Now that the class-action sharks have begun to notice the juicy potential of the trillion-dollar corporate buyback fraud, its time to carefully evaluate their chances of winning.

All it will take is one highly-publicized successful suit with billion dollar damages to convince corporate executives of the error of their ways, sending tort lawyers into a feeding frenzy, reducing corporate buybacks, and crashing the market.

In “Stock Buybacks, Dividend Equivalency, and Securities Fraud“, the flaws in the “stock-buybacks-are-just-a-form-of-dividends” argument were exposed.

Here I discuss the quid-pro-quo offered to shareholders in lieu of dividends — the sop proferred to those who don’t sell into a buyback: the highly-touted advantage of “increased earnings-per-share“.

After a Buyback, Will Your Stock Really Be Worth More?

The fast-talking con men who cook up buyback schemes tell naïve investors:

“Stock buybacks are a more efficient form of dividends, but if you don’t want to sell us your shares, you’ll still benefit: your earnings-per-share will increase and your stock will be worth more.”

Surprisingly, millions seem to be taken in by this line, including SEC commissioners, professors at leading business schools, editors of financial newspapers, and certified financial analysts.

So slick is the Great EPS Scam that only those who really spend time and stress their brains to think about it, escape being fooled.

The EPS Scam and Three-Card Monte

	Can you pick out the joker?

Three-card Monte is a time-honored, street-corner con game the uses misdirection, sleight of hand, and shills to separate victims from their money.

The Great EPS Scam is a similar con game, using Wall Street ‘experts’ as shills to distract investors with promises of “enhanced EPS“, while corporate flim flam artists misdirect billions of shareholder money into their own pockets through the artifice of stock options.

The key to this scam is the suggestion that higher earnings-per-share somehow benefit shareholders. The argument is that, as a result of the stock buyback, the number of shares will decline, while earnings will stay the same (or increase): therefore, earnings per share for the non-selling shareholders will go up!

Of course, there is a much simpler and far less costly way of increasing earnings-per-share (if this were indeed something good in itself). A company can simply do a reverse stock split: substituting every ten shares with five shares (for example). Earnings per share will automatically increase and the company will not have to distribute cash to only some shareholders in order to achieve this “benefit”.

The EPS Scam also involves an implied ‘forward looking statement’ about earnings. The fact that historical earnings per share increase as the result of a buyback should be irrelevant to shareholders; it’s future earnings that count.

The buyback con artists are therefore saying or implying that future earnings will stay the same or increase — despite the drain on corporate finances related to the cash and borrowings needed to pay for the buyback.

Conned Professors

It is not difficult to find finance professors at famous universities who have gone on record endorsing the EPS Scam.

	Let's get rid of that excess blood ...

They equate increased earnings-per-share, with increased intrinsic value for the entire company, disregarding the cost of the cash “bloodletting” that stock buybacks entail.

In this they resemble medieval sorcerers, extracting blood from patients to bring body humors into balance. Does a company really benefit from having less cash? How can financial solvency be improved by giving away money? What about reserves for bad years?

If you think about it, you’ll realize that increased EPS does not necessarily mean increased intrinsic value for the whole company. For example, a reverse stock split increases EPS without improving corporate intrinsic value one iota.

See: “The Boeing Buyback” essay for a case showing flaws in the “buybacks-are-good-for-shareholders” argument.

Increasing Earnings Per Share Without Costly Buybacks

Now, I’m not one to suggest the increased earnings per share, taken out of context, are necessarily good for shareholders. However, if for some reason corporate executives want to increase earnings per share, they can, as suggested above, do a reverse stock split.

Because most US stocks are held in book-entry form, brokers and custodians can effect reverse stock splits by changing a few lines of computer instructions.

The fact that some investors will end up with fractional shares is no big deal: fractional shares are an essential element in the operations of money market mutual funds and dividend reinvestment schemes. With most brokers, it is no longer necessary to go to an odd-lot market to sell fractional shares. (Charles Schwab, for example, handles sales of fractional shares for clients at no extra cost, and pays proportionate dividends on fractional shares.).

If corporate executives were honest and sincerely wanted to distribute excess cash fairly to shareholders, while increasing earnings per share, all that would be necessary would be to pay a regular dividend in lieu of a buyback, while doing a reverse stock split.

But obviously, that would defeat the purpose of the Great Buyback Fraud: to divert corporate cash into the pockets of executives by means of stock options.

A Simple Test For Your Investment Advisor

If you wonder how smart your investment advisor really is (despite all those letters after his or her name), just ask about the advantages of stock buybacks.

If your advisor gives you the “increased EPS is good for you” line, you know that you’re facing either a shill for buyback con men, or a victim of the “EPS mushy brain syndrome” that has infected such a large part of the financial community.

See: “The Great Misleading” for bogus arguments in favor of buybacks.

The Efficient Market Hypothesis continues to impede understanding of how capital markets work.

The front-page article in the WSJ of June 12, 2020, announcing record levels of stock buybacks, continued to promote a common misperception that stock repurchases enhance equity prices by the following mechanism:

1. By reducing the number of shares outstanding through buybacks, earnings per share increase;

2. Investors, noting this increase in earnings per share, are willing to pay higher prices;

3. Therefore, buybacks. by increasing earnings per share, cause prices to rise.

This, of course, is in line with the Efficient Market Hypothesis, and depends upon the assumption that increasing earnings per share improves intrinsic value and that a crowd of rational, competing, profit-maximizers will therefore force prices upwards.

Ignoring the Evidence

The popular line of reasoning of the WSJ ignored Federal Reserve flow of funds accounts that showed that something far removed from the Efficient Market Hypothesis was driving the market in Q1 2006:

1. Corporations were spending vast sums (more than $146.7 billion) to take stocks off the market with the intent of directly manipulating prices upwards;
2. Individual, sophisticated investors, dealing in specific stocks, were not bidding up prices because of enhanced earnings-per-share, but rather were selling out on a grand scale ($216.6 billion) — cashing in their stock options;
3. Unsophisticated investors (according to surveys by the Investment Company Institute) were naively buying ’stocks for the long run’ through automatic payroll deductions channeled to tax-deferred mutual funds, with no perception, whatsoever, of changes in earnings-per-share of individual securities.

The WSJ interpretation of the record level of buybacks, supported by the Efficient Market Hypothesis, puts a spin on events that is far kinder to corporate executives, stock brokers, and option exercisers, than the unvarnished truth that prices were supported not by improved earnings per share and crowds of rational investors seeking ‘intrinsic value’, but rather by the brute force of $146.7 billion in corporate cash being applied to take stocks off the market from option holders, many of whom were the same executives ordering the buybacks.

Furthermore, what was going on in Q1 2006 was not some random event — mere noise in the market — but rather the continuation of a long-standing pattern of behavior involving corporations, option-holders, and mutual fund investors that has been going on for many, many years.

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Long-term investors in equities continued to be disadvantaged by corporate executives who favored stock buybacks over cash dividends.

If it were not for the practice of distributing earnings as buybacks, instead of as dividends, dividends could have been increased by 176% which would have been greatly to the advantage of long-term investors, rather than speculators, fund managers, stockbrokers, and hired professional executives.

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