Why Did Corporations “Waste their Capital”?

Hi Roger,
I’ve got a basic question about how the post-2008 “economic fragility” you mention in your May 13 briefing relates to the “wasted” leveraged buybacks Raoul Pal talks about in the May 15th briefing:
QUESTION:
Was the consumer too weak to support robust growth post-2008 and is that why corporations “wasted” their capital by buying back shares with borrowed money?
Background:
——————————————————————————————
 
(21:06) RAOUL PAL: So I’ve talked about this in the doom loop on Real Vision before as part of a whole thesis of mine, which is based around the maximum amounts of corporate debt in US histories now. That debt was driven by corporations basically wasting their own capital to buy back their shares, without putting it to more effective use and efficient and productive use. 
MY QUESTION:
What accounts for the use of buybacks rather than productive investments?
Why didn’t corporations use their capital for productive purposes?
(My suspicion is that consumers were too maxed out to afford substantially more consumption, so why invest in increased capacity?)
——————————————————————————————
Here’s what you said about two days earlier about “economic fragility”:
06:57
ROGER HIRST: … That’s going to be what’s happening, and so it becomes all about balance sheets. It’s corporate balance sheets, it’s household balance sheets and it’s government balance sheets. Have they been impaired?07:16
I think the key to all of this is that there was the underlying fragility of the global economy prior to this. This was not a strong economy, and I’m not just talking about the last year where we saw some numbers deteriorate. I’m talking about the world post-crisis 2008 where there’s never proper recovery. We had anemic growth. We had the illusion of health because the equity market in particular and in particular in the US, rose to these astonishing heights, but overall, a lot of people, median wages took a long time– real median wages in the US took a long time to get back to the 2007 levels. I think it was ’15, ’16– 2015 and ’16.

07:52
The man on the street, the woman on the street didn’t see a pickup in wages for a long time. A lot of people are living paycheck to paycheck, 46% of Americans have less than $1000 of cash in their savings account.

——————————————————————————————
MY QUESTION:
Did corporations think that their consumers were too maxed out to generate further growth in 2009 – 2020?
In other words, did they view their customer’s balance sheets and income growth potential so dimly post-2008 that they decided productive investments in additional capacity, etc were too risky and that it would be safer to take advantage of low-interest rates to use debt to buy back their own stock?
I understand interest rates were low and executives were looking to meet their bonus targets, but why did that entail so many share buybacks rather than productive investments?
 
SPELLING OUT THE IMPLICATIONS:
I figure the pros may already understand that this has taken place, but as a “citizen investor” I’d appreciate hearing this spelled out more explicitly.
If corporations were reluctant to invest before, what does that say going forward?

Why did corporations borrow to buy back their stock rather than invest it for productive purposes?

Investment

Question:

Why do you think many large corporations chose to borrow money to buy back their stocks rather than invest it for productive purposes between 2012 and 2020? (pre-Covid-19)1 2 3

* (this is US-centric, but I’d be interested in a global perspective too)

 

Some Possibilities:

    1. Too much regulation to make investment profitable?
    2. Too high taxes?
    3. Too much political uncertainty? (2012-2020)
    4. Customers already have what they need?  Customers don’t want to buy more?
    5. Customers too maxed out.  Customers can’t afford to buy more?4
    6. Company has a mature market position- there is little room to grow. 5 Better to “mortgage their credit rating”67 and redirect the money to other companies with better opportunities?
    7. Outsourcing to foreign firms removes need to build own manufacturing capacity?89
    8. Executives don’t want to take a risk on innovation and growth when low-interest rates make significant debt-driven share price increase a low-risk choice?
      • Low interest rates tell you why borrowing is attractive but not why innovation and growth are less attractive than stock buybacks.

 

Vote in a Twitter Poll

Twitter  has a maximum of 4 options:

I’m interested in other possibilities too.  You can reply to this on twitter /reddit.

Obviously, the low interest rates were key in enticing companies to borrow. The question is why they didn’t invest more for productive purposes rather than buying back their stock.  I obviously haven’t investigated this fully, that’s part of the reason why I ask the question.

My hypothesis is that the biggest factor behind buybacks was that companies didn’t believe that consumers in the US could afford to increase their consumption level.

US Wages have been stagnant for decades and 40% of American’s can’t afford a $400 emergency, so who would want to invest heavily into selling to such a customer.

That doesn’t answer the question of global demand.  Further work will have to be done to research consumption potential and indebtedness in other countries.

Post your comments on twitter/reddit.

Read Background Info:

 

1) The Story of the Seven Dwarfs Mining Inc:

How the Coronavirus Masked the Corporate Debt Bubble

Seven Dwarfs at Table

Disney’s Seven Dwarfs team up to tell the story of corporate America (2012-2020)

 

2) Was Pre-Coronavirus Stock Market a Bubble Inflated by “Financial Engineering”? (2014-2020)

Wall Street Bubbles Cartoon, 1901
Read More

 

Follow-up:

If corporations were unwilling to invest then, what make you think that they will be willing to invest post-Covid?

 

by Tim Langeman

 

Footnotes:


  1. From 2014 through the start of 2018, corporate profits declined. The one-time spike in profits after 2018 was due to the corporate tax cut. Essentially, without the corporate tax cut, the corporate sector has seen virtually no profit growth since 2014.

  2. “It’s a fair critique of corporate earnings to say that earnings “growth” in 2019 is a bit deceptive as the value is being financially engineered by corporate finance departments, not organic, core-business growth,” wrote Tom Essaye, president of the Sevens Report, in a Wednesday note to clients. “Companies aren’t making any more money than in 2018—they just have a smaller share count to spread the money over, so EPS are rising.”

  3. Indeed, more than half of all buybacks are now funded by debt. And while there’s an argument that repurchases benefit share prices and investors, at least in the short run, it’s questionable whether highly indebted companies should be doing this. Sort of like mortgaging your house to the hilt, then using it to throw a lavish party.

  4. 40% of Americans can not afford a $400 emergency.

  5. Coca-cola has a harder time expanding market share than a startup company.

  6. NPR’s “Planet Money” show had an excellent episode explaining Why so Few Companies have a Triple-A rating.

  7. Many companies have had their credit rating downgraded to BBB – the lowest investment grade above “junk”.  50% of all Investment-grade debt is rated BBB.

  8. Why build manufacturing capacity yourself when you can contract with Foxconn/etc and have them build manufacturing capacity?

  9. This may relate to why they don’t invest, but it doesn’t answer why they choose to borrow to buy back their stock.

The Story of the Seven Dwarfs Mining Inc:
How the Coronavirus Masked the Corporate Debt Bubble

Seven Dwarfs at Table
Disney’s Seven Dwarfs team up to tell the story of corporate America (2012-2020)

by Tim Langeman 2233 words (17 min read)

Introduction

Before the coronavirus, a false narrative arose that the economy was healthy, as measured by:

  • growth in the stock market and a
  • reduction in the unemployment rate ..

when in fact this facade was only made possible with an increasing mountain of debt and low interest rates.

Wall Street Bubbles Cartoon, 1901
1901 Cartoon depicting JP Morgan as Bull

But there is more to the economy than the stock market and unemployment rate. The bond market is larger and “smarter” than the stock market. When assessing the pre-coronavirus economy, one must also take into account the stagnant profits1 corporations disguised by borrowing in the bond market to fund purchases of their own stock, artificially inflating the stock market.

Like an Injured Athlete taking Pain Killers

The US economy was like a professional football player who had been “playing hurt” for many years.

Brandon Scherff Injury: Falcons at Redskins 11/04/18
Brandon Scherff Injury, Nov 4, 2018
Keith Allison Sports Photos (CC BY-SA 2.0)

The economy used debt, like the football player uses pain killers.  The debt masks the economy’s  problems2 and allows it to perform at a higher level than otherwise would have been possible had  pain-killers not dampened the brain’s ability to perceive reality.  But unfortunately an economy is not like an athlete in that it can’t retire at the end of a 15-year career.

Featuring: The Seven Dwarfs

The story I’m about to tell is intended to illustrate how corporations borrowed money and then used that money to buy their own stock, inflating the stock price.3  In finance jargon this is called “leveraged stock buybacks”.4  Corporations have used stock buybacks as a major strategy to boost their share price but many corporations don’t have enough profits to buy back their stock because the overall level of (pre-tax) corporate profits has been flat since 2012.5.  Some companies profits have gone up and they can afford to buy their own stock with profits, but over 50% of those buybacks were done using borrowed money.

In fact, if you look at who had been the buyer of most of the stock purchases in 2018 and 2019, it had mostly been the companies themselves purchasing their own stocks.

I illustrate how this concept works using a fairy tale featuring the seven dwarfs and their mining company “7 Dwarfs Mining, Inc.” Early in the story the dwarfs seemed to have discovered a easy way of making money until an unforeseen emergency struck and disrupted their carefully laid plans.

It is commonly known that emergencies reveal.

This story illustrates what emergencies can conceal.

The Founding Members:

Grumpy Dwarf
Grumpy Dwarf

Once upon a time, the 7 Dwarfs Mining company was founded in a small Forest Kingdom town by Seven dwarfs:6

  1. Dopey,
  2. Doc,
  3. Bashful,
  4. Happy,
  5. Grumpy,
  6. Sleepy, and
  7. Sneezy

After a number of years in business together, the mining company was valued at $7 million7 and generated $700,000 profit per year, which they split 7 ways.8

Assets# of SharesYearly ProfitProfit per ShareDebt
$7 million7$700,000$100,000$0

Going Into Debt to Hide Flat Growth

Federal Reserve: Profits before Taxes
Notice how Corporate Profits flattened out over the last 6-8 years

One year, Grumpy decided he was unhappy in the mining business. Perhaps this was due to his sour attitude, or perhaps he was feeling blue because the mine’s profits had not increased at all in the previous 6 years.9 Grumpy decided to sell his share in the mining company, but there were not a lot of other dwarfs that wanted to buy out his stake at the price of $1 million.

The other 6 dwarfs in the company wanted to continue in the business but they didn’t have the cash to buy out Grumpy, so they decided to borrow the $1 million from the bond market. Interest rates were low in the Forest Kingdom because the economy hadn’t fully recovered from the previous debt-fueled financial crisis a dozen years prior.10 The kingdom’s treasury secretary’s belief that low-interest rates stimulate growth was also a factor in setting the interest-rate climate.11 This easy lending environment allowed the dwarfs to succeed in borrowing $1 million at an interest rate of 3% per year.

The Dwarfs’ Epiphany: Earnings per Share

Earnings per Share
Earnings Per Share by Nick Youngson
CC BY-SA 3.0 Alpha Stock Images

After Grumpy exited the company, the 6 remaining dwarfs renamed their business: “6 Dwarfs Mining, Inc“. The total value of the company (market cap)12 was still $7 million and they split the same $700,000 profit six ways instead of seven. This resulted in profits of $116,666/share, a 16.7% increase over the prior year. Grumpy sulked for the next year and a half about missing out on the share price increase his exit had created, but Dopey reminded him that it was his own idea to leave. 🙁

ExitMarket CapLeverage RatioYearly ProfitProfit per Share% Profit Increase
per Share
EquityDebt
Original 7 Dwarfs$7 m7/7$700,000$100,000$7 m$0
Post-Grumpy Exit$7 m7/6$700,000$116,667 1316.7%$6 m$1 m
(Note: I’m abbreviating “million” as “m” to save space in this chart.)

Upon learning of this increase in EPS (Earnings Per Share), the 6 remaining dwarfs were elated! By taking on debt to buy out Grumpy’s stake, they managed to reduce their number of shares, thereby achieving their first share price increase in 6 years! Things were looking up! **

** “Earnings per Share” were up even though the Dwarf’s equity in the company was down.14

Scrabble Series Debt
Scrabble Series Image By: ccPixs.com

Setting Dopey’s Debt Plan in Motion

Bashful was known to wear his heart on his sleeve, especially if he had romantic feelings for someone.15 So the next year, after Bashful’s most recent crush departed the village, Dopey encouraged a lovestruck Bashful to retire from the company and follow his sweetheart to the neighboring Mountain Kingdom to the North. Dopey wanted to reduce that number of shareholders in the mining company because he had learned the benefits of having fewer shareholders from Grumpy’s exit, even if that comes at the expense of having more debt. He calculated that splitting $7 million five ways would result in a share price of $1.4 million per share. This would be a 40% increase over the original $1 million share price, although the company’s profit was still the same $700,000 per year. Once again, the dwarfs went to the bond market and used borrowed money — an additional $1 million dollars — to buy out one of their fellow dwarf’s share.

ExitMarket CapLeverage RatioYearly ProfitProfit per Share% Profit Increase
per Share
EquityDebt
Original 7 Dwarfs$7 m7/7$700,000$100,000$7 m$0
Post-Grumpy Exit$7 m7/6$700,000$116,66716.7%$6 m$1 m
Post-Bashful Exit$7 m7/5$700,000$140,000 1640%$5 m$2 m

After the successful payoff, Dopey said to Doc: “Wow, this debt thing is really an easy win. A few years ago we were struggling with plans to make efficiency improvements to the mines but that would have required us to invest some of our profits into new machinery, research and development, and employee training. Instead, I only needed to identify the key to Bashful’s heart and use some accounting wizardry17 to increase our share price the “easy way” — with more debt.”

Following the Plan

Dopey had a reputation for harebrained plans, but he knew that Sleepy’s drowsiness was no reason to doubt his intelligence or acumen.18 Dopey concluded that the two things that would most motivate Sleepy to sell his share were the attraction of sleeping in until noon and a bonus of $100,000, so he struck up a conversation with Sleepy on these two themes when the two had a private moment together. The next year, Sleepy was enjoying a restful retirement in the tropics and the mining company had one fewer shareholder.

2020 Ferrari F8 Tributo
2020 Ferrari F8 Tributo
Debt King License Plate
Debt King License Plate

The pattern continued again the following year with Happy given a $150,000 bonus contingent on his retirement, causing the share price to rise to $2,333,333 (a 133% increase). All the remaining dwarfs were extremely happy at this turn of events, as was Happy himself. 🙂 Dopey took out a loan to buy a red Ferrari with the vanity license plate “Debt King” in anticipation of his upcoming buyout. Yet, at the same time, the company’s total profit remained the same $700,000 per year it had been originally before Grumpy exited.19

ExitMarket CapLeverage RatioYearly ProfitProfit per Share% Profit Increase
per Share
EquityDebt
Original 7 Dwarfs$7 m7/7$700,000$100,000$7$0 m
Post-Grump Exit$7 m7/6$700,000$116,66716.7%$6 m$1 m
Post-Bashful Exit$7 m7/5$700,000$140,00040%$5 m$2 m
Post-Sleepy Exit$7 m7/4$700,000$175,00075%$4 m$3 m
Post-Happy Exit$7 m7/3$700,000$233,333 20133%$3 m$4 m

(Note: These figures are simplified. They do not include reinvesting profits or interest charges on the debt.)

 

A Declining Credit Rating

Credit Rating Chart
Credit Rating Chart

One of the unnoticed consequences of Dopey’s plan was that the mining company’s credit rating began to deteriorate as the company borrowed money in the bond market. The company was effectively agreeing to devote some of its future revenue (i.e. paying interest on the additional debt in the future) in exchange for a higher earnings per share today. Before Grumpy exited, the company had a AAA credit rating, but as Bashful, Sleepy, and Happy’s shares were bought out, the company’s credit rating fell to AA, then A and now stood at BBB, the lowest investment grade.21

Dopey was warned that if the company was assessed another credit downgrade the company would fall to a non-investment grade status (often referred to as “junk” bond status22). Were that to happen, pension funds and many investors would no longer be legally permitted to own the company’s debt and the interest rate the dwarfs would have to pay would spike higher. Dopey calculated that there was a higher risk to the company’s finances in the coming years, but he figured that would be Doc and Sneezy’s problem, not his, because he, Dopey, planned to be the next dwarf to exit. After Dopey left the company his financial interests would be separate from the mining company and he would not longer care if the company should happen to suffer losses.

The Unforeseen

Coronavirus
Rapidico virus

The number of shares now stood at 3, with Dopey, Doc, and Sneezy remaining, when something unforeseen happened — a sickness called Rapidico took hold in the neighboring kingdom of Achin. As the illness reached the cities of the Dwarfs’ Forest Kingdom the advisors to the kindom’s Queen — Queen Elizabeth II’s23 privy council24recommended that the kingdom go into lockdown to prevent the spread of the disease.

The Response

A lockdown seemed like a radical idea, and one that the queen deferred to individual provinces.25 As other provinces of the kingdom went into lockdown, Dopey, Sneezy, and Doc were dismissive and continued business as usual at 3 Dwarfs Mining, Inc.

Sneezy Dwarf
Sneezy (Disney Fandom)

A month and a half later, an outbreak of Rapidico took place at 3 Dwarfs Mining, Inc., set off by an asymptomatic Sneezy. Dopey later recalled, “Sneezy is always sneezing; I didn’t think nothing of it.” But the tight quarters of the mine proved to be fertile ground for the contagion to spread and many mine workers were infected. True to his name, Doc threw himself into the job of treating the afflicted dwarfs and heroically saved countless lives, but the mine’s production ground to a halt nonetheless. Other businesses were similarly affected and the queen was forced to move beyond her earlier deference to provincial autonomy and call for a strict quarantine.26

Quarantine Sign
Quarantine (PublicDomainFiles.com)

The Divided Kingdom

Because the Forest Kingdom was so fractious and the forest creatures so impatient, financially vulnerable, and headstrong, not all parts of the kingdom followed the queen’s orders closely. This disunity among the provinces resulted in stubborn pockets of disease in the lagging parts of the kingdom which hampered the economic recovery.27

The length of the quarantine caused heavy losses to the 3 Dwarfs Mining, Inc., requiring them to borrow more money. Of the original $7 million that the company had started with, the 3 Dwarfs Mining Inc had only $3,638,841 equity left ($9,846,549 assets – 6,207,708 debt)28 because they had borrowed in the bond market to buy out the shares of Grumpy, Bashful, Sleepy, and Happy, resulting in a debt of $6,207,708.29

The Risk and Reward of a High Leverage Ratio

Debt vs. Equity: The Risk and Reward of Leverage: Dopey's Debt Plan

Companies can choose how much risk they want to take to accelerate growth (Risk vs Reward). The use of debt is a key contributor to the speed at which a company can grow but it also increases the risk that the company will falter should an unforeseen risk arise.

In this particular case, the leverage ratio30 I’m comparing is the ratio of market cap31 to debt. Notice how the Leverage ratio increases as the number of shares (or equity) decrease. Reducing the equity, in this case, increases the leverage ratio (7/2 = 3.5), which increases the profit per share.

Notice how the profit per share increases as the leverage ratio increases.

ExitMarket CapLeverage RatioLeverageProfit per Share
Original 7 Dwarfs$7 million7/71.0$100,000
Post-Grump Exit$7 million7/61.17$116,667
Post-Bashful Exit$7 million7/51.4$140,000
Post-Sleepy Exit$7 million7/41.75$175,000
Post-Happy Exit$7 million7/32.33$233,333
Planned Dopey Exit$7 million7/23.532$350,000

Note: This chart has been simplified33

When Dopey planned to exit, the share price would have risen from $1 million to $3.5 million on the leverage ratio alone. A more complex calculation that reinvests profits each year would have the original $1 million share price to rise to $4,923,274, not including a bonus of $200,000, which would leave Dopey with a total exit package of $5.1 million dollars!34

When things are going well, leverage has the effect of multiplying a company’s earnings per share by the leverage ratio. But when an unforeseen tragedy hits, it leaves companies with less of a cushion to ride out a storm.

The “Debt Bomb” Goes Undiscovered

Debt Bomb
Debt Bomb (Creative Commons Zero – CC0 )

There had been a concern before the Rapidico virus hit, that a large number of Forest Kingdom companies had also been following Dopey-like plans to increase their share price the easy way — through financialization — that is “financial engineering” that inflates share price but does nothing to improve labor productivity. In the 7 Dwarfs Mining Company, profit growth is assumed to be zero, but EPS (earnings per share) still goes up anyway because the number of shares goes down. The shareholders retain ownership in the company, but often with higher levels of debt.

Resetting the “Debt Bomb”

Ticking Time Bomb
Reset the Clock on a Debt Bomb Creative Commons 4.0 BY-NC

The result is a potential “debt bomb”35 36 where a buildup of debt can threaten the whole economy. The companies contributing to this “debt bomb” report share price growth, but this “growth” is artificial because total profits are flat and earnings per share growth is only made possible by taking on more debt. When the debt bomb explodes (or pops like a bubble) it threatens to spill over into the broader economy, threatening the whole country, not just the borrowers. 37

The Rapidico crisis had given the government the opportunity to blame some of the kingdom’s problems, which had been years in the making, on the Rapidico virus and the country of Achin, even though a significant part of the financial problems were the fault of the kingdom’s systemic dysfunction. Had the kingdom not already experienced a financial crisis a dozen years prior, and had there not been such low interest rates, the Dwarfs would not have taken on so much debt, leaving their mining company financially vulnerable in a time of crisis. Had the Rapidico crisis not happened, such debt dysfunction was bound to lead to another recession anyway and leave the kingdom to grapple with questions about the authenticity of the prior decade’s growth.

Debt for Productive Purposes?

Amish Hay Wagons
Productive Purposes

When some of the queen’s more intellectually self-critical advisors speculated that it would have been better had the Forest Kingdom’s companies invested the money they borrowed into productive assets rather than share buybacks, others replied that too few workers could afford to buy38 what the companies would have produced.3940

Sweeping it Under the Rug?

Sweep it Under the Rug
Sweep it Under the Rug
from “Whistle While You Work”
Disney’s Snow White and the 7 Dwarfs, 1937

A lone advisor commented that the prior 6-8 years of flat profits41 during supposed “good times” boded poorly for future growth prospects. “When was the last time we’ve generated substantial growth without a lot of debt and the creation of another artificial bubble?”, said the deputy finance minister. Many advisors agreed with her, but were hesitant to break the bad news to the public. Nevertheless, all agreed that the queen’s legacy depended upon her taking steps to prevent such a debt bomb from re-emerging and requiring yet another bailout. You might be able to afford this bailout, but we haven’t done anything to pay down the debt from the previous financial crisis and we certainly can’t afford to make bailouts the norm. Next time, her advisors said, you won’t have the Rapidico virus to blame for the bailout and you won’t be able to sweep all that debt under the rug.

Will the Dopey Financial Plans Stay Concealed?

A cute little girl is hiding behind a tree and peeks around holding her finger to her lips saying, shhh
Stay Hidden? photo by Sheila Brown (CC0 Public Domain)

“I know we’ve got to face our problems,” said the queen,42 but a financial crisis is no time to address deep weaknesses within the economy. Calling attention to the country’s debt dysfunction will only erode consumer confidence when we need it most. Besides, many of the Debt-Dopies are particularly crafty and hire former members of parliament as their lobbyists! Another bailout is inevitable. It is better for me to let the “Debt Dopies” 43 remain concealed by the wider bailout for now, encourage optimism about the economy’s revival, and let someone else deal with the problem later.”

To repeat my opening statement:

It is commonly known that emergencies reveal.

This story illustrates what emergencies can conceal.

Dopey Dwarft
Dopey’s Debt Plan to increase EPS (Earnings per Share)

 

by Tim Langeman

Perhaps you have ideas on how this story could be improved. I welcome your suggestions.

I also welcome suggestions about who you think would be interested reading about and collaborating on this issue.

Tags:

Note:

This is a very simplified example of financialization involving only debt and share buybacks at large corporations. More complicated cases can involve some profit growth, executive compensation, and cost-cutting. This story is not about small businesses. It has been simplified to a case of only 7 shareholders for illustrative purposes.

Questions:

  1. Had you heard how much many USA large corporations’ credit ratings declined in the years before the coronavirus crisis started in early 2020 and that much of their debt was rated just above “junk” status at that time?44 45 NPR’s Planet Money has an accessible and entertaining story on why Credit ratings declined. It was this 9-minute podcast story which inspired me to do the research for this piece.
  2. Did you know that most of the stock purchases made before the crisis were NOT made by pensions, individuals, foreign investors, or hedge funds, but by the companies themselves?
  3. Did you know that over half of companies’ stock buybacks were funded with debt?
  4. Why do you think many large corporations chose to borrow money to buy back their stock rather than invest it for productive purposes between 2012 and 2020? Here’s some possibilities to start with:
    • Too much regulation to make investment profitable?
    • Taxes too high?
    • Too much political uncertainty?
    • Customers already have what they need?
    • Customers too maxed out to afford to buy more?
    • The company has a mature market position- there is little room to grow. Better to draw down on the company’s credit rating (“mortgage the company”) and redirect the money to other companies with better opportunities?
    • Executives don’t want to take a risk on long-term innovation and growth when low-interest rates make significant short-term debt-driven share price increase a low-risk choice?
    • Perverse incentives reward executives for hitting bonus targets in any way they choose, even if their choices are contrary to the long-term interests of the company?
  5. How would you feel if it turns out that, contrary to conventional wisdom, corporate profits (before taxes) had been flat from roughly 2012 – 2020 and stock prices were inflated with debt?4647
  6. What other political or economic things are being revealed or concealed by the coronavirus?

 

Background Reading:

  1. Financialization is profit margin growth without labor productivity growth. (by Ben Hunt)
  2. Texas Instruments: a poster child for financialization, the Obama/Trump Zeitgeist: an unparalleled transfer of wealth to the managerial class (by Ben Hunt)
  3. 9 Questions about the Finance System: Was the Pre-Coronavirus Stock Market a Bubble Inflated by “Financial Engineering”? (2014-2020) (by Tim Langeman)

 

See Linked Spreadsheet for Details of Dopey’s Financial Plan.

(Improve my numbers: download Excel version, tweak and Email me.)

 

Videos


Social Capital CEO Chamath Palihapitiya’s case against stock buybacks, dividends

 

 

More that is Concealed:

Federal Reserve enters new territory with support for risky debt

Programme to support ‘junk’ bonds aims to soften blows from coronavirus and downgrades

.. The Federal Reserve has jolted credit markets by expanding the scope of its support measures, announcing plans to buy debt issued by riskier companies in a radical addition to its crisis-fighting toolkit.

Junk Bonds
Junk Bonds by Simon Cunningham

.. Under the programme, the central bank will buy corporate bonds that were rated triple B minus or above — the threshold for a company’s debt to be considered investment-grade — on March 22. That still includes bonds from recently downgraded companies such as Ford, known as “fallen angels” when they lose their coveted investment-grade ratings.

Read More: Financial Times (British)

 

Obscure Section of CARES Act Provides $195 billion for Wealthy

.. the $2.2 trillion CARES Act passed by Congress last month contains deep within its 800 pages two barely-noticeable tax clauses that only benefit rich Americans, perhaps including the president.

The new tax clauses will cost Americans about $195 billion over 10 years48

Super Yacht: The Rising Sun: Larry Elison & David Geffen
Yacht: The Rising Sun owned by David Geffen
photo by Scott Smith

.. The astronomical cost only became evident a day after CARES was signed into law, when the nonpartisan congressional Joint Committee on Taxation (JCT) published an analysis of the provisions. The committee’s latest findings show that four of five millionaires will pocket an average of $1.6 million more this year alone thanks to the stimulus bill. This of course dwarfs the $1,200 one-time checks average Americans will receive.

In total the tax clauses will cost taxpayers more than the funding allotted in the CARES Act to all hospitals throughout the US, and more than the relief provided to all state and local governments, according to the JCT analysis. Together, they are the costliest elements of the relief package.

Read More: Quartz

Echoes of 2008: They Mistook leverage for genius

Steve Eisman (of Michael Lewis’s book and Movie “The Big Short“)


Steve Eisman: Quantitative Easing was a failure: it didn’t get corporations to borrow and invest. Rather, they borrowed and bought up their own stock. They didn’t really invest in the economy.

In other words, they increased their profits by increasing their debt (leverage) ratio.

(the interview is from 2017)

 


Steve Eisman: Inequality was a cause of the 2008 Financial Crisis (10:17)

People “levered themselves” (ie took out loans that increased their debt-equity ratio)

 

Steve Eisman: They made money because they increased their leverage (debt ratio) and they mistook their leverage for genius (12:19)

Creative Commons License
This work is licensed under a Creative Commons Attribution 4.0 International License.

(Most images created by others)

 

Footnotes


  1. You might wonder why this Federal Reserve chart looks different than upward sloping graphs you are used to.  The first reason is because this graph uses pre-tax figures that do not include the boost that corporate tax cuts gave to the stock market.  The other reason is that this graph is based upon total profits, rather than earnings per share.  In the rest of this article you will learn how corporate debt artificially inflates earnings per share .

  2. The fallout from of the prior 2008 financial crisis was not delt with.  The government bailed out the system and assumed the debt.  Most Americans’ wages had stagnated and healthcare and education expenses gave gone up dramatically.  In order to compensate for week customer demand, companies had begun to borrow money and buy back their own stock.  Even with a deficit of $1 trillion/year, the economy grew at a rate of 2.1% and was projected to fall to 1.6% in by 2024.

  3. Now with the coronavirus crisis, the federal reserve is buying some of that debt, as well as allowing corporations to issue additional debt at artificial prices.

  4. Leveraged” is just a fancy term used to indicate that a financial activity is amplified by borrowing.

  5. Pre-tax Corporate profits peaked in 2014 and have been roughly flat since 2012.  The perception of growth is mostly due to the additional debt (share buybacks) and the  2017 tax cuts (federal government debt).

  6. There are many variations of the Seven Dwarfs’ Names. I’m going with the 1937 Snow White and the Seven Dwarfs animated musical fantasy film produced by Walt Disney Productions

  7. The value of all the stock is equal to the value of all the company’s assets minus its liabilities.

    ( total stock shares = number of shares x share price)

  8. I picked round numbers for this. If you want to help me improve the numbers, see the excel doc in the footer and edit it.

  9. In Place of the Finances of the 7 Dwarfs Mining, Inc., I’ve inserted a Graph above referring to US Corporate Profits before Taxes, as reported by the St. Louis Federal Reserve. Read more about the chart and about “Financial Engineering” that turns this flat graph into a growing one.

  10. While the level of consumer debt was reduced, corporate and government debt went up.

  11. How different would rates have been if the government had not pushed for a late-cycle stimulus and not resisted advice to raise interest rates?

  12. Market Capitalization is the total value of all outstanding shares. Shareholders own what remains after everyone else has been paid (this includes employees, bondholders, vendors, etc)

  13. 7/6 = 1.67

  14. Equity” is the what the shareholders own after all the bills (including debt) have been paid. It is the value of assets minus liabilities. The additional debt they took on to buy out Grumpy’s share is a liability.

  15. Disney Fandom: “Aside from his coyness, Bashful also appears to be romantic. He adores the idea of true love, and when Snow White decides to share a story with the dwarfs, Bashful joyfully suggests a love story, which she obliges to.”

  16. 7/5 = 1.40

  17. Investopedia.com: financial engineering is the use of mathematical techniques to solve financial problems. .. Although financial engineering has revolutionized the financial markets, it played a role in the 2008 financial crisis. As the number of defaults on subprime mortgage payments increased, more credit events were triggered. Credit Default Swap (CDS) issuers, that is banks, could not make the payments on these swaps since the defaults were happening almost at the same time.

  18. Disney Fandom: “However, in spite of spending most of his time nearly falling asleep, Sleepy is apparently the most observant and logical of the seven dwarfs, whether he knows it or not. He was the only dwarf to make the assumption that the Evil Queen may be attacking Snow White at the cottage when the forest animals frantically interrupted the dwarfs’ mine work.”

  19. This is a simplified version of the finances that doesn’t include interest or profit reinvestment. I was concerned that adding them at this point would take away from the broader point.

  20. 7/3 = 2.33

  21. Prior to the coronavirus, roughly half of all corporate debt was rated BBB , which is the minimum “investment grade” rating. A lot of this debt was purchased by the Fed as part of the bailout, including debt that was downgraded to “junk” status.

  22. “Junk” bonds are often referred to as “high yield” bonds. “High yield” sounds nicer and it accurately conveys that these bonds have a higher yield (or interest rate) as compensation for the extra risk the lender takes.

  23. I am deliberately using the British System as a way to distance the reader from drawing favorable or unfavorable inferences onto current American officials. This story is really about the dwarfs (and especially large corporate businesses) and the way they relied on debt to raise their share price.

  24. The Privy Council of the Forest Kingdom is a formal body of advisers to the Sovereign. Its membership mainly comprises senior politicians who are current or former members of either the House of Commons or the House of Lords.

  25. Provinces are like states in the American context. The head of a province is the Premier.

  26. Yes, I know in the British system the Queen would leave this governance to the prime minister but I figure an audience of Americans don’t understand the British system and this version is simpler to explain while taking the spotlight off of particular American politicians.

  27. In some parts of the kingdom the quarantine was applied multiple times to respond to re-occurrences.

  28. Equity” denotes how much their company is worth — how much remains for the shareholders after everyone else is paid.

  29. One might think the debt would be (4 x $1 million)= $4 million. But the actual cost of buying out each share increased as the share price increase: $1 million + $1.28 million + $1.67 million + $2.35 million + bonuses.

  30. For simplicity, I’m using a leverage ratio which uses marketcap/debt. A more common ratio is debt/equity.

  31. value of all shares, which is the share price multiplie by the number of shares

  32. Leverage = 7/2 = 3.5

    • I’m assuming a constant total profit of $7 million to simplify this example
    • I’m not including reinvesting profits or deducting interest paid on the debt

  33. See spreadsheet at the bottom of this page

  34. A debt bomb is a situation where a default on a large accumulation of debt can produce major negative consequences not only for the borrower but for many other market participants. That is to say, other people’s debts can harm you even if you were not over-indebted yourself.

  35. .There is more than one type of debt bomb. Banks can become debt bombs. Countries can become debt bombs due to public debt. This is a simplified example of a small business as a metaphor for an entire country.

  36. Low-interest rates make it easier to have more debt and to create “debt bombs”.

  37. 40% of Americans can not afford a $400 emergency. Why should companies invest in increased capacity when consumers’ wages have been stagnant for decades and therefore can’t afford to purchase more products and services?

  38. One can argue that share buybacks are a good way for established companies with limited opportunities to redirect money to shareholders, but does this also apply when companies don’t have the cash but decide to take on extra debt for this purpose?

  39. I’ve heard that leveraged stock buybacks can be thought of as “refinancing,” but refinancing only changes the interest rate of existing debt. These seem more like talking on additional debt for the purpose of converting equity to debt. The average homeowner can think of this like taking out a second or third mortgage on a house. You’re taking on more debt. If the debt doesn’t have a productive purpose it is likely to be problematic.

  40. Yes, profits per share increased because the number of shares decreased, but total profits were flat.

  41. My goal is to focus on the debt and the circumstances why it was incurred, rather than to focus on Trump (in the American context) or any particular politician, which is why I cast Queen Elizabeth II in the role of queen.

  42. In the Disney series, Dopey does not talk, which does make it a problem if you want to portray him as a “Financial Schemer”

  43. When I talk about large corporations, I’m not talking about small businesses of less than 1,000 employees. The 7 Dwarfs were used as an illustration to make the situation easier to understand, but I don’t mean to include small businesses in this analysis at all.

  44. Roughly half of all corporate debt is rated BBB, which is the minimum “investment grade” rating. A lot of this debt was purchased by the Fed as part of the bailout, including debt that was downgraded to “junk” status.

  45. It is possible that profits are not flat, that they have actually gone up but the unreported profits were siphoned off to tax havens.

  46. Another factor that contributed to corporate share price growth was tax cuts which were “paid for” with additional growth in the national debt.

  47. I don’t know how much money David Geffen will personally get from this bill. I use his yacht as a symbol of the wealth that isolates rich people from the typical citizen and curries favor with the politicians that write, vote for, and sign the bailout packages.

Was Pre-Coronavirus Stock Market a Bubble Inflated by “Financial Engineering”? (2014-2020)

Wall Street Bubbles Cartoon, 1901

1901 Cartoon: “Wall Street bubbles – Always the same

American financier J. P. Morgan is depicted as a bull, blowing soap bubbles for eager investors

 

What Will the “Corona Virus Correction” Reveal?

It’s only when the tide goes out that you learn who’s been swimming naked.

-Warren Buffett (1992) 1 2

 

Hypothesis:

What if Corporate Profit Growth from 2014 to 2020 was “anemic“, rather than strong?  What if many companies who had very little profit growth obscured this fact by borrowing in the bond market and using the proceeds to buy back their own stock.  Their stock prices went up, not because they had greater earnings, but because they had reduced the total number of shares.  In one dimension — earnings per share — these companies looked more attractive, but the borrowing corporations used to achieve this metric masked profit growth weakness and caused the companies’ credit ratings to decline, with many corporations falling to near “junk” status (BBB).  On the Eve of the Coronavirus Correction, corporate debt was $10 Trillion, leaving many corporations vulnerable to an unexpected stress, and ensuring that once a “match was struck”, the dry “tinder” would burn quickly.

Now that the recession has begin, governments will be faced with reduced tax revenue and, as a result, will reduce their pensions’ purchases of bonds.  Corporations have used money borrowed from these pension funds to buy back their own stock.  Now that the pension systems have (indirectly) stopped lending them this money, corporations will have to reduce the amount of their stock buybacks.  As stock buybacks decline,  the ratio of sellers to buyers will rise and the price of these stocks will come under pressure.

It is too early to say where the bottom is to this recession, but we have reason to believe the Millennials and Generation X do not have the resources to purchase the stock that Baby Boomers want to sell at prior market highs.  With Corporate profit growth unmasked and the Baby Boomer’s transition into retirement, it seems unlikely that stocks will make a quick return to their prior levels unless governments engage in massive asset inflation.

Here are my top 9 questions: #

  1. Is it true that Corporate Profits have been “Anemic” since 2014 and this has been obscured by “Financial Engineering”? 3 4

      • Eric Basmajian writes on Seeking Alpha (Feb 28, 2020):
        (click blue CiteIt.net arrows above and below quote to expand)

        Corporate America has been plagued by anemic economic growth in this economic cycle. Masked by the rising share price of roughly 500 companies, thousands of corporations that aren’t publicly traded have been forced to operate in a low-profit growth regime.

        Financial engineering has allowed publicly-traded companies to report strong earnings growth. Total corporate profits reported in the GDP report is a far more accurate, albeit delayed, data source on the real (non-adjusted) profits generated by the corporate sector.

        From 2014 through the start of 2018, corporate profits declined. The one-time spike in profits after 2018 was due to the corporate tax cut. Essentially, without the corporate tax cut, the corporate sector has seen virtually no profit growth since 2014.

        This assessment might seem “off” if you’re used to charts like this:
        Chart 1: from JPMorgan (page 7):
        S&P Earnings per share (JPMorgan)

    But note that the S&P Earnings per share are heavily influenced by the share count reduction caused by buybacks.

  2. Is it true that Corporations have been the dominant buyer of their own stocks in 2018 and 2019?
  1. Chart 3:  Source: Goldman Sachs via MarketWatch Corporate buybacks are dominant source of equity deman

    “It’s a fair critique of corporate earnings to say that earnings “growth” in 2019 is a bit deceptive as the value is being financially engineered by corporate finance departments, not organic, core-business growth,” wrote Tom Essaye, president of the Sevens Report, in a Wednesday note to clients. “Companies aren’t making any more money than in 2018—they just have a smaller share count to spread the money over, so EPS are rising.”

    (click blue arrows to expand quotations, created by CiteIt.net app)

  2. Is it true that over half of all stock buybacks have been made with borrowed money (Corporations borrowing to buyback their own stock)?

    Indeed, more than half of all buybacks are now funded by debt. And while there’s an argument that repurchases benefit share prices and investors, at least in the short run, it’s questionable whether highly indebted companies should be doing this. Sort of like mortaging your house to the hilt, then using it to throw a lavish party.

  3. Is it true that there are only Two US Companies with a AAA credit rating and that many high profile brands have the the lowest possible rating credit rating above “Junk” status (BBB)?

      • If the junk market were to be sufficiently disrupted, companies could be forced to default on their debts. That would likely force massive layoffs and sharp reductions in business investment, turning the financial market’s headache into a punishing economic ill, economists and money managers said.

        “It’s going to amplify everything,” said Krista Schwarz, a finance professor at the University of Pennsylvania’s Wharton School. “It’s going to make everything happen faster, larger, worse. The recession would just be that much deeper.”

      • To what extent are these companies’ debt a result of productive investment verses “financial engineering”?
      • Has Russia and Saudi Arabia’s decision to engage in an oil price war already made a Corporate Debt Crisis more likely? (Washington Post March 10 2020)
  1. Is it true that Corporate Debt is at an all-time high ($10 Trillion), which, including off balance sheet debt, amounts to 74% of GDP?
      • In July of 2019, Goldman Sachs Alum Raoul Pal explained how Corporate Debt could cause a financial crisis: (Starting 39 minutes into this video)
      • Will a reduction of taxes during the recession cause government pension plans to reduce pension contributions, cutting off funding which corporations use to buy back their own stock, causing stocks to fall sharply?
    • 50% of all corporate investment grade debt was rated BBB in 2019 when this video was made (43:45)
    • How high is the risk that 10-20% of BBB corporate debt gets downgraded in the next recession and become “fallen angels” , freezing the Junk bond market.
    • Will a frozen Junk bond market prevent maturing bonds from being rolled over?
    • Will Corporate Debt downgrades cause many pensions to go bankrupt?
    • What effect will Corporate Debt have on the depth of the next recession and the speed of the recovery?
    • Update: This is why the Fed started to buy BBB debt and fallen angels (recent “junk” bonds)
  2. If Corporations have had access to money (either cash or through low-interest borrowing or through tax-cuts), why didn’t they invest more of it for productive purposes, rather than buying back their own stock?7
    • Have corporations viewed many of their investment opportunities as unattractive?
    • Is this a problem on the demand side, rather than supply side?8
  3. Is it true that real median men’s wages have declined by 5% from 1979 to 2018? (Congressional Resource Service, R45090, Updated July 23, 2019) 9 10
  4. Is it true that ~40% of Americans surveyed by the Fed couldn’t come up with $400 in an emergency?
  5. Is it true that Millennials make 20% less than their parents did at the same age (with much higher student debt)?
    • The answer to these last 3 questions determines the purchasing power of a significant portion of the population.  The answer to this last question influences the ability of the Millennial and Gen X generations to buy out the baby boomers’ stock market holdings as the boomers sell stocks to finance their retirement.


Update:

 

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Footnotes


  1. New York Times columnist James B. Stewart cited Buffett’s quote from a 1992 letter to shareholders. Stewart describes leveraged loans as a potential problem areas to watch: (March 10, 2020)

    Leveraged loans, which are private loans to already heavily indebted borrowers, could now emerge as the mortgage-backed securities and collateralized debt obligations of the financial crisis.

  2. Warren Buffet repeated this “swimming naked” quote in his Feb 2008 letter to shareholders.

  3. I recognize there are other factors.  Performance has been obscured largely by a combination of:

    1. Financial Engineering,
    2. Corporate Tax Cuts, and
    3. Loose Federal Reserve Monetary Policy

  4. It is also possible that tax avoidance could result in under-reporting of profits. (Source: Wall Street Journal: Dec 19 2019)

  5. Note: this is not to say that there are not companies that have shown growth, but that the overall trend is towards stagnation (or a “plateau” in profits), while the S&P 500 rose from 1259 on Jan 1 2012 to 3230 on Jan 1 2020, an increase of 156%!

  6. Some of McDonald’s motivation to pursue stock buyback may have been to “mollify activist hedge funds”. “More pertinently, a huge program like McDonald’s buyback of 2014-2016 is designed to encumber an organization’s balance sheet, adding so much debt that potential activists can’t leverage the company further to fund their own turnaround plans.”  (Source: Motley Fool : May 10, 2018)
    How commonly is debt taken on defensively to prevent shareholder activists from taking over the company?

  7. Yes, I understand the theory is that it is better for mature businesses to return capital to shareholders so that shareholders can direct it to companies that can make better use of capital, but this does not apply to buybacks made with borrowed money.  If this is true for a broad range of companies, what does that say about how companies’ view of their opportunities?

  8. Do Americans have too much debt and not enough income to warrant investment in the US?  How much of that lack of income is due to globalization or other factors that can not be fixed by tax cuts or other supply-side incentives?

  9. Race, education, and gender are factors in employment wages.  I chose median white male wages because recipients had historically received compensation sufficient to reach the “American Dream” .  Compensation for women and minorities has improved, but these improvements seem unlikely to reach parity with the compensation white men received in the 1950s-1970s any time soon.

  10. I also realize that benefits have risen (particularly health insurance).  So if you are an employer, I can see your point that total compensation is rising, even if wages aren’t.  Nevertheless, median wages are stagnant or declining, which may explain why more households feel like they need two incomes, working a higher number of hours.