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Incentives to pump stock instead of generate long term enterprise value


Source: Financial Times, September 21, 2014 column > comment >





September 21, 2014 3:24 pm

The short-sighted US buyback boom

By Edward Luce

Unless the roots of the problem are fixed, boardrooms will keep on draining their treasuries

©Matt Kenyon

In the late 1980s, corporate America was turned inside out by the mania for hostile takeovers. The so-called barbarians at the gate upended the typical US chief executive’s outlook. From then on, the only thing that mattered was to keep the share price as high as possible. Today, with stock repurchases running at record levels, their descendants are sitting inside the gates of corporate boardrooms. They are more serene than their disruptive forerunners. Instead of leveraging other people’s money to fund takeovers, they boost share prices with their own company’s revenues. But the effect is much the same. They take from the future to flatter the bottom line today. Other stakeholders be damned.

At a time of soaring profitability, US companies have piled up huge amounts of cash, much of it parked offshore. Yet investing it in long-term growth is the last thing on their mind. According to Barclays, US companies have lavished more than $500bn in the past year on stock buybacks – a multiple of what most are spending on research and development and other capital investments. In the first six months of the year, buybacks surged to $338.3bn – the largest half-yearly volume since 2007. The rationale is simple. By reducing the volume of outstanding shares, chief executive officers increase earnings per share. That in turn lifts their pay, which is heavily tied to short-term stock performance. If you need an explanation for why the top 0.1 per cent is doing so well, start with equity-based compensation.

But the impact is much broader than that. According to William Lazonick, a scholar at the University of Massachusetts Lowell, seven of the top 10 largest share repurchasers spent more on buybacks and dividends than their entire net income between 2003 and 2012. In the case of Hewlett-Packard, which spent $73bn, it was almost double its profits. For ExxonMobil, which came top with $287bn in buybacks and dividends, it amounted to 83 per cent of net income. Others, such as Microsoft (125 per cent), Cisco (121 per cent) and Intel (109 per cent) were even more extravagant. In total, the top 449 companies in the S&P 500 spent $2.4tn – or more than half their profits – on buybacks in those years. They spent almost the same again in dividend payouts. Taken together, they came to 91 per cent of net income.

The US economy is starting to pick up speed. The trend has only steepened in the past year, however. Can America’s boardrooms really have no better use for their cash? The answer is evidently no. There are two forces driving the buyback boom.

First, there is a dearth of investment opportunities. Lawrence Summers, the former senior economic adviser to President Barack Obama, blames secular stagnation – the expected return from investment is lower than the cost of capital, even though interest rates are near zero. In other words, the borrowing rate would have to be negative to persuade companies to boost their capital spending. Since interest rates are positive, it makes more sense to juice up the share price with repurchases. The theory fits the facts. Companies are clearly pessimistic about the future of innovation. Corporate R&D spending is stagnant and a growing share goes to product development rather than basic research. But it is only a partial explanation.

The more immediate culprit is the decline in the quality of corporate governance. The average tenure of the US CEO is falling. Buying back shares instead of investing makes sense if you do not expect to be around for the pay-off. It is a no-brainer if you measure the time horizons of most executive reward packages. In 2012, the 500 highest paid US executives made on average $30.3m each, according to Prof Lazonick. More than 80 per cent of it came in the form of stock options or stock awards. Their incentives are skewed towards extracting value from the companies they run, rather than creating future value.

What can be done? The lazy instinct is to blame executive greed. But human avarice is as old as the wheel. If properly aligned, we should all benefit. The problem is that US corporate incentives have become badly out of whack with the interests of society. Since the fashion for buybacks took off, average corporate pay has risen to more than 300 times average earnings (up from a multiple of 20 times in the 1970s), while median wages have stagnated. Meanwhile, corporate taxes keep dwindling as a share of federal revenues. Weak antidotes, such as shareholder “Say on Pay”, which is non-binding, have not checked the trend. Moral exhortations are almost always futile. Tougher remedies are needed.

In the past week, consumers have gone wild over the launch of the iPhone 6. It is US innovation at its best. Will Apple still be at the cutting edge a decade from now? Not if you judge by what it does with its cash. The company keeps tens of billions of dollars offshore to avoid paying US corporate taxes. Yet it borrows at home – including a record $17bn bond issue last year – to fund a massive share buyback spree (Apple spends more on equity repurchases than any other US company). The roots of the problem lie with poor governance regulations and a badly outdated tax system. Unless these are fixed, boardrooms will keep on draining their treasuries at the expense of other stakeholders. Greed will always be with us. Dumb laws are optional.


© The Financial Times Ltd 2014



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