Larger Stock Buybacks Are A Signal Of Increasing Stock Market Efficiency

You don’t have to go far these days to find someone shouting that corporations buying back their own stock is a sign with all that’s wrong with the financialisation of our society. Instead of just enriching shareholders companies ought to be expanding their businesses by investing the money internally. This is rather to miss the point about how financial markets work. They’re supposed to be intermediaries that allocate capital to its most productive uses. And there’s nothing at all that says that the next most effective use of last year’s profits is inside the organisation or company that made those profits. Indeed, there’s good theory to tell us that, at least at times, efficiency is gained by extracting profits from one activity and taking them off to do something else entirely.

What prompts this is something from Tim Taylor. He gives us this chart:

stockbuybacks

About which the CEA says:

The decline in the invested share of internal funds from 2011 to 2013, together with the rise in share buybacks, suggests that firms had more internal funds than they thought they could profitably invest. As can be seen in Figure 2-25, the investment outlook appears to have improved in 2014, and the investment share of internal funds has rebounded to near its historical average. Share buybacks, however, remain high.

Now my point isn’t so much about this short term but rather about the long term in that chart.

Yes, it’s most certainly true that stock buybacks are a larger feature of the financial markets than they used to be. However, it’s not obvious that this is in fact a bad thing. It could be a reflection of how the financial markets as a whole are more efficient these days. As the CEA also says:

(When firms raise investment funds by issuing new equity, the nonfinancial sector aggregate of share buybacks in the figures can be negative, as was common in the 1950s and 1960s.)

There’s no particular reason for us to prefer investment within extant companies as to the removal of profits from successful companies and their investment in new companies (or even just different companies) elsewhere in the economy. We can construct, in fact, models where the latter is preferable. For example, technological change generally comes from exit from and entrance to the market rather than extant firms changing their processes.

In those 50s and 60s when overall the public companies raised capital on the stock markets it was rather the fashion that a corporation should be a conglomerate. It was a good idea if several different lines of business were under one corporate roof. It allowed diversification of risk for example. That diversification allowed lower financing costs and thus conglomerates were more profitable than one line of business companies.

That was also a time when it was rather difficult for the individual investor to diversify. To do so meant purchasing individual stocks in individual companies. And rare was the person rich enough to be able to diversify across the entire market.

Then came the rise of the mutual fund (unit trust to a Brit like me) and then later on index funds. This made diversification across the entire economy, for the investor, by far the simplest and cheapest investment choice. No longer was it necessary, or even desirable, to purchase diversification at the conglomerate level. It’s worth noting that one of the very few conglomerates we still have that is successful is Berkshire Hathaway Berkshire Hathaway, and they gain enormously from being able to use their insurance float to finance the business. They’re getting those lower finance costs by an entirely different method. It thus now makes sense for a line of business to be run by a company and for each company to be in one line of business.

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