Stock Buybacks and Innovation: An Analysis of the Effects of Share Repurchases on Research & Development Expenditures

Rates of stock buybacks have recently hit an all-time high, and have gained a lot of attention from both the business community and the mainstream media. A polarizing debate exists over whether or not stock buybacks are harmful to the economy, especially in the context of stagnant wages and rising income inequality throughout the United States. The primary goal of this research paper is to examine what effect stock buybacks have, if any, on the innovation of large multi-national corporations. The analytical framework uses logit regression and ordinary least squares regression analysis to add to the debate surrounding the effects of share repurchases. Results show that share repurchases are correlated with an increased likelihood that a given company will increase its research & development expenditure in the subsequent year following the repurchase. This can be likely attributed to correlation between large cash holdings and repurchases as well as between large cash holdings and the pursuit of new innovations. While results add to the literature by suggesting correlation between research & development increases and share repurchases, additional paths for future research are proposed. Part 1: Introduction In just 2018 there was over $1 trillion of stock buybacks, with over $460 billion of this concentrated in only 19 companies. Companies' use of stock buybacks as an addition or substitute to dividends is a trend that has been consistently increasing since the SEC's legalization of the practice in 1982. However, the profound increase in the use of stock buybacks, and its recent precipice in 2018, has led to a new height. This trend can be largely attributed to the large cash reserves of corporate behemoths, as well as the recent tax reforms. Furthermore, in an economy in which technological disruption has become more fast-paced and shareholder returns can be volatile, the use of buybacks as a vehicle for shareholder value that is more flexible than dividends has been gaining traction. The increased use of employee stock options as a compensation method has also been cited as a reason for the rise of the practice. While there exists a vibrant debate regarding the causes of stock buybacks and the intentions of companies that carry them out, one thing is clear: the increasing use of the practice has elicited polarizing responses. There are two main schools of thought surrounding stock buybacks: one which posits that they impede real value creation, and another which claims that buybacks are simply a healthy way for companies to reward shareholders, signal undervalued share prices, and manage debt. Those that argue against stock buybacks claim that that their extreme use is a form of market manipulation that creates short-term profits for rich investors and executives while impeding long-term growth of innovation, wages, and real investment (Lazonick, 2015). However, others hail the trend as indicative of healthy growth following the great recession and argue that the flexibility of stock buybacks in conveying value back to shareholders allows for more liquid and efficient financing (Chan et al., 2001). This debate has become increasingly important in our increasingly globalized economic system, especially in the context of a United States in which tens of millions of jobs have been offshored, wages have been stagnant for decades, and inequality is climbing to century-long highs. To contribute to the debate surrounding stock buybacks, my research objective is to examine the relationship between stock buybacks and innovation in the contemporary American economy. In order to do so, I will analyze the incentives for why companies engage in stock buybacks, as well as what the implications of the practice are for firms’ investment and research. This research question will be empirically tested using research & development expenditures as an indicator of innovation, examining whether companies that repurchase shares decrease their spending on research & development in periods following buybacks. In doing so, this paper will add to the literature by providing an analytical framework that helps inform the current debate surrounding the incentive structures around buybacks, as well as their practical implications for innovation in large multinational corporations. This paper is structured by first analyzing the current dialogue on the topic to contextualize the research question, and then setting up the empirical framework for an analysis between buybacks and R&D. Setting up and analyzing the empirical framework, results are analyzed and discussed. Study limitations and potential questions for future research are included in the conclusion. Part 2: Literature Review This literature review consists of several key sections, which serve to first introduce the reasons that companies have for buying back stock as the link between stock buybacks and R&D is examined. Sections 1 through 5 provide a background and analysis of the hypotheses surrounding company motivations, as well as an examination of the implications of these hypotheses for R&D expenditure. Section 6 then furthers the connection back to the main research question, and the conclusion of the literature review highlights next steps for my research, outlining how this paper will address the research question in light of the relevant literature. Section 2.1: Why Repurchase Stock? Within the two perspectives of buybacks being either destructive or constructive, there are many nuances informed by theoretical frameworks for why companies choose to repurchase shares in the first place. While there are legitimate reasons to buy back stock, there are also reasons that are illegitimate at best, and illegal at worst. Different sides of the debate surrounding the legitimacy of stock buybacks as a practice are informed by the credence to which economists give certain theories. There are several legitimate reasons to repurchase shares. First off, stock buybacks are a way to compensate investors at a lower tax rate than dividends since they are taxed as capital gains instead of as income. Secondly, they provide management flexibility while rewarding investors because once a firm commits to paying a dividend, it must continue to do so since terminating dividend payments sends a negative signal to shareholders (Iyer & Rao, 2017). However, this is not the case for buybacks since buybacks are not recurring; this flexibility that stock buybacks give managers is known as the flexibility hypothesis. Also, according to the signaling hypothesis buybacks show confidence of growth and future earnings, showing to investors that investment in a company's stock is better than any other asset the company could have invested in. They also allow a Company to increase its earnings per share if it can’t actually generate more earnings, since it can simply reduce the number of shares outstanding (Stunda, 2014). Furthermore, if a company does not have positive net present value investment opportunities, it may be more efficient to invest retained earnings back into stock instead of into an unprofitable investment. It could be argued that this is an acceptable reason, but could also be argued that firms that are not innovating should not be allowed to boost their stock prices in this way. While innocuous reasons to repurchase stock may exist, there are undoubtedly several other reasons that are not legitimate and could be indicative of share repurchases being a corrupt practice. For example, companies may repurchase stock in order to simply boost stock prices in the short term at the expense of long-term growth and innovation (Tan et al., 2016). Additionally, buybacks may create moral hazard as they enrich company executives at the expense of long-term performance and innovation (Lamba & Miranda, 2010). Developing a solid understanding of the literature's consensus on these reasons for repurchasing stock is crucial to understanding the relationship between stock buybacks, innovation, and R&D investment. Section 2.2: The Signaling Hypothesis Findings in the literature provide important context for the signaling hypothesis-the theory that firms repurchase shares because the market is currently undervaluing them. Evidence for the signaling hypothesis is important in informing the relationship between buybacks and R&D, because R&D expenditure does not immediately materialize as returns. Companies that invest in research experience time delays between R&D investment and the returns that are received from the new products that are the results of said R&D (Chan et. al., 2004). So, stock buybacks would then be a way to simultaneously provide shareholder returns during that interim and bring stock prices up to more appropriate levels that reflect the impending impact of the yields from R&D activities. Chan et. al. (2004) used cross-sectional differences in market reactions and long-run performance following stock buybacks to investigate three of the main economic motivations for engaging in them: mispricing, disgorging free cash flow, and increasing leverage. In their analysis of open market repurchases from 1980 to 1990, supplemented with cases from Securities Data Corporation (SDC) from 1980 to 1996, they found evidence of positive abnormal returns following buybacks to provide support for the mispricing (signaling) hypothesis, and found very little evidence for the leverage and free cash flow hypotheses (Chan et. al., 2004). However, this study’s sample period was over 20 years ago so it’s results may be less relevant in the contemporary economy. While this short-term support for the signaling hypothesis exists, clear-cut evidence for the signaling hypothesis is not ubiquitous in the literature. For example, while performing inter-industry comparisons on a sample of open market common stock repurchase announcements reported in the Wall Street Journal Index from 1982 to 1997, Liano et al. (2003) show that long