Tax Reform Causes a Wave of Stock Buybacks. Here’s How Investors Benefit.

With a lower repatriation tax rate, the new Tax Cut and Jobs Act encourages companies to bring upwards of $2.5 trillion of offshore capital back to the U.S. — and company executives and boardrooms are developing allocation plans to put this fresh capital to work. To wit: There’s discussion of Apple doing just that with the $250 billion it’s bringing back home. While many companies will opt to increase dividend payouts, increase capital expenditures and pay down debt, some will respond by increasing stock buybacks.

Over the past decade, companies have poured approximately $4 trillion into buybacks, reducing share count and contributing to the historic rise in stock prices. While stock buybacks help lift the market, shareholders should ask themselves if the price appreciation has been worth the cost in lost capital.

A common trap for investors is to confuse the value created by returning cash to shareholders (i.e. price appreciation) with the long-term value that could have been created by investing that capital in new product development and operational improvements.

There is a dark side to stock buybacks that most investors don’t realize. Put simply, buybacks are a form of financial engineering. Because buybacks reduce the number of outstanding shares, executives use them to make earnings “look better” by spreading earnings over fewer shares. This creates the illusion that earnings are rising, when in reality they may not have changed.

Even worse, for companies that continue to issue new shares in employee stock plans, share buybacks are akin to flushing the capital down the drain, because they shift cash off the companies’ balance sheet and into the hands of executives. Here’s how it works: Executives sell held stock to the company, engineered earnings rise enough to allow them to meet performance hurdles, and the company’s board grants the executives more shares. Even though they sold their stock in the buyback, the new grants allow executives to maintain their ownership position. As a result, a significant portion of the buyback capital never permanently reduces the share count.