Stock buybacks enrich CEOs and shareholders but deny taxpayers and employees their fair share of profits and stifle innovation and job creation, according a study by William Lazonick, a professor at the University of Massachusetts Lowell and 2014 HBR McKinsey award winner.
Lazonick summarized his findings in an article published in the September 2014 issue of Harvard Business Review (HBR). In April, the article, “Profits Without Prosperity,” was recognized by McKinsey & Company and HBR as the best HBR article of 2014. The panel of judges called it “meticulously researched.”
“Trillions of dollars that could have been spent on innovation and job creation in the U.S. economy over the past three decades have instead been used to buy back shares for what is effectively stock-price manipulation.”
Stock buybacks divert profits away from value creation to value extraction.
Stock buybacks, according to Lazonick, yield a net disinvestment in productive capacity and innovation, excessive compensation for executives, windfall gains for shareholder activists, job destruction, declining real wages, income inequality and economic stagnation.
Most corporate profits are going to stock buybacks and shareholder dividends—91 percent for 449 companies in the S&P 500 Index between 2003 and 2012, according to Lazonick. That leaves very little for investment in long-term productive capacity or higher incomes for employees.
It has not always been this way.
From the end of World War II until the late 1970, major U.S. corporations used a retain-reinvest approach. “They retained earnings and reinvested them in increasing their capabilities, first and foremost in the employees who helped make firms more competitive. They provided workers with higher incomes and greater job security, thus contributing to equitable, stable economic growth.”
“This pattern began to break down in the late 1970s, giving way to a downsize-and-distribute regime of reducing costs and then distributing the freed-up cash to financial interests, particularly shareholders. By favoring value extraction over value creation, this approach has contributed to employment instability and income inequality.”
SEC regulations against stock buybacks were rolled back in 1982, during the Reagan administration, when the first Wall Street insider in 50 years headed the commission.
The argument for “value extraction” over “value creation” is based on a business philosophy of “maximizing shareholder value.” MSV is premised on the view that only shareholders make investments without a guaranteed return. By this view, shareholders bear the most of the risk and deserve most of the return. However, as Lazonick points out, most shareholders are merely investors in outstanding shares who can sell their stock when they want to lock in gains or minimize losses.
By contrast, “The people who truly invest in the productive capabilities of corporations are taxpayers and workers,” according to Lazonick.
Corporations rely on government investments in physical and social infrastructure. Corporate taxes are the returns on those investments to taxpayers. And workers, whose efforts generate productivity improvements, “have claims on profits that are at least as strong as shareholders’.”
To encourage a retain-reinvest approach that promotes long-term investment and shares prosperity, Lazonick recommends (1) ending open-market stock buybacks, (2) basing bonuses for executives on criteria that reflect investment in innovative capabilities, not stock performance, and (3) changing corporate boards to include taxpayers and employees.
He says, “It’s time for the U.S. corporate governance system to enter the 21st century.”
By Mike Brown. Contact Mike at firstname.lastname@example.org.