Stock buybacks have become a popular way for banks to return capital to shareholders, but at least one high-profile analyst believes this should stop.
"Banking companies should never buy back stock," Richard Bove of Rafferty Capital Markets told me on Monday. This applies equally to banks such as Bank of America (NYSE:BAC) and Citigroup (NYSE:C), shares of which are trading for 40% discounts to their book values, as it does to Wells Fargo (NYSE:WFC), which is trading for a 50% premium to its book value.
In a research note issued earlier on Monday, Bove listed multiple reasons he believes stock buybacks are harmful to banks, including:
- Buybacks by banks have historically destroyed shareholder value. "The recent travesty of the huge buybacks in 2007 followed by the just as huge stock issuances in 2008 to 2010 indicates the peril of stock buybacks in a cyclical industry," Bove writes. "The companies are buying back at the high and selling at the low."
- Stock repurchases consume funds that could otherwise be invested in the business. "Assuming the cash is not being used for any productive purpose, implies that there is something wrong with the company's business model -- i.e., the bank cannot find a positive use for its funds," says Bove.
- Along similar lines, whereas reinvesting the funds back into a bank's business would increase revenue, buying back stock will not. This is particularly important right now, given the negative impact on revenue from ultralow interest rates.
- Because banks operate with so much leverage, the equity used to buy back stock is necessarily displaced on a bank's balance sheet by debt, which increases a bank's costs of funds.
- Finally, buying back stock reduces common equity, which thereby reduces the amount of leverage banks can use and thus lowers their secular growth rate.
It's hard to deny that Bove has a point. In an almost comical sequence of events in the years before the crisis, Bank of America spent $40 billion on buybacks only to then have to raise roughly the same amount of capital after the crisis took hold. As I recounted in 2013:
There are few companies that have destroyed more shareholder value through share buybacks over the last few years than Bank of America.
Between 2003 and 2007, it repurchased a little over 768 million shares of its common stock at an average price of $52.05 per share, equating to a grand total of just under $40 billion.
A year and a half later, the Federal Reserve ordered it to raise $33.9 billion in new capital "in order to weather two years of the most severe economic circumstance."
It did so, and then some, by issuing 3.5 billion new shares in 2009 at an average price of $13.47 per share for a grand total of $47.5 billion.
That's what you call buying high and selling low. As a result of these operations, Bank of America's shareholders found their ownership interests diluted by a factor of two.
Citigroup suffered a nearly identical fate. It repurchased $41 billion worth of its stock at sky-high multiples to book value in the decade preceding the crisis, only to then issue new stock during the crisis at enormous discounts to book value. Aside from an egregious lapse in risk management, this is the reason Citigroup's shares are still 90% below their pre-crisis peak.
The theoretical benefits to buybacks
Viewed in this light, Bove has a point that banks should stop buying back stock. At the same time, however, it's worth noting that there are important theoretical benefits stemming from the practice that would be lost if banks did away with buybacks altogether.
In the first case, buybacks give banks a more flexible avenue than dividends to return capital to shareholders. When banks cut their dividends to retain capital, it signals that something is amiss, which could send their share prices plummeting and lead to withdrawals of institutional deposits. The same isn't true of buybacks, which are often increased or decreased with little fanfare. This is why the Federal Reserve favors buybacks over dividends when grading bank capital plans in its annual comprehensive capital analysis and review process.
Using buybacks to distribute capital to shareholders also reduces a bank's incentive to take imprudent risks. If a bank were to retain the capital instead of using it to repurchase stock, that would drive down its return on common equity. To offset this, a bank would be incentivized to drop lending standards in order to increase the yield on its asset portfolio. This is why executives at U.S. Bancorp (NYSE:USB) and M&T Bank (NYSE:MTB), two of the best-run banks in the country, have emphasized to me in the past the importance of using buybacks to remove excess equity from their balance sheets.
Finally, it's worth noting that the companies outside the bank industry that have produced the best shareholder returns since World War II have almost all used buybacks to catalyze value creation, as William Thorndike notes in his excellent book The Outsiders. The "Babe Ruth of repurchases," Thorndike says, was the late Henry Singleton, founder and CEO of the 1960s-era conglomerate Teledyne. Over the course of his 27-year tenure, Singleton bought back 90% of Teledyne's stock, yielding a 42% compound annual return on the buybacks alone.
The practical roadblocks to successful bank buybacks
Theoretically speaking, then, it seems like buybacks give banks an important tool to boost shareholder value. But the problem is that, as Yogi Berra once proclaimed, "In theory, there is no difference between practice and theory. In practice, there is."
The issue for banks is that the merciless nature of the credit cycle combined with the extreme leverage innate in bank business models all but eliminates the possibility that they can use buybacks as effectively as the CEOs profiled in Thorndike's book. This follows from the simple fact that bank stocks tend to be cheap, and thus a good value at which to buy back stock, at the same time banks need to retain capital. Generally speaking, in other words, the only time banks can repurchase stock in sufficient quantity to benefit shareholders is when their stocks trade for high multiples.
This is the case with Wells Fargo right now, which recently announced it could buy back as much as $17.5 billion worth of stock even though its shares trade for a substantial premium to book value. It's also the case for Bank of America and Citigroup. While their stocks are cheap right now, trading for meaningful discounts to their book values, the Federal Reserve has strictly constrained how much capital the two banks can return to shareholders.
It's a catch-22 that seems impossible for all but the best-run banks such as U.S. Bancorp and M&T Bank to overcome. Consequently, while there is no possibility banks will heed Bove's call to stop buying back stock, he's clearly onto something anyway.