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Problems of Success – Populism and Stock Buybacks

March 5, 2019 / Jonathan Holtaway and Jacques Rebibo

We have watched with wry amusement politicians battle over corporate common stock repurchasing, or “buybacks”, the process where a company repurchases its own stock on the open market.  Elevating a mundane, but important, business tool into a social fault line is the nature of our times.  Buybacks are the other side of the coin of public companies issuing shares to strategically manage capital.  Those against buybacks say it makes rich people richer while damaging future growth, which hurts employment and the economy.  This statement is demonstrably false, although truth is underappreciated these days.

A Republican senator, Marco Rubio, has proposed stock buybacks be taxed to give corporations more incentive to invest profits into growth.  This shows that bad policy will follow bad ideas if they become popular.  The controversy stems from the December 2017 Tax Cut and Jobs Act, which cut the corporate tax rate from 35% to 21% and allows a window for overseas profits to be repatriated at a reduced tax rate.  This flood of new liquidity for some public corporations has led them to repurchase shares at increased rates.  The amounts are large and have captured the interests of journalists and politicians.  The buyback blowback is an attempt to rehash the corporate tax debate.

Whatever the motivation, it’s nonsensical to use the tax code to gum up the mechanisms corporations and capital managers use to fulfill their purposes.  Here is an example.  One of our local Virginia banks was in growth mode in 2006 and issued 2 million common shares to raise $20 million of capital from primarily institutional investors.  In 2006 the bank and economy were growing, and the new capital was a strategic decision to invest in growth.

By 2007 it was apparent the economy was losing its footing and investors were afraid of banks doing poorly regardless of their individual quality.  Bank stock prices were falling rapidly.  The equation of investing in growth changed rapidly.  This Virginia bank was well diversified and highly profitable.  Confident in its financial stability, but unable to grow in a declining economy, the bank announced a stock repurchase plan in March 2007 and repurchased every share issued in the 2006 offering at much lower prices.

The institutional shareholders were happy for the liquidity provided by the company.  They wanted to avoid further short term losses and to meet redemptions.  If the company didn’t buy, the stock price would have gone much lower.  The company spent about $15 million on these buybacks.  When this local Virginia bank recently sold, these repurchased shares generated incremental value for the remaining shareholders of $60 million.  This turned out to be almost 10% of the total gain generated by the company in its 20 year lifespan.

Many of our readers and clients know this bank as Access National Corporation.  The entire history is available in their public documents.  Jacques Rebibo was Chairman of the Board at the time of the buyback in 2007-08.

This example underlines what stock buybacks are – a tool for a corporation to fulfill its purpose.  There were no losers in this story.  The institutional investors got the liquidity they needed at a higher price, while the bank achieved long term goals of generating capital gains for shareholders.  If the bank hadn’t changed its strategy when the facts changed and instead tried to aggressively deploy capital like many banks actually did, it simply would have made bad loans in 2007-08 putting the company at risk.  This example underlines a basic principle of stock buybacks.  The decision to repurchase should be taken when it produces better long term results.

There were other positive side effects of the Access National buyback.  The bank managed its shareholder composition.  A bank generally has control when it raises capital, allotting shares to people and organizations committed to supporting its vision.  When markets are dislocated and prices are at panic lows, banks can suddenly have strange, new bedfellows as large investors.  A small Virginia hedge fund accumulated 4% of Access National’s shares at bargain prices in spite of the fact the bank repurchased 20% of its outstanding shares.  If the bank didn’t buy, hedge fund purchases may have altered control of the company.

If Access National didn’t buy, the price would have gone lower and even more founding shareholders would have panicked, losing the bulk of their investment.  This is the nature of a stock market crisis.  Puritans might say “so what”, these investors did it to themselves, but this attitude undermines the collective purpose of a corporation and a community bank.  The people who would have “done it to themselves” are founding investors, employees, customers and in many cases literally family.  Their well being is wrapped into the purpose of the company. Saying “so what” is unethical and foolish.

Let’s consider a different bank.  A sizeable community banking company in Illinois had some loan troubles during the Great Recession, but was able to work through them over time.  In spite of the recovery, the stock languished below 90% of tangible book until 2016 and trades at 106% of tangible book today, about 30% below peer levels.  In the last five years the leverage ratio has climbed from 9.6% to 10.7%, signaling capital accumulation in excess of growth.

If this bank had repurchased 3% of its shares in each of the last five years, it would have 14.7% fewer shares today.  Based on the average value of the stock each year, it would have had to spend 25% of earnings on buybacks, and this would have kept the leverage ratio at 9.6%, or the same as five years ago.  For long term investors, though, tangible book per share would be 6.5% higher and earnings per share would be 17.6% higher.

Were there enough shares available at these low prices?  Well, we bought 5.8% of the bank’s stock and another fund bought 6.5% of their stock during this period and this didn’t push up the price that much.  The shares were available because there isn’t broad buyer interest in the stock and the current shareholder base is aging.  The bank suffers primarily from a liquidity discount, not a performance discount.  This company is Foresight Financial, a bank holding company in Rockford, Illinois.  All of this is in the public record for anyone to read.

So why does all this matter?  Shareholders have very little power, individually.  They are usually members of the community who believe in the business opportunity and were sold into their shareholding by members of management and the board of directors.  The wealth they contribute as capital to the bank is local community wealth.  After many years of supporting the bank with their capital, their business and their referrals, many people need to cash their shares because they are older, wish to retire or organize their estate.  For community banks with very little institutional following, a buyback plan can provide this liquidity to everyone’s benefit.

The alternative is specialist funds will cash out local shareholders at low prices reflecting illiquidity.  This is a slow motion selling of the bank for less than book value, but anonymity allows insiders to pretend otherwise, at least until the new owners make known their rights.  Control changes hands to outsiders, and a massive amount of local wealth is transferred to outsiders.  The board fails in its commitment to shareholders, to the community and to its employees.  Eventually the bank will attract a bid from a better run institution and if the board fails to consider the bid, its previous failures are compounded by legal negligence.  The ethical management and board use stock buybacks as an arrow in their quiver to accomplish a core purpose for a corporation.

But what about stock buyback abuse?  Assume a management and board knowingly uses stock buybacks to support an overvalued stock price so that management can earn bonuses.  Fortune 500 CEOs make $20 to $30 million, so let’s assume one of them uses $1 billion of earnings to fund buybacks at a 30% inflated price so that the CEO can earn an extra $20 million bonus.  The CEO has wasted $300 million in order to get $20 million and shareholders are paying this bill.  If the $300 million is needed to fund growth projects that subsequently never move forward, the opportunity cost is even higher.

This hypothetical underlies the argument for taxing buybacks, but upon closer examination does not support it.  In this hypothetical, rich people aren’t getting richer, they are getting ripped off.  The real money is with owners, not management and the board.  If good growth projects are rejected to fund overpriced buybacks, this compounds the rip off.  Taxing the mechanism of corporate buybacks isn’t the redress.  This is a corporate governance problem and a company with a deceitful CEO and enabling board has a much, much bigger problem than ill priced buybacks.

There is another logic error in the proposition that stock buybacks crowd out potential growth projects.  Stock buybacks move capital captive to the narrow view of a single corporate management team into the hands of thousands or even millions of investors.  This capital is free to flow to a multitude of ideas and investments.  Buyback capital doesn’t disappear, it is re-allocated by the invisible hand.  Historically, corporations and banks tend to sit on too much retained capital in hopes of growth that doesn’t materialize.  Buybacks alleviate the human tendency reflected in corporate decision making towards hoarding and inertia.

So what about Marco Rubio and his tax plan?  First of all, stock buybacks are already taxed.  A corporation earns money on which it pays a statutory 21% tax rate and then uses aftertax monies to fund buybacks.  A buyback is a stock transaction with a buyer and a seller.  The seller, if they have a gain, will pay a tax on that gain.  A dividend payment is very similar except a dividend is sent out to all shareholders regardless of their desire for liquidity, whereas a buyback focuses all the money on people who want liquidity and don’t mind triggering the tax.  Warren Buffet identifies this better matching of cash to the people who want cash as one of his reasons to favor stock buybacks over dividends.

If you tax a stock buyback, not only are you triple taxing (corporate, cap gains and now buyback tax), but you have a technical problem.  With dividends you give cash to shareholders, who then pay appropriate tax.  Buybacks occur anonymously, as the seller doesn’t know the organization is repurchasing his or her shares.  This means a buyback tax is only feasible by taxing the corporation directly.   You get the same effect with a lot less trouble by just raising the corporate tax rate, so Rubio, who voted for the corporate tax rate reduction, is just using smoke and mirrors.

And this brings us to the elephant in the room on any discussion of buybacks.  The four largest banks in the United States have been using most of their earnings in the last few years to fund dividend payments and stock buybacks.  Last year Bank of America earned $28 billion and used $19 billion for buybacks and $7 billion to pay dividends.  This is a 93% payout ratio.

Bank of America’s Tier 1 Common capital has barely increased since 2015.  Its gross loans are up less than 7% over a three year period, which is lower than inflation and much less than nominal GDP growth.  Bank of America is shrinking in relation to the economy even as its earnings per share, stock price and net income are rising rapidly.  The employee count at Bank of America is rising and their cost base is falling.  From a systemic risk and too big to fail perspective, everything at Bank of America is improving even as they are spilling out capital for other people to use productively.   If you don’t like this scenario, then you don’t think success matters.

A company’s relationship with its investors is a two way street.  A public company evaluates raising money at the best price the market will bear and relates this cost of capital to the potential for growth in earnings.  Similarly, when a public company has earned excess cash, it has the option to repurchase shares at the best price the market will offer, after relating this price to the long term potential for growth in earnings if the capital is retained.  These situations are two sides of the same coin.  In both instances the market price and the potential for growth in earnings are the key ingredients determining which way the capital flows.

In banking we are lucky.  Banking has excellent metrics, clearly defined capital requirements and hundreds of comparable companies.  Establishing a price upon which to make a capital decision is relatively straightforward.  Most industries have fewer metrics, fewer comparable public companies and higher performance volatility.   This makes capital flow decisions more difficult to evaluate, but in banking, there is little excuse not to have a regular eye on the buyback equation.

Jonathan Holtaway

Jonathan Holtaway

Jon Holtaway is an expert in the banking sector and has been quoted in national publications such as The Wall Street Journal, The Financial Times and The Washington Post. As a hedge fund manager and former investment banker, he has dedicated his career to investment analysis and building relationships in the banking sector. After spending twelve years with a premier regional investment house, Jon has co-founded two companies and has extensive experience working with wealth management and residential mortgage companies. In his free time, he is a passionate reader and writer. He authored “The Growth Penalty: Unfinished Business, Banking and the American Recovery” in 2013 and is working on a follow up book.

Jacques Rebibo

Jacques Rebibo

Mr. Rebibo has been a community bank investor for over 30 years. He entered the banking industry in 1985 when he invested in and joined the board of a de novo bank, Fairfax Bank & Trust. In 1999, Mr. Rebibo was an organizing director and subsequently became Chairman for nine years of Access National Bank, which grew to $3 billion assets before selling in 2018. In 2009, Mr. Rebibo co-founded and was Chairman of 1st Portfolio Holding Corporation, a residential mortgage and wealth management company. 1st Portfolio was sold to WashingtonFirst Bankshares, “WFBI” in 2015.