Buyback Bubble

"And with the surplus cash, we'd implement a major stock repurchase. So Trask is protected and their stock goes up, and everybody's happy. Or not."
--Tess McGill (Working Girl)

Not sure there is a more perverse incentive program than incentive stock options (ISOs). The thinking behind ISOs is that they help solve the agency problem. Managers are hired agents who may have different objectives from the owning principals. Because owners would like to see their share prices increase over time, then why not get the hired agents on the same page by offering them stock options, and rewarding them when they act in manners that get share prices higher?

The problem is that there are prudent and imprudent ways to boost share prices. Prudent approaches increase the intrinsic value of the firm over time. Smart investment in productivity-improving projects. Careful financial management. Product and process innovation. New market development.

But these things take time and capital--something that most agents (and many principals for that matter) don't have.

It can be a lot faster to boost share prices by imprudent means. A favorite approach currently is to borrow money on the cheap and use the proceeds to buy back shares. As shares are retired, there is less supply. With less supply, the price per remaining share should go higher. Both principals and agents are happy.

The problem, of course, is that stock prices become disconnected from the intrinsic, cash generating potential of companies and their shares. As long as credit is cheap and managers are rewarded via ISOs for boosting share price, there is no such thing as share prices that are too high to buy in.

Meanwhile, balance sheets get ever more levered...

Currently managers are borrowing money and buying in shares at all time stock market highs. Principals look at their monthly statements with glee. These ISOs really work, they conclude.

In reality, ISOs create a situation of mismanagement based on measurement. ISOs drive share prices higher for non-fundamental reasons. All are mesmerized by the rocket ride of price. What they can't see is overvalued shares and weakened balance sheets.

Welcome to the buyback bubble.