Buying a Lack of Ideas

Corporations continue to announce stock buybacks. The premise for such efforts center around a simple piece of logic. Through a stock buyback, a company attempts to lift its stock price because fewer shares exist to trade. In the abstract, the idea works. In the reality, the idea fails because a firm is signaling that it lacks better, strategic alternatives. Co-head of asset allocation at investment-management firm GMO, Ben Inker gives the money signal:

Corporate profits are very high, but corporations are not expecting a huge burst of growth. Given that they’re not expecting a lot of growth, there isn’t a lot of reason to invest. So they’re finding ways of getting money back to shareholders.

The corporate buyback rarely if ever lifts the share price despite the overly seductive simple logic of supply and demand. Instead of the theory of perfect competition, consider Signaling Theory as the explanatory theory.

Michael Spence argued for the receivers of a signal consider what the behavior does and does not state. For example, a person with a Harvard degree signals that he or she was smart enough to gain admission into and complete  a bachelor's degree from Harvard. The signal is that this person is smarter and/or more intelligent  than the people who did not gain admission to Harvard as well was the people who did not complete their degree from Harvard.

Signaling Theory explains the lack of an increase in share price in a stock buyback scenario because the action signals to investors that the senior management has run out of strategic alternatives. That is, senior management looked at its Ansoff matrix and decided that the best use of the firm's cash was to buyback its stock, and not invest in new products, customers, or markets. Taken to its extreme, a leverage buyout represents the next and final step of a stock buyback.

So, beware Apple, CarMax, Krispy Kreme, and almost every large bank holding company. Their senior management has no ideas as signaled through the announced stock buyback.

Signaling Theory Presentation