On October 25, 2016, members of the Lead Director Network (“LDN”) met to discuss capital return to stockholders. King & Spalding and Tapestry Networks published a ViewPoints report that provides a summary of the discussion at the meeting.
LDN members discussed the following four topics: (1) the pressure on directors to buy back shares, (2) the determination of directors to resist pressure for excessive buybacks, (3) directors finding strategies for managing internal and external pressure to buy back shares, and (4) the circumstances in which a company should repurchase its shares.
Highlights of the meeting are as follows:
LDN Members feel the pressure to buy back shares
LDN members confirmed that they have experienced considerable pressure from investors and management to buy back shares. One director noted calls from investors, especially activists, to return cash and stated: “If you have too much cash, you’re a target.”
Some leaders of investment companies have emphasized the importance of a long-term focus for CEOs and boards. But LDN members viewed this with some skepticism, citing incentives that impact not only activists but also larger institutional investors. As one member explained: “There’s a difference between what Larry Fink [the CEO of BlackRock] says and what his fund managers do.”
Lead directors acknowledged that shifting investment horizons toward the long term is not as straightforward as some would assert. Several directors said that projections of returns on both organic growth and acquisitions have proven unreliable. In an environment of global political uncertainty, slow growth, and depressed profits, boards are examining investment proposals with deeper scrutiny than ever. One director summarized the inhibitive effects of the current climate and said: “We’ve become risk-averse. It’s hard to measure the value of M&A and capital expenditures.”
Lead Directors are determined to resist pressure for excessive buybacks
Despite an uncertain investment environment and strong outside pressure to return capital to shareholders, LDN members were determined to avoid buybacks that could be counterproductive for their companies. They discussed several reasons for proceeding with caution on a buyback proposal.
Although buybacks are somewhat more flexible than dividends, members observed that they have to be sustained if they are to create any value. As one member explained: “Announcing a buyback program is actually a big commitment. If you announce and then then don’t buy back, you get pressure from analysts. So you tend to buy back. We sometimes buy above the yearly average, but it worked because we continued to do it. We didn’t get credit in the first few years. Only in the last three years has the multiple gone up – it’s finally built in.”
Another concern for members was that buyback programs can leave companies unable to respond to value-creating investment opportunities. One member said, “There’s been a number of companies that had strong cash positions and used them for buybacks, then went into a period when they really could have used the cash. They capitulated to the pressure.”
Directors find strategies for managing internal and external pressure
Directors described the following three ways in which they have managed biases for capital return: (a) broadening the search for investment opportunities, (b) communicating the company strategy, and (c) adjusting compensation programs.
Broadening the search for investment opportunities
Members discussed doubling down on the issue of investment opportunities in strategy discussions. One member said: “Most boards invest a lot of time on strategy. How is the management team looking at opportunities? What are their aspirations? It would be a concerning sign for board members if there’s not a lot of ideas for investment. You could see it in R&D.”
Directors also mentioned having management or board committees that identify and evaluate investment opportunities. One director described overseeing the work of a management committee: “There’s a committee that vets opportunities. The board sees specific cases as they come forward. But once a year, we ask to see the ones that didn’t come forward. We want to see the magnitude. We want to see if there’s some we want to pull forward.”
Communicating the company strategy
Once the company has developed its investment strategy, the board must ensure that it is communicated in a way that reduces pressure for excessive buybacks. Investors need to understand how investments will create value and how long it might take for returns to materialize.
“It’s incumbent on us that the executive team is really getting the story out there,” asserted a lead director. “They need to explain that ‘this is what you can expect.’ So when investors come to you two years later, you can push back.” The member noted that investors want this kind of information: “Most investors want to understand your intentions. You have to provide a reasonable amount of information. If they disagree, they should go somewhere else.”
Adjusting compensation programs
Some compensation plans for the CEO and other top managers can also create a bias against buybacks. If a CEO’s bonus is tied to increases in earnings per share (EPS), she or he has a clear incentive to reduce the number of shares outstanding. Several members noted that their firms remove the effects of buybacks from bonus calculations.
Investors, as well as directors, have worried that buybacks can result in unjust enrichment for senior managers. In response, a few companies, such as FedEx, IBM, and Johnson & Johnson, have enhanced disclosures, stating that they adjust performance metrics to take into account the potential effect of buybacks.
Circumstances in which a company should repurchase its shares
LDN members did not categorically rule out buybacks and noted the following circumstances in which a company should repurchase its shares:
When all worthwhile investments in the growth and maintenance of the business have been made, cash that remains should be handed over to shareholders. This can be accomplished through dividends, but members preferred the greater flexibility afforded by buybacks, which can be scaled back, if necessary, without provoking investor ire. As one member explained, “In a volatile business, dividends are risky. You don’t want to cut the dividend. A buyback is a way of providing a return when the business is more robust.”
Low share price
If a company deems that the intrinsic value of its shares is greater than their market value, buying the shares back may be a worthwhile investment. A key issue, though, is how confident a board can be in its assessment that the stock is undervalued. In a pre-meeting conversation, one member said, “Nobody knows the business better than the board and the executive team.” But others were more skeptical. A member said: “One question I always ask is, how do we know it’s undervalued? Compared to what?”
Dilution of shares driven by executive compensation
A member who generally did not view buybacks favorably said, “Executive compensation often includes stock and option grants, which could end up diluting shareholders, so I can see covering this dilution.”
Ultimately, the decision to initiate a buyback depends on the particulars of a company’s situation. One member explained, “It’s unique to each circumstance. We’re in the middle of a buyback. We have a lot of excess capital. We’re generating a lot of cash. We’re measured on return on capital. We’re also trading at a discount. You put all the circumstances together, and it makes sense.” The member added that the company’s management and board didn’t find compelling alternative uses for the capital at the moment: “We would have to do a monster acquisition, which has its own set of execution risks.”