The problem with buybacks... and, with granting options to CEOs!

Peter Lynch -- an investor whose historical realized performance we should all be hoping to emulate! -- was just gaga about stock buybacks: i.e., he just loved being long companies who used some of their accumulated earnings to buy back some of their stock.  So, if I admire Lynch, and he was the hottest fan of buybacks... why am I so, overall, "meh" about owning stocks of firms that do a lot of buybacks...?

"Anno Domini", my dear sir... the eternal problem of time!-).  Lynch's great books, and great performance, are from the 1990's... it's now the 2010's, 20 years later.  Companies' management has had plenty of time to figure out that stock buybacks are "costly signals" to the market, and therefore ones with a lot of intrinsic credibility... but the cost, if any is to be paid, is not from their pockets, but, the shareholders'.  (Agent-principal issues potentially emerging again;-).

When a company buys back its own shares it clearly signals (costly, thus credibly) it believes shares are undervalued - contrarywise, stopping or delaying a buyback plan would signal it believes shares are fairy valued, or overvalued.  CEOs typically hold far more in ("call") options than in shares -- a terribly badly designed incentive that makes them participate fully to the upside, but not at all to the downside.

Let me expound simply on why options (vs, e.g., restricted stock) are a terrible way to provide incentives to top management.  Suppose you owned stock of ABC, currently trading for $100 a share. A certain move has 50% probability of moving ABC stock to $90, 50% probability of moving it to $110.  As a shareholder, would you like that move?

Surely not -- it leaves you with the same expected returns while increasing your volatility, AKA risk... a crazy tradeoff!  Normally, you'd demand higher expected returns to withstand an increase in risk (volatility).

But -- say you didn't own the stock itself, but a call option at strike 100 close to expiry.  What would you think of the 90-or-110 move now?

You should be all in favor -- going down from at-the-money 100, to out-of-the-money 90, for the underlying, doesn't decrease the value of your expiring options... it stays at 0 either way.  But, should the underlying soar to 110, you're making a 10% profit.  "heads I win, tails I break even" is a superb bet, so of course you'll just love such a move which increases risk but not (shareholders') expected returns!

If you give your firms' CEOs options (rather than restricted stock), you're giving them strong incentives to increase the stock's volatility.  Increasing future expected value would be great, too, of course... but, increasing risk with no increase in expected returns is clearly way easier... and by granting the CEO who works for you options rather than restricted stock, that (increase volatilily) is exactly the incentive you're giving him or her.

So that's problem #1 with buybacks (and acquisitions too): if they increase volatility but not expected returns, they're a great idea for your options-incented CEO... yet a bad bargain for you, the shareholder.

This is a general problem with giving top management options-centered bonuses.  Buybacks have more specific issues, too... but, I guess that's a theme for a future post!-)