Tuesday, January 17, 2017

Corporate Financial Strip Mining - The Plague of Stock Buybacks

A paper by William Laconic entitled "Profits Without Prosperity" looks at the main reason why high levels of corporate profitability after the Great Recession have not translated into economic prosperity for Main Street, USA.

Here is a graph from FRED showing what has happened to after tax corporate profits since 2000:


While the growth in corporate profits has levelled somewhat since 2012, at $1.679 trillion in the third quarter of 2016, profits have grown by $270 billion since their pre-Great Recession peak in 2006.  With that in mind, why has it seemed like Corporate America appears to be suffering from lethargy?  According to the author of the paper, the blame can be laid at the feet of corporate stock buybacks.  Let's look at a bit of corporate history to help explain the current situation.

From the end of the Second World War until the 1970s, Corporate America took a "retain and reinvest" approach to business; they retained their earnings and reinvested them in both human and mechanical capital.  Companies used their profits to train their workforces and purchase additional machinery (among other things) to improve their competitiveness, ultimately leading to higher but sustainable levels of both profitability for companies and prosperity for workers.  This approach can be considered value creation.  In the late 1970s, things began to change; companies changed their operating philosophy and took a "downsize and distribute" approach; they reduced costs and distributed the increased cash to shareholders.  Companies reduced investments in both human and mechanical capital and used the freed up cash to enrich both employee and non-employee shareholders which led to increased income inequality and higher base levels of unemployment.  This approach can be considered value extraction.

It should not be surprising to anyone who has been paying attention over the past few years, but the value that Corporate America has extracted from itself has been used to enrich company executives at the same time as the growth in wages for "working stiffs" have done this since 1978:


Over the past 15 years, real wages have increased by a paltry 12.8 percent while CEO compensation has done this (again, compared to 1978 compensation):


With stock-based compensation forming a larger and large part of overall executive salaries, its pretty obvious who benefits from the "downsize and distribute" approach to doing business.

One of the key ways that Corporate America has implemented the "downsize and distribute" model is through the use of stock repurchases.  By repurchasing its own stock, a company removes those shares from its overall outstanding share inventory and can then provide Wall Street with higher per share earnings numbers, the key metric to maintaining the appearance of business success.  This is often touted as a way of returning value to a company's shareholders including even the smallest of shareholders.  

All of this stock repurchasing began in 1982 when the SEC instituted Rule 10b-18 of the Securities Exchange Act which redefined how equities could be purchased by the issuer of those equities  This rule provided a "safe harbour" for companies when that company wishes to repurchase its own shares; in other words, companies would not be deemed to have violated the anti-fraud portions of the Securities Exchange Act of 1934.  Purchases had to meet the following criteria:

1.) Manner of purchase: The issuer or affiliate must purchase all shares from a single broker or deal during a single day.

2.) Timing: An issuer with an average trading volume less than $1 million per day or a public float value below $150 million is unable to trade within the last 30 minutes of trading. Companies with higher average-trading-volume or public float value can trade up until the last 10 minutes.

3.) Price: The issuer must repurchase at a price that does not exceed the highest independent bid or the last transaction price quoted.

4.) Volume: The issuer can't purchase more than 25% of the average daily volume.

This change to the Securities Exchange Act opened the proverbial can of worms.  The SEC only requires companies to report total quarterly purchases rather than daily purchases, meaning that it cannot determine whether a company has actually breached the 25 percent limit on any given day.  Even with the 25 percent limit, companies with very high market capitalization can purchase hundreds of millions or even billions of dollars worth of their own stock on a given day.  Basically, Rule 10b-18 legalized stock market manipulation through open market stock repurchases.

Let's look at the top ten repurchasers for the period between 2003 and 2012 and how much of each company's net income went into repurchasing their own stock:



These 10 companies spent a combined $859 billion on stock buybacks between 2003 and 2012.  During that same ten year period, the CEOs of these same companies received, on average, total compensation of $168 million each with 34% of that compensation in stock options and 24% in stock awards.  As well, the data shows that, in seven out of the ten companies, the combination of dividends paid to shareholders and funds spent on repurchasing stocks consumes more than 100 percent of net income over the ten year timeframe.

What we see from this report is that Corporate America is far more interested in enriching itself through stock repurchasing than it is in investing in innovation and human and mechanical capital.  This could easily be termed corporate financial strip mining; companies strip their own livelihood and future potential to benefit their own insiders and those on Wall Street over the short-term.  This has led to a situation where employment is far less secure than it was in the decades immediately after the Second World War and where those who dwell in the upper floor corner offices get wealthier and wealthier while their workforce falls further and further behind. 

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