Smithers; I studied economics at Cambridge and used to run the fund
management business at S G Warburg which became Mercury Asset
Management and is now BlackRock.
I set up
Smithers & Co in 1989 as an economics consultancy. Much of the
comments on economics and markets that I read as a fund manager struck
me as nonsense and I have had great fun in pointing this out to
clients over the years.
I now have
the opportunity to disseminate my views more widely and hope that this
will amuse and inform readers.
Buybacks and the parallel universe of bankers
| Nov 05 07:00
The damage done to the UK and US economies by
buybacks in preference to capital
investment was a central theme of my book The Road to Recovery, and
it has found its way, not too often I hope, into these blogs. I have
therefore been heartened by the growing interest shown by the financial
press in this threat to our economies.
The Economist recently devoted a
major section to the issue, as did the
Financial Times on October 12.
The change in the way managements are paid drives buybacks but this has yet
to be widely appreciated. The US Federal Reserve’s quantitative easing
programme was rightly underlined by my colleagues as adding the fuel of
cheap debt but, without the preference for buybacks, low bond yields would
have encouraged capital investment. This they markedly failed to do. An
important paper, shortly to be published in the Review of Financial Studies,
Investment and Stock Market Listing: A Puzzle?” by John Asker,
Joan Farre-Mensa and Alexander Ljungqvist demonstrates that a huge
difference has appeared in recent years in the levels of investment by
quoted and unquoted companies.
It is clearly absurd to claim, as is nonetheless so often done, that
companies are deterred from spending on new equipment by fears about future
demand. If this were correct, it would be a concern restricted to quoted
companies and to which unquoted ones are immune. Listing matters because
unquoted companies are more often controlled by investors with a long-term
interest in the company’s future. While this has always been true, the
change in management remuneration has greatly magnified the difference in
incentives and, thus, in the behaviour of the two groups. The difference,
therefore, does not lie in fears about economic prospects but is determined
by whether the companies are listed.
Another misunderstanding was shown in a
letter to the FT from
Insead finance professor
Theo Vermaelen, who criticised the October 12 article by Michael
Mackenzie and Nicole Bullock on the grounds that it is a “widely documented
fact that, on average, companies that buyback stock outperform their peers”.
The key issue here has been misunderstood. The concern is not that buybacks
damage share prices. What we observe is that high buybacks and low
investment have a common cause, which is the change in management
remuneration. While this may or may not be in the interests of shareholders,
the problem is that it severely damages the economy.
Not everything that is good for shareholders is good for the economy. Weak
competition is an outstanding example, to which the impact of modern
management remuneration systems has important similarities. In many
industries, companies have considerable short-term monopoly power. If they
choose to push up prices, which increases the risk of being undercut by
competitors, or keep investment levels low, which would allow competitors to
have lower production costs through newer equipment, they increase the risk
that their companies will lose market share. But, particularly in the case
of investment, these risks are long-term rather than short. Furthermore, if
the incentive to push up prices and underinvest is widespread, the
short-term risks are reduced. The risk of losing market share is low if
almost everyone in an industry is seeking to boost prices and keep down
A reduction in competition will boost profits and, looked at exclusively
from the narrow view of shareholders, there is no call for governments to
seek to prevent an increase in monopoly power. Indeed, if what is good for
shareholders was automatically good for the economy, then economic policy
would be devoted to reducing competition. But rent-gouging monopolies do
great damage to the economy, which is why we need to be alert to the risks
of falling competition and have an active policy to prevent the rise of
oligopolies. For the same reason, we need policies to counter the damage
that is being done by the change in management remuneration.
There are many ways that this can be done but, before the necessary policies
can be introduced, it is essential that the problem is recognised and widely
debated. The increase in concern, illustrated by the articles in the FT and
The Economist, is therefore to be welcomed. But the level of
misunderstanding and distraction is high and comes in various guises. The
idea, discussed earlier, that the issue is whether or not shareholders
benefit is one misconception. The perceived unfairness of the huge increase
in management pay is another distraction. I sympathise with such concerns
but there is ample evidence that shareholders have received no benefit from
the rise in pay. There is therefore a strong case against the rise in
management remuneration, even from the narrow view of shareholders’
interests. But fairness is a very subjective matter and I fear that, if the
discussion of management pay is limited to whether it is fair or in the
interests of shareholders, it will result in unfocused debate rather than
effective action. I am anxious therefore that the economic damage should be
the subject that receives most attention.
While we seem a long way from the widespread understanding of these dangers,
a paper published in the Harvard Business Review’s September 2014 edition, “Profits
Without Prosperity by William Lazonick,
does an excellent job of pointing them out. The paper rightly scorns the
excuses that corporate executives give for buybacks. Prof Lazonick correctly
identifies the true motivation for buybacks, which is that stock-based
instruments make up the majority of senior executives’ pay.
In addition to their economic importance, buybacks are very important for
equity prices. As companies are the main, and often the only significant,
buyers of shares, the stock market is likely to suffer if companies are
deterred from buybacks by the negative publicity that they are receiving.
Experience, however, points to the direction of change in share prices as
being a more likely deterrent to buybacks than adverse publicity (see chart
one above). This shows that buybacks rise and fall with the level of the
stock market and it is surely difficult to praise buybacks as being good for
shareholders when they are made at such disadvantageous times. Buying
overpriced shares is a way of destroying value and spending more money when
the market is most overpriced is particularly egregious.
When the market falls, share buybacks destroy less value for shareholders
but they also become less valuable for managements, whose bonuses are linked
to share prices. They become more valuable, however, for those whose bonuses
are linked to returns on equity or earnings per share because the cheaper
the shares are, the more these metrics can be improved by the same dollar
expenditure. If profits start to fall, buybacks cease to be of much help to
management as they cannot offset the negative impact on ROE or EPS.
Provided profits hold up, I think it is more likely that buybacks will
continue to support the stock market. Many of the incentives for managements
will remain in place and, if profits do not fall, the key issue will be the
financial ability of companies to buy shares, which depends on their cash
flow and balance sheets. The extremely high level of profit margins (see
chart two below) means that cash flow is abundant for financing buyback. In
addition, companies claim and presumably believe that they have low
leverage, so, if cash flow alone is not enough, increasing debt should pose
Mr Mackenzie and Ms Bullock quoted
an alternative view in their article from an investment banker who remarked
that “ buybacks will continue until companies regain pricing power”. Now, in
the universe in which I live, pricing power is revealed in profit margins.
As chart two shows these are at their highest recorded level in the US.
There would appear therefore to be no lost pricing power to be regained.
However, readers of this blog will know that investment bankers and I appear
to inhabit parallel universes.
© The Financial Times Ltd 2014