Pending infrastructure legislation is currently wreaking havoc on Congress. Disagreements on everything from the price tag to the specifics of certain programs have stalled the two promised bills for months now. Regardless of the final cost: new funding will be required for this initiative, and the authors of the initial bills are looking at new attack surfaces for taxing businesses. One of the proposed taxes by some in Congress is a 2% tax on money that companies use to buy back their own stock.

This raises the question – why would a company buy back its stock? Do I want to own shares of an organization that is buying back shares?

Share buybacks refer to a company opening its wallet, going out into the market, and buying its own shares. Really, it is that simple – in this case, the name tells you most of what you need to know. The crucial step in a share buyback is that once the share is purchased, it is then retired. While this may seem silly at first glance, it is an extremely powerful tool in management’s repertoire.

The goal of initiating a buyback is to return capital (in this case, basically cash) to shareholders. It can serve a similar purpose to a dividend, in which a company sends shareholders some cash once a quarter. However, there is a nasty problem at the heart of dividends – they are effectively taxed twice. Dividends are not a deductible expense, and therefore companies must use after-tax dollars to pay them. Once the investor receives the dividend, the dividend is once again taxed similarly as either a capital gain or ordinary income.

Let’s do some quick math: the current average corporate tax rate is about 25%, and the top tax rate on qualified dividend payments is 20%. This means that $0.40 of a pre-tax dollar destined for dividends will be spent on tax and that $0.15 of that $0.40 is paid directly by investors.

Share buybacks also allow for capital to be returned to shareholders, but only those who are ready and willing to take the hit from capital gains taxes. Although companies must still use after-tax dollars for share buybacks—buybacks can be opportunistic.  As an investor, I am under no obligation to sell my shares back to the company, meaning that I do not need to take the capital gains hit. I can wait until I have an opportunity to cancel out those gains with other losses, or I could hold them for my entire life until the eventual step-up at death.

Does this mean that I am missing out on the return of capital? Not at all. Consider the following – in 2010, O’Reilly Automotive (ORLY) had 141 million shares outstanding. At the end of 2020, ORLY had only 71 million shares outstanding. If you held 100 shares of ORLY for those 10 years, your ownership stake in ORLY effectively doubled, as existing shares were snapped up by ORLY itself. Had ORLY not cut its share count in half over that period, 1 share of the common stock would have increased in value by about 275% over the period. However, driven by buybacks, 1 share of ORLY purchased on 12/31/2010 appreciated by an excellent 649% over the following 10 years. Excluding any growth in earnings, an investor in ORLY over that period realized a 100% gain without ever owing a cent in capital gains tax along the way. Of course, one day, the shares will likely be sold, and on that day an investor would incur capital gains. That tax would be at an investor’s discretion rather than an arbitrary quarterly schedule.

So why are companies willing to spend so much to buy back their stock: for the same reason they issue dividends.  Most companies, particularly the largest and most dominant, will reach a point where they have run out of profitable growth opportunities. Consider Apple – it is a lot harder for Apple to grow revenue by 1% now than it was in 2008 when the iPhone was an exciting new product. It is still possible, but after a point, it becomes very costly. It is the mark of a world-class CEO to realize the point at which growth investments are no longer profitable compared to paying a dividend or buying back stock, and to then act on this realization by aggressively investing in ways to return capital to its shareholders.

In this regard, Tim Cook is certainly a world-class CEO – in the last 10 years, he has led Apple in repurchasing $423 billion of its stock. At the end of 2020, Apple had $90 billion in cash on its balance sheet – cash that was not being put to use in investments and was decreasing in value as a result of inflation. I am sure that investors are glad it was instead used to increase the value of their existing shares – and for those who have sold shares along the way, for the increased value at which they were able to sell.

Let’s now circle back to the question of funding infrastructure bills through tax increases on buybacks. Proponents of the plan argue that it would raise $100 billion in tax revenue over the next 10 years.  This argument hinges on the assumption that companies would continue to spend this amount on buybacks. If it suddenly becomes more expensive to repurchase shares, firms may do so far less often, reducing the tax revenue raised.  Stock buybacks could essentially become triple-taxed: cash flow that is taxed at the corporate tax rate, a 2% buyback charge, and finally a capital gains tax when the shareholder sells.

As with the example of Tim Cook, it takes an exemplary CEO to avoid investing in growth just for the sake of spending excess cash. Firms are acting in an extremely shareholder-friendly fashion when they return capital to shareholders—capital that would otherwise remain on a balance sheet serving no purpose, or be potentially used for unfruitful investments. Proponents of taxing buybacks are often also the parties that critical of corporate waste, although a buyback tax could in effect lead to more corporate waste.

At Beese Fulmer, we aim to buy shareholder-friendly companies for our clients, and we view stock buybacks as one of the friendliest things a CEO can do. We recently performed several studies on the performance of shareholder-friendly companies in our portfolios and the S&P 500. Based on a series of metrics, including share buybacks, companies in our portfolios are far more shareholder-friendly than those in the overall market. We ranked the S&P 500 constituents by their shareholder friendliness, then sorted them into equal-sized buckets, ranging from most to least friendly. In the average portfolio, 62% of holdings are in the friendliest segments, 28% are in the middle segment, and only 10% are in the least-friendly. We believe that this is a long-term investable trend – when a management team decides to buy and retire their stock, this indicates prudent, competent, and selfless decision-making. Political pundits make the contradictory case that taxing buybacks will boost tax revenue while incentivizing investments into the “real American economy.” Surplus cash on the balance sheets of the globe’s biggest firms, which is likely to happen in the event of a buyback tax, is not favorable over more cash flowing to the retirement and savings accounts.   

Sources: Factset, S&P Global, Bloomberg LP, WSJ