficient” manner possible.

    Somehow, something important is missing in this picture.


  25. Winston Munn commented on Mar 10

    In other words, the psychology of the financially engineered buyback is a double-edged sword. If either the market seriously corrects or the economy slows (or both), we should expect buybacks to drop too.

    Mr. R:

    Although I have not reseached this, it would seem that exceptional buybacks would be a leading indicator for lowered economic growth expectations. If you consider business investment as levels, then level 1 would be investment in expansion of existing business, new products, new markets, and increased R&D – this is what you would expect if uninterrupted 3-5% GDP were anticipated for the foreseeable future. If level 1 is saturated, then Level 2 would be growth by acquisition, which in an isolated instance would not be significant, but if widespread could indicate a perceived lack of growth opportunity in the primary business. Level 3 investment would be buybacks – this would indicate that level 1 and level 2 options do not show as much promise for share performace as the simple expedient of reducing outstanding shares – hence, a expectation of slowing enomonic conditions.

    Is there any validity to this common sense thinking?

  26. JKH commented on Mar 10

    “Although I have not reseached this, it would seem that exceptional buybacks would be a leading indicator for lowered economic growth expectations.”

    See comments by G. Alton above. Buybacks alone don’t necessarily imply reduced levels of investment for the economy as a whole. Money spent on buybacks can eventually flow back into the corporate sector through debt issuance. Also, earnings after dividends for the corporate sector as a whole may exceed buybacks – i.e. retained earnings may still be positive, financing investment. Portfolio adjustments at the micro level (e.g. specific corporate buybacks) don’t necessarily translate to the same investment adjustment at the macro level. Finally, national investment actually exceeds national saving – the difference is the current account deficit. This demonstrates that there is still more than enough macro level investment to be financed, notwithstanding the micro level buyback behavior of some corporations.

  27. Winston Munn commented on Mar 10

    Thank you, JKH. Now I believe I grasp it. The key to the kingdom is the cost of debt.

  28. View From Silicon Valley commented on Mar 10

    This was same argument promoted during the initial stages of the decline after the dot.com peak. It was, & still is, complete drivel.

    Ignoring for the moment that diluation &/or IPO’s will launch at the first hint of any actual “shortage,” if you chart the top 10 or so guys buying back shares, you will see the buybacks are essentially off-setting dilution from options issuance.

    In other words, management is spending the company’s money to buy shares to award to itself. The nearest thing to a legal printing press you will find.

    (If someone had asked, I would have said this site had been a leading proponent of that very argument, but perhaps this is incorrect?)

  29. wcw commented on Mar 10

    VFSV, in a word, no. Corporations really are retiring equity.

    In 2000, net issuance was 0.3% of outstanding corporate equity.

    In 2001, net issuance was 0.6%.

    In 2005, it was negative, at -0.9%.

    In 2006, that more than doubled to -2.1%.

    You could just have clicked on my handy chart or, better still, downloaded the flow-of-funds data and run the numbers yourself.

  30. Winston Munn commented on Mar 11

    Perhaps there is a correlation between the increased equity retirement and the dramatic increase in insider selling in 2006? One might argue the perceived need to brace prices via reduction of shares combined with the sales of personal holdings to be an indication that businesses are more prone to believe that Goldilocks has been eaten by the Big Bad Bear.

  31. JKH commented on Mar 11

    “Perhaps there is a correlation between the increased equity retirement and the dramatic increase in insider selling in 2006?”

    Corporate insiders prefer stocks buybacks to dividends because buybacks tend to increase the value of their options.

    Dividends hold back option values because they reduce the growth rate of stock prices, other things equal (e.g. distribute 100 per cent of earnings as dividends, and you might expect 0 growth in the stock price, because you’re always discounting the same expected future cash flow stream, other things equal).

    Stock buybacks, on the other hand, keep reducing the denominator (# shares) over which the expected future cash flow stream will be shared. Stock buybacks therefore increase stock prices over time (and they increase earnings per share). This increases the value of options over time.

    Insider selling is consistent with buybacks to the degree that insiders may not expect buyback capacity (i.e. earnings) to go on forever (i.e. bear devours goldilocks).

  32. DavidB commented on Mar 11

    The emotional me sees these buybacks and thinks why aren’t they paying employees more?

    The counter argument(not that I agree with it, I think buybacks are a terrible waste of money and are very executive-centered in their motive) Aaron is that the employees have every right to participate in the buybacks by owning shares in the company. Not only that but since many of these companies have favorable stock purchase plans for employees, which even adds to the benefit employees can get, this would then level the playing field between them and shareholders which could be argued is the fairest way to spend company resources.

    Personally, if they are using debt to buy back the shares it is a tremendous waste of corporate resources, future earnings(because at some point earnings have to pay for the interest on the money borrowed) and implies a lazy and possibly balance sheet destructive management. If they are just using cash to buy back the shares then it implies to me a management that has run out of ideas and are only interested in boosting the value of the shares or options they already own.

  33. Eclectic commented on Mar 11

    Time to define Eclectic’s adaptive lexicon:

    Private Equity – Industry that is a great proponent of the concept of “shrinking equity supply,” circa: mid-late-2000s.

    Investment Trusts – Industry that was a great proponent of the concept of “shrinking equity supply,” and subsequently did a good job of “shrinking all the equity it was supplied,” circa: 1929 through the mid-1930s.

    Last Ticket – The last ticket… to the last train leaving this miserable town. The ticket you must buy now before all the equity in the known universe is forever sucked down the black hole of private equity.

    Future – a situational place of the forward accretion of time, a place likely to be knee-deep in train tickets.

    Barringo – A shifty-eyed, Mac-lovin’ one-shot gunslinger. Usually scores bulls-eyes, sometimes forgets gun and shows up with only a knife.

    Kudlowvia – A situational place, the seat of all Say’s Law, supply-side and GSNT worship.

    GSNT – The Greatest Story Never Told.

    NeverToldVille – Legendary capitol of The Greatest Story Never Told.

    Kudlownians – A situational mentality [distinct from: ‘Kudlowvia’ (place)]: a theory of mind requiring a corrective doctrine, as in “Bernanke’s First Epistle to the Kudlownians.”

    AA – A shifty-eyed machine gunner with a proclivity for lexicological adventurism. Try 10-letter word across (study of proper names); cross it down at 5th letter across with 2nd letter of down-word (near or adjacent to the mouth); finally, cross down-word last letter with 1st letter of new 7-letter word across (Mayan City).

    Eclectic – Part-time economic theoretician , philosopher, objectivologist, and author of “The Perceived Liquidity Substitution Hypothesis.”

    Objectivologist – One who practices the art and study of objectivity.

    Paul Volcker – Mythological god, considered the ‘Zeus’ of the Dallas Fed.

    Milton Friedman – Patron Saint of the Dallas Fed.

    Big Mouth Bombastia – Disease of known causative microbial infection – the genus and species: “bombastus hyperbolus.” First symptoms are a small fever accompanied by loudmouth profound willfulness, with or without fundamental basis. Disease typically (but not exclusively) borne by optimists. Kudlowvia a high source of known contagion.

    Hoof-in-Mouth Disease – Secondary disease often accompanying primary infection of bombastus hyperbolus. This disease never curable because aggressive financial media lacking. Use of an intensely hot follow-up spotlight on patient is a theoretical treatment as yet untried.

    Prestidigitation – A collective enterprise associated with: 1) – pro-forma EBITDA accountancy, 2) – supply-side economic theory, 3) – Employer-granted corporate stock options, and, 4) – Say’s Law advocacy. Alternative definition: “Hocus Pocus.”

    Hurricane – A gigantic circular wind that might destroy many houses.

    MBS Derivatives Market – A gigantic circular wind that might destroy the housing industry and the economy.

    Monetarism – False religion.


  34. JKH commented on Mar 11

    “Paul also points out that the massive corporate buybacks and scarfing up of shares by the acquisition-hungry private- equity types have had another effect: Together with mortgage-equity withdrawal, they’ve helped fund the $503 billion deficit that households ran last year. Said households, either directly or indirectly via mutual funds or pension funds, he reckons, were net sellers of stocks in 2006.”

    The Fed and others have done studies that estimate the use of MEW in funding consumer expenditures. It’s unlikely the same can be said for share buybacks. The strength of the causality is much less knowable. Investors do not raise cash to spend by “choosing” buyback counterparties through the stock exchanges. The fact that households are net sellers of stock doesn’t mean they’re spending the money. There are other asset allocation possibilities. Moreover, the wealth effect has been proven to be much stronger for housing than for stocks, and it’s likely that consumer expenditures (and household deficits) respond more strongly to MEW opportunities than to stock buybacks.

  35. greg0658 commented on Mar 11

    No one mentioned buybacks as job security for top management in a M&A climate, supported by anyone who believes in halting a near monopoly from growing strength.

    Lastly going private says thanks for allowing us to be great and we’d prefer you go away now. (for whatever reason).

  36. Joseph Combs commented on Mar 11

    28 years ago at MIT Sloan, we were correctly taught that share repurchases are dividends. I do not think anyone in a corporate finance course in recent history has every been taught otherwise, at any school. In the national income accounts, share repurchases are also treated as dividends by the Commerce Dept. I wonder why there is always some puzzlement on this fairly basic notion. Managements should call ’em as they are: share buybacks are dividends.

  37. Barry Ritholtz commented on Mar 11

    I define a Dividend as: an after tax transfer of capital from the company to its shareholders.
    Buybacks are a pre-tax reduction of float.

    Dividends are a sure thing — a check gets issued to shareholders, and thats that. Buybacks are more complex — they are not always completed (at least to the full announced amount). Even whem the full buyback is effected, shareholders still have market risk. Dividend recipients already cashed their checks, and without selling any shares, either.

    There are benefits to both, but to say a share buyback are dividends grossly overstates the case.

    Joseph — can you explain how MIT precisely defined those terms? Were they identical, similar, or something else?

    Can you conflate different concepts into one amorphous equivalent?

  38. wcw commented on Mar 11

    I’m with Mr. Combs. The forms of the transactions differ, but the substance is identical: the corporate person transfers cash to its shareholders. Similarly, in a DRIP no cash changes hands during a dividend payment, though it is identically a dividend whether you elect payment in cash or shares.

    However, buybacks are as you noted much more volatile, which is why I tend to analyze them as special dividends. You can’t really plan on special dividends the way you (usually) can on regular ones. However, even regular dividends can get cut or suspended at a moment’s notice.

  39. Eclectic commented on Mar 12

    Joseph Combs,

    You are most correct. Stock buy-backs are dividends in which the capital gains taxes (from the perspective of the shareholder) are both, 1) – substituted for ordinary income taxes, and, 2) – they are deferred to the future.

    Taken marginally and constantly to a remaining single share of stock, the net effect of stock buy-backs is the vesting of the entire value of the company in that one single share.

    Should you own that one share… then when selling your share you would realize the capital gains (if any) of the effectively reinvested stream of deferred (ordinary) dividend income that had been theoretically reinvested in the shares you own. You would have passively acquired the entire 100% equity in your company.

    It was a different world 28 years ago. I suspect Sloan was then teaching a more conventional interpretation of stock buy-backs they’d observed during the prior 10-25 years (as you prefer), rather than the one that has developed over the last, say, roughly 25 years, since the beginning of the great supply-side revolution that led to this exotic pro-forma EBITDA accountancy that has caused us so much trouble.

    Today, often the buy-back is simply a result of the need of the company to capitalize the diluted equity hidden in hocus pocus employer-granted stock options. Here, the objective is to disguise the transfer of capital away from the shareholders. And, in that sense the marginal continuation of the process leaves one shareholder with “zero equity.” In that case, Sloan would have to consider him a terminal bag holder.

    Buy-backs should (repreat: should!) only occur after a deliberative analysis of the marginal cost of capital versus its marginal efficiency shows that it favors marginal efficiency, and that “that” marginal efficiency is most efficiently employed by buying the company’s own shares, rather than either, 1)- buying the shares of some other company, or, 2)- expanding the operations of the host company itself.

    No… often today’s typical routine of buy-backs is a sort of pigeon-drop scheme of transferring disguised capital in the form of unrecognized dilution (the criticism was that, formerly [and even still], the costs of corporate options have not been fully recognized by pro-forma EBITDA), followed by the requirement to recapitalize the equity by a secondary offering of the shares.

    In a sense then, this means (adding to past discussions on option issues) that often, ultimately, all the conventional and backdated option grants accomplish is, effectively, a sort of UNAUTHORIZED and UNRECOGNIZED secondary stock offering, after the buy-back, in order to recover the capital diverted to the option holders.

    In no sense could this be reasonably considered a dividend.

  40. JKH commented on Mar 12

    “28 years ago at MIT Sloan, we were correctly taught that share repurchases are dividends. I do not think anyone in a corporate finance course in recent history has every been taught otherwise, at any school. In the national income accounts, share repurchases are also treated as dividends by the Commerce Dept. I wonder why there is always some puzzlement on this fairly basic notion. Managements should call ’em as they are: share buybacks are dividends.”

    I guess nobody told Mr. William Poole, President of the St. Louis Fed.

    In a February 15, 2007 speech, he said the following:

    “The capital gains issue has grown, and not just because stock market gains have often been substantial in recent years. A company can throw off cash to investors either through paying dividends, which appear in personal income, or through share repurchases. Share repurchases tend to increase stock prices, yielding capital gains to shareholders which do not appear in personal income. If companies have increasingly used share repurchases instead of dividends—which appears to me to be the case—the result would be to create a downward bias to the measured saving rate.”

    In addition to not being included in personal income, share repurchases are also substantially different from dividends in terms of risk and economic effect. Dividends are recorded as income because they are “book value” economic items – there is no market risk to a cash dividend at the time it is received. Buy backs, on the other hand, are fraught with market risk, because the size of the “dividend equivalent” benefit is a function of the price of the stock when the buyback occurs.

    The Poole speech, which I just noticed this morning, is very wide ranging on the issue of savings, and well worth reading, although it is heavy slogging in the explanation of NIPA and flow of funds account construction. The issue of stock buybacks is embedded within the issue of capital gains, about which the debate is well disseminated in the financial blogosphere.

    It is one thing to debate the ideas, but the facts are the facts in terms of how the national accounts and flow of funds are constructed. One shouldn’t change definitions to argue one’s point of view. And don’t underestimate the challenge of achieving consistency in the treatment of complexity.

    Poole himself offers some alternative definitions of savings. But at the same time, he works within the existing framework to arrive at his conclusions:

    “First, household saving behavior does not seem to have changed in any fundamental way. What has changed to a degree is the trend in asset values. Households have consumed some of the increase in asset values in about the same way they always have.

    My second tentative conclusion is that the behavior of households, though perfectly sensible and responsible for households as a whole, has led to a situation in which the United States as a whole is saving too little of its national output. U.S. domestic investment has not suffered, because capital has been flowing into the United States from abroad. However, at some point the U.S. net international investment position will stop becoming ever more negative. U.S. saving will then finance a larger fraction of U.S. domestic investment and, perhaps, repurchase some U.S. assets now held by international investors. There is no reason why this adjustment should be difficult or disorderly, but it will require that U.S. consumption outlays expand more slowly than U.S. GDP for a time.”

    (Poole Speech:


  41. Eclectic commented on Mar 12


    There are 3 things that act to justify everything you said (and generally how you quoted Poole) with what Joseph Combs said:

    1)-the advent and acceleration of use of pro-forma EBITDA accountancy,

    2)-investors’ apparent current rationalization to higher P/E multiples*, and,

    (*and thus also expressed as lower dividend yields by circumstance than expected by Poole)

    3)-investors willingness to substitute irrational deferred and unrealized capital gains** for current income.

    (**the whole subject of our market debate today)

    Combs I think directed his comments at an isolated company’s decision criteria, and then I explained how that works through as true dividend income. It IS true dividend income, regardless of how Poole rationalizes it.

    You, and your quoting of Poole, are looking to the wide macroeconomic effects and trends in how those decisions are made.

    And I would say to Poole: Of course a paid dividend, net of taxes, in the hand has less inherent risk than an involuntarily reinvested dividend that might or might not produce a future capital gain (net of taxes), but there’s nothing that says the investor couldn’t take the cash dividend in hand instead and then invest it himself in something as risky or more so than the company’s shares themselves.

    A substantial market downturn would at the same time both: 1)- make Poole right, and, 2)- bring his obvious interpretation of appropriate dividend policy closer to his expectations for what it ought to be.

    But, making Poole right would require either a dramatic increase in cash dividend payments or a substantial decline in market P/Es.

  42. JKH commented on Mar 12

    Corporations face a problem with share buybacks analagous to the problem that mortgage hedgers face with “negative convexity”.

    In mortgage hedging, as rates drop, duration drops, and hedgers must buy more bonds at ever higher prices to square their positions.

    In share buybacks, corporations tend to generate the excess cash that motivates buybacks in an environment of rising share prices. To the degree they follow through on their buyback programs, they buy back shares at ever higher prices.

    This is a pattern that risks blowing one’s brains out in terms of delivering value to the remaining shareholders. With a subsequent downturn, the corporation runs out of excess cash, just when the shares become longer term value from a buyback perspective.

    This makes about as much sense as “inverse” dollar cost averaging – buying more stock when it is more expensive.

    Dividends spread the residual valuation effect across shareholders in aggregate and on an equitable basis. Buybacks tend to transfer wealth from holders to sellers.

  43. Eclectic commented on Mar 12


    Excellent points. Now work logically through some of the things you said “quoted,” in association with my **comments that follow:

    “In mortgage hedging, as rates drop, duration drops, and hedgers must buy more bonds at ever higher prices to square their positions.”

    **I’m not that informed on the specifics of hedging, but I think generally the reverse is also true, and according to the worrisome size of these “secondary portfolios” that must be hedged, that Mr. Bernanke (whom I assume “is” well-informed on hedging techniques) has recently attacked, I will observe that the net effect of the hedging, at times, is to present a strategy to the market that acts to the d-e-t-r-i-m-e-n-t of the very providers of capital to the GSEs that provide them with their bread and butter for their operations… the good faith buyers of their MBSs.

    To my mind, this can clearly present a conflict of interest between the GSEs and the good and faithful providers of the mannow that drops from their heaven.

    Consequently, MBSs are packaged and sold to good faith buyers who then must endure random bouts of extreme volatility as the GSEs work to hedge the risks of those excessive secondary portfolios that Mr. Bernanke has carefully drawn his gunsights on.

    “In share buybacks, corporations tend to generate the excess cash that motivates buybacks in an environment of rising share prices. To the degree they follow through on their buyback programs, they buy back shares at ever higher prices.”

    **so, who said just because corporate execs are smart enough to have risen to their positions in life, that they aren’t as susceptible to the emotional momentum of a market top as anyone else is.

  44. Eclectic commented on Mar 12

    I suppose that would be “manna” rather than my earlier “mannow,” but I don’t recken it changes the heaven it drops from.

  45. JKH commented on Mar 12

    Agreed. Hedging is a market risk challenge for the GSEs, given the size of their portfolios. This, in addition to other risks, could sum to broader systemic risk at some point. Bernanke and Greenspan both agreed on this, and see no reason why GSEs should need to hold captive portfolios of this size.

  46. Eclectic commented on Mar 12

    Addendum to the:

    “First Epistle to the Kudlownians”

    Yes… MBS issuers and their investors and the buyers of their MBSs all have every right to make mistakes and go broke… but not with public money.

    Your supply-siders should always “supply their own side,” and thus when things go wrong, they can sing false praises to Adam Smith while going around the bowl and down the hole.

    “The Greatest Story Never Told
    ….Is sometimes cause they were too bold,
    And should the piper need his pay,
    ….For pence on dollars they’ll be sold.”


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