Thursday, March 24, 2011

Share Buybacks, Dividends, and Inefficiency Caused by Government Regulation

One of my axioms is that, behind any incongruous anomaly in the markets, there is usually some government regulation or intervention causing it.

For example, why do so many people drive SUVs? Why, because of Section 179 of the United States Internal Revenue Code, which allows a taxpayer to deduct the cost of a vehicle weighting more than 6,000 pounds gross vehicle weight as an expense, rather than requiring the cost to be capitalized and depreciated over time.

I have been studying share buybacks because of my micro-capitalization value investments like Conrad Industries. Apparently, as recently as three or four decades ago, companies in the US were wary of buying back their own shares because this could be considered illegal price manipulation.

However, the SEC established a safe harbor for stock buybacks called Rule 10b-18, which provides a safe harbor for purchases on a given day. The rule has manner, timing, price, and volume conditions that a company must satisfy when repurchasing its own stock in the market.

  • The manner of purchase condition requires an issuer to use a single broker or dealer per day to bid for or purchase its common stock.
  • The timing condition excludes from the safe harbor purchases at the opening and during the last half hour of trading because market activity at such times is considered to be a significant indicator of the direction of trading, the strength of demand, and the current market value of the security. Therefore, where there is no independent opening transaction on a given trading day, the issuer is precluded from making purchases under the safe harbor for that day.
  • The price condition is intended to prevent the issuer from leading the market for the security through its repurchases by limiting the issuer to bidding for or buying its security at a price that is no higher than the highest independent published bid or last independent transaction price.
  • Under the current volume condition, an issuer may effect daily purchases in an amount up to 25 percent of the average daily trading volume in its shares (the "25% volume limitation").
If you look at the trading history for CNRD, you can see there are days when the stock doesn't trade at all. So, the company cannot use any of its massive cash horde to repurchase its own stock on those days.

Share repurchases are more advantageous for shareholders than dividends, due to the disparate tax treatment. I read a study which said that "one year after the approval of Rule 10b-18, the aggregate amount of cash spent on share repurchase programs tripled."

Here's an interesting argument though, that may explain why share buybacks don't appeal to value investors as much as dividends: "[I]f - for whatever reason- managers are more reluctant to cut dividends than to cancel repurchase programs, then it can be argued that dividends may be a better controlling device than repurchases because they represent a stronger commitment (in the same way that debt is a stronger commitment device than dividends.)"

Truth be told, there is more than government regulation behind the odd capital allocation decisions (or, lack of decisions) at these micro-cap value companies. Most of the time, it seems to reflect extreme management conservatism.

2 comments:

kj said...

There are very few SUV's that weigh more than 6000 lbs (especially the popular ones), so certainly not "why" people drive SUV's.

C. Fischer said...

CP,

KJ is right, none (or very few) of those vehicles weigh over 6000 pounds - at least empty. But they can be loaded over that, and that is the qualifier for business expensing.

But you're wrong if you think this "is the reason people drive SUV's." The law only applies to businesses and purchase or lease cars through the businesses.

And even for those people, it amounts to an accelerated depreciation (all in year 1) versus spreading it out over 5 years. So the tax break amounts an NPV problem of 80% of the car costs.

Many of these businesses that need trucks (F-150's,etc.) would have to buy them anyhow to get their job done. So we're really talking about business owners that may decide to drive a luxury SUV because they want to write it off and year one. What percentage of total SUV sales do you really think this is?