Thursday, May 28, 2015

Financial Engineering

The Wall Street Journal just published a solid piece entitled Wall Street Gamblers At Work—U.S. Firms Spend More on Buybacks Than Factories. Following the crash of 2008, The Federal Reserve Bank cut interest rates to near zero in an attempt to kick start the economy and recapitalize the banks damaged in the subprime loan fiasco. While they successfully rebuilt the banks’ balance sheets at taxpayer expense, they weren’t so successful in restoring Main Street.

Corporations took advantage of the cheap money, but not to construct new factories, buy new machinery, and hire new workers. Instead, companies increased their bottom line by replacing old high interest rate debt like my beloved GE 6.25% preferred with commercial paper that paid more in the neighborhood of 2.5%. Once they refinanced their own debt, they did use some of that cheap money to buy new equipment like programmable machine tools and acquire artificial intelligence applications like cloud accounting systems. This allowed companies to replace expensive employees with low cost data entry clerks or completely eliminate those pesky humans along with their salaries and health insurance.

As long as the Fed is passing out cheap money, the big corporations are willing to take their share. Now they are increasing profits by financial engineering. Rather than making more products or new products, they are finding it more profitable to engage in activities like share repurchase programs, commonly called buybacks.

Buybacks are a pretty common way for management to give something back to the shareholders without losing control of that money. It can be a very good way to increase shareholders value without the specter of the taxman’s cold dead hand. If the share price is undervalued, buybacks will increase that price through several mechanisms. First of all when a buyer (in this case the company) is purchasing large blocks of stock, the price will increase through simple supply and demand. Even after the buyback is complete there are now fewer shares available to the general public. This should tend to hold the price at a higher level. Also the company (now the shareholder) is paying dividends to itself. This gives the company’s managers more money to invest in new projects or to increase dividends at some later date. In essence the company is doing dividend reinvestment for its shareholders without any income taxes. In this scenario, if the shareholder decides to sell then he will pay capital gain taxes. Most likely this will be at a lower rate than income taxes.

In this particular case, much of this activity is the result of activist investor groups, like hedge funds, buying control of corporations, then using their leverage to improve the value of their shares through buybacks and less often through increases in dividends.

What’s wrong with this picture? Share prices are going up. Potential tax liabilities are going down. Profitability is just a few notches below record levels. The article quotes Laurence Fink, chief executive of BlackRock Inc., the world’s largest money manager, “More and more corporate leaders have responded with actions that can deliver immediate returns to shareholders, such as buybacks or dividend increases, while underinvesting in innovation, skilled workforces or essential capital expenditures necessary to sustain long-term growth.”

The problem is the future.

There are other unintended second order effects to generating profits through financial engineering rather than creating real wealth in the material world. Building a new factory puts money in the hands of suppliers, truck drivers, and construction workers as well as the new workers the factory will eventually and hopefully permanently employ. This is the kind of economic activity that will ultimately make our country strong and prosperous.

Like most financial problems there is another side to the story. The great investor Peter Lynch was famously afraid of buying shares in a company that had too much cash. It was his experience that managers given control of other people’s money inevitably found something stupid to do with it. Responding to the spectacular growth and failure of conglomerates like LTV during the 1960s, he coined the term, “diworsification.” In our own times think about the AOL fueled merger with Time Warner, perhaps the worst corporate merger in history.

The article also quotes a letter from the activist fund Starboard Value LP, “The history of corporate America is littered with a long line of companies that relinquished their leading industry position and spent enormous resources attempting to reinvent themselves and ultimately failed.”

That would be the truth.

There are other considerations driving the decisions of our corporate managers. The United States has the highest corporate tax rate in the world. We punish companies for creating jobs and keeping profits in this country. We reward them for creating jobs in other countries and not repatriating those profits. There are currently over 1,000,000 Federal regulations. The cost of even knowing they exist, let alone the cost of compliance is enormous. Whether it is a good thing or a bad thing, environmental regulations alone make it impossible to build a new primary steel mill in this country.

The best way for a company to avoid the interference of activist investors is to run a tight disciplined ship. A company that sticks to its knitting; pays a steadily increasing sustainable dividend over long time periods; that reinvests its money wisely won’t need any fancy financial engineering to thrive over decades, sometimes centuries.

You can find companies like this in lists like the Dividend Aristocrats, S&P constituents that have increased their dividends for 25 consecutive years or longer. They aren’t flashy, but they have been doing a very good job for a very long time.

No comments:

Post a Comment