The hot new investment strategy on Wall Street these days is to go activist, but what those activists do once they go after their targets could be slowly killing the companies they invest in.
It looks like this: A hedge fund manager buys a significant stake in a company, gets their people on the board, and then puts their plan to make things better into action.
The problem is when this “plan” is just forcing the company to use its cash to buy back stock, according to a study by professors Edward P. Swanson and Harrison Liu at the University of Texas.
This is what Carl Icahn is asking Apple to do, for example. And what Dan Loeb wants to see at Sotheby’s.
A share buyback will give a company’s stock a quick bounce as demand for the stock increases, but after the bump, you (the shareholder) may want to bounce.
Why? Because it’s very likely that stock bump is just a way for the company to look healthy while it’s not innovating and/or its fundamental business is flawed.
Right before the financial crisis, banks like Merril Lynch and Lehman Brothers were buying back their stock in order to support its price. Internet companies were doing it right before the dot.com bubble burst too.
Warren Buffett has talked about this before, for what it’s worth, and here’s what Swanson and Liu have to say about it:
A pattern of high corporate repurchases at market peaks suggests that companies may be using repurchases to support overvalued equity. Our study investigates this possibility. Warren Buffett in his 2000 Berkshire letter states: “repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price.”
Swanson and Liu also point out that companies aren’t that great at picking the time when they should buy their stock. That’s only logical if companies are buying back stock to make it appear as if everything is fine when it’s really not — i.e. Lehman.
Even if imminent disaster is not the case, though, a share buyback can deplete a company of cash that it should be spending on investing in itself — on developing or streamlining its business. Ultimately, that hurts the long term performance of the company and the stock price that the C-suite and/or investors are trying to support.
Swanson and Liu write:
Our evidence shows that companies reduce long-term shareholder value by repurchasing stock to support a high price, and short interest can be used by investors to identify such firms.
That bit about the short-sellers is why you may see the Jim Chanos’ of the world circling around these companies. They see the buyback, ignore the inflated stock price, and look at the fundamentals.
Chanos told the WSJ:
“Corporate CEOs, with their massive share-buyback programs are in effect investing in the stock market rather than in expanding business opportunities at their companies. Either they expect higher returns from the market, or lower returns in their business, or some combination of both. Given their questionable track record in timing the market, this may be a cause for concern.”
One has to wonder if activist investors have any better timing than corporate CEOs — because on today’s Wall Street, sometimes it’s not corporate, but the corporate raider who decides when it’s time to buyback shares.
Business Insider Emails & Alerts
Site highlights each day to your inbox.