Naturally, the data appears disturbing but a recent report from Reuters puts an even finer point on the issue. In an investigative article entitled The Cannibalized Company, Reuters states:
“Almost 60 percent of the 3,297 publicly traded non-financial U.S. companies Reuters examined have bought back their shares since 2010. In fiscal 2014, spending on buybacks and dividends surpassed the companies’ combined net income for the first time outside of a recessionary period, and continued to climb for the 613 companies that have already reported for fiscal 2015. In the most recent reporting year, share purchases reached a record $520 billion. Throw in the most recent year’s $365 billion in dividends, and the total amount returned to shareholders reaches $885 billion, more than the companies’ combined net income of $847 billion.”
The premise behind the current executive pay structure argues that the talent associated with the strategic decision-making and leadership qualities required to successfully drive large organizations is unique, hard to find and, once found, critical to be retained. In efforts to better align the incentives of corporate executives and the interests of the company, executive compensation has increasingly become tied to outcomes associated with stock price. Award executives more stock, and, assuming they make good decisions for the growth of the company, the share price will rise and reward the executive and shareholders alike.
Alternatively, what is happening is the compensation structure for CEO’s and senior executives has become so skewed towards stock-based incentives of such gargantuan size that it has become the predominant driver of corporate decision-making. Companies eschew the idea of making longer-term investments through capital expenditures because it does not immediately help the measurement ratios upon which Wall Street bases “success”, and it may indeed hurt those ratios. Of course, these are the same ratios upon which executive compensation depends, since Wall Street analyst recommendations drive share prices and share price drives executive compensation. The result in one case is strategic decision-making that naturally neglects long-term commitments of capital into what Clayton Christensen calls “market-creating Innovations” in favor of “efficiency innovations”. As described in Innovation, companies become increasingly dependent upon efficiency innovations and the balance between important long-term and short-term uses of capital is quickly lost causing economic harm.
In another case, executives use precious capital, often borrowed, to conduct share repurchases precisely because it has the immediate effect of driving share prices higher. As 2007 illustrated, this façade of “value” is short-lived because it does nothing to organically enhance the value of the company and hurts long-term prospects by diverting cash to a very expensive use. In this case, the perceived “talent” of leadership required in senior executives to successfully drive large organizations is fallacious and runs counter to the logic applied in their exorbitant pay structures. It also disregards “the eternal rules of order” George Washington spoke of in his first inaugural address.
The end result of either case is that corporate cash, earned or borrowed, is squandered for the self-serving purpose of maximizing executive compensation instead of being used for productive purposes.
“Maximizing Shareholders Value”
Several events have come together over the years to enable and encourage such behavior by executive leadership. In the mid-1970’s, the concept of maximizing shareholder value was introduced by Jensen and Meckling, professors at the University of Rochester. Thus began the era of myopia related to stock-based incentives for executives with no foresight as to the long-term implications of such an ill-conceived concept. We see this effect repeatedly in policy construction within our government. Politicians identify a problem and then set about crafting a bill that will address it without realistic consideration for either the immediate peripheral implications or the long-term unintended consequences. What begins as a well-meaning, if not vote-attracting, proposal soon becomes a law that in 5 or 10 years mushrooms into a vast government program and deep financial burden offering little economic benefit.
In 1982, the Securities Exchange Commission created a rule that allowed companies to buy back their own shares. Rule 10b-18 allows a company’s board of directors to authorize senior executives to repurchase up to a certain dollar amount of stock over a specified or open-ended period of time. The company must publicly announce the program after which it may then proceed to repurchase their own shares on the open market without concern that the SEC will charge it with stock price manipulation. There are a few guidelines within which the company must operate regarding share repurchases but the oversight is structurally weak and only monitored quarterly. Rule 10b-18 explicitly legalized stock market manipulation through open-market repurchases.
The rule was radically divergent from the agency’s original mandate laid out in the Securities Exchange Act of 1934 which properly responded to the multitude of corrupt activities that fueled speculation and led to the 1929 stock market crash. The adoption of Rule 10b-18 reflected the view of then commission chairman John Shad, former vice-chairman of E.F. Hutton and obvious Wall Street insider, that the risks of sweeping deregulation of securities markets were justifiable. With the stated mission of the SEC in mind, “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation”, liberties currently afforded corporate executives through share buybacks are at odds with that mission.
Taxpayers Subsidize Corporate Spending – Stock Buybacks Subsidize Executives
The power and influence of corporate America is further on display in their lobbying efforts to extract public-sector funding for assistance in trade and research and development. Despite trillions in accumulating public debt and on-going deficits, publicly-held companies with record profits, lobby for and receive assistance in funding pet projects to their benefit. At the same time, instead of using their own cash to advance these projects, they engage in share buybacks which divert capital toward a highly self-serving purpose. Although the public assistance of funding such projects occurs under the guise that the U.S. corporations cannot remain competitive without the aid of federal funds, it is unclear why taxpayer funds should be used to subsidize the investment activities of corporate entities which at the same time are using their own capital to repurchase stock.
According to William Lazonick a professor at the University of Massachusetts at Lowell who cites the Center for American Progress, Exxon Mobil received $600 million per year in subsidies for oil exploration. The energy giant spent approximately $21 billion a year on share buybacks while spending approximately zero dollars on alternative energy efforts. Microsoft, GE and other companies lobbied the U.S. government to triple their investment in alternative energy research and subsidies to $16 billion per year. Over the past ten years, Microsoft and GE spent about the same amount annually on share repurchases.
The same thing happens in nanotechnology, pharmaceuticals and virtually every other business sector. Powerful companies lobby congress for federal spending on what are certainly important issues that deserve research and development focus. However, the companies themselves turn around and spend multiples of billions manipulating their stock price which boosts already egregious executive compensation. Lazonick points out that Intel spent four times the budget of the National Nanotechnology Initiative (NNI), which receives federal funding, then on buybacks in 2013. According to the Wall Street Journal, Intel CEO Brian Krzanich received $10 million in compensation in 2013, less than 10% of which was base salary (Krzanich received a 20% pay increase in 2014).
Major pharmaceutical companies such as Merck, Allergan, AbbVie and Pfizer generally argue that the profits from high priced healthcare drugs permit more research and development to be done in the United States. Importantly, Lazonick points out that these firms coincidently enjoy tremendous benefits of favorable intellectual property rules and weak price regulation by doing their business in the US. Yet in the 10 years between 2004 and 2013, Pfizer alone used over 70% of its profits for share buybacks. The painfully high prices Americans pay for prescription drugs has far more to do with stock price manipulation and inflated executive compensation than the stated cost of conducting R&D in the United States. That explanation is a smokescreen intended to deceive legislators, regulators and the public. Pfizer CEO, Ian Read, was paid $23.2 million in 2014, nearly 70% of which was stock and option-based rewards.
The prophetic warnings of corruption of America’s moral ideals may have begun in 1789 with the words from America’s first President, but they have been routinely revisited throughout our history. In 1961, Dwight Eisenhower also issued a dire warning in his farewell address to the nation. In that address he pointed specifically to the military-industrial complex, a term he coined, but words which today have far broader application.
“…we must guard against the acquisition of unwarranted influence… The potential for the disastrous rise of misplaced power exists and will persist. Only an alert and knowledgeable citizenry can compel the proper meshing of the huge industrial and military machinery of defense with our peaceful methods and goals, so that security and liberty may prosper together.”
It is vital to give proper consideration to the improper liberties that are being taken by those with “unwarranted influence” and “misplaced power”. Value extraction has replaced value creation in pursuit of short-term, self-serving benefits at the expense of long-term stability and durability of corporate America and therefore the country as a whole. As citizens, our obligation is to be well-informed, cognizant, outspoken and to vote. As investment managers, our role is to always protect the wealth of clients through a critical view of the actions of authorities with fair and rigorous questioning of intentions and incentives. The words of men may temporarily suspend but they do not alter the laws of financial dynamics. The fundamentals always take precedence eventually.
This likely will not be the last piece 720 Global writes on stock buybacks. We will continue to focus on this topic in an effort to inform equity and bond investors of the harmful activities they are knowingly or unknowingly supporting.
Thanks for reading.
Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.