3 Ways Stock Buybacks Hurt Investors

<b class="credit">David Paul Morris/Bloomberg </b>Last year Oracle decided to put aside an additional $10 billion for stock buybacks, which will help make CEO Larry Ellison's options more lucrative for 2013.
David Paul Morris/Bloomberg Last year Oracle decided to put aside an additional $10 billion for stock buybacks, which will help make CEO Larry Ellison's options more lucrative for 2013.

Walmart's (WMT) new $15 billion stock repurchase plan may be popular among shareholders. But this method of returning money to shareholders has its downsides. Here are three that investors should consider before celebrating any company's buyback plan.

1. They increase insiders' power. Just as buybacks increase your ownership stake in the company, they also increase the ownership stakes of insiders like the Waltons, whose slice of Walmart's outstanding shares has grown from 38 percent in 1992 to just over 50 percent today, largely due to buybacks.

Now that the Waltons own more than half the company, they have control over all matters submitted to shareholders for a vote, including board member elections and shareholder proposals.

We don't have to look far to find areas of disagreement between insiders and average outside shareholders. The Wall Street Journal reports that the Waltons voted for all board members in the most recent shareholder vote. However, this vote of confidence in the company's top brass does not appear to reflect the feelings of other shareholders.

Twelve percent of non-Walton shareholders voted against board nominee CEO Mike Duke; 12 percent cast ballots in opposition to audit committee chair Christopher Williams, and 10 percent voted against board chair Robson Walton.

While these votes still represent a minority of outside shareholders, it highlights that insiders and average outside shareholders at Walmart can have substantially different views about how the company should be run. And in this case, the outside votes could have no impact on the board makeup.

2. Buybacks can help even the most poorly performing CEOs score huge paydays. That's because many CEOs receive equity in the form of restricted stock units (RSUs) and/or fixed-price stock options as part of their yearly compensation packages.

RSUs are shares that are held in treasury by the company until they vest (that is, until the employee gains nonforfeitable rights to claim them). Fixed-price stock options allow the owner to purchase the underlying stock at a specified price at some later date. The price of an option is pegged to the price of the underlying stock. So as the stock price goes up, the value of the option goes up.

In both cases, CEOs will get more money if the company repurchases stock than if it increases its dividend.

Why? Buybacks push up the stock price (because the number of shares outstanding are reduced), which is what CEOs need to happen if they want to get the most out of their equity packages. Dividend increases, on the other hand, will do little to increase the value of RSUs and options because they have little effect on the price of the underlying stock, and because RSUs and options do not entitle the owner to collect dividends.

As investing guru Warren Buffett points out, "every dime paid out in dividends reduces the value of all outstanding options." Thus, increasing dividend payouts would actually decrease the value of a CEO's stock options -- giving executives a tremendous incentive to push buybacks over dividend increases even when dividend increases are better for shareholders.

Consider also Oracle (ORCL), whose CEO, Larry Ellison, was one of the highest-paid of 2012, and whose pay included 7 million stock options. Last year, Oracle decided to put aside an additional $10 billion for stock buybacks, which will help make Ellison's options even more lucrative.

3. Buyback announcements aren't binding. Companies have no legal requirement to follow through on the buybacks they've announced. Walmart also announced a $15 billion buyback program in 2011, and as of its annual meeting on June 6, 2013, it still needed to purchase an additional $712 million in shares to meet that commitment.

That doesn't mean Walmart will abandon the agreement now that it has announced its new buyback program. However, shareholders may do well to avoid counting their chickens before they hatch. Just last year JPMorgan Chase (JPM) abandoned a buyback program it had announced two months prior. Also, many companies abandoned their repurchase plans once the recession hit. Only when stock prices started to recover did they begin to repurchase shares.

You Decide
Despite these potential downsides of stock repurchasing programs, they aren't necessarily always a bad thing. As Buffet notes, "continuing shareholders are hurt unless shares are purchased below intrinsic value." Arguably, many CEOs get the timing wrong and make poor use of company funds by buying back shares when they are already overvalued, and using them to promote personal goals not shared by average investors.

For these reasons, it's best to examine buyback announcements according to the circumstances of each company and its management, and not to judge them as unqualified goods.

Do you think Walmart's buyback program is good for shareholders? Chime in below!

Motley Fool Contributor M. Joy Hayes, Ph.D. (@JoyofEthics), is the Principal at ethics consulting firm Courageous Ethics. She has no positions in any of the stocks mentioned. The Motley Fool owns shares of JPMorgan Chase and Oracle.