February 11, 2015

The Reality Discount

If reality were measured like stocks in multiples of earnings, how much should we discount it?

Alert (and good-looking) reader Karen Quast sent a Feb 8 story from The Atlantic by entrepreneur Nick Hanauer, Amazon investor and founder of aQuantive, acquired by Microsoft for $6.4 billion. Called “Stock Buybacks are Killing the American Economy,” Hanauer’s treatise contends companies have shifted from investing in people and stuff to trafficking in earnings-management.

While Hanauer’s real target is sociological, he offers startling statistics compiled at theAIRnet.org. Companies in the S&P 500 have repurchased $6.9 trillion of stock the past decade including $700 billion last year.

The Sept 2014 Harvard Business Review ran a similar story by UMass professor William Lazonick called “Profits Without Prosperity.” Mr. Lazonick says S&P 500 components between 2003-2012 spent 54% of profits, or $2.4 trillion, on buybacks, and another 37% ($1.6 trillion) on dividends, thus sending 91% on to holders.  What strikes me is that companies must’ve borrowed roughly $3 trillion more for buybacks.

Hanauer also nods toward GMO Capital’s ($120 billion AUM) James Montier, whose incendiary white paper “The World’s Dumbest Idea” (drawn from a Jack Welch observation) has been the subject of contention in the investor-relations profession and beyond.  Montier claims a tally of buybacks from the 1980s forward shows firms repurchased more shares than were issued.

If that seems to defy the existence of the stock market (if more shares were bought than offered, how are there any to trade?), it doesn’t. There once were nearly 8,000 companies in the Wilshire 5000 while today it’s 3,750 (you’d think the Wilshire 5000 described the number of companies in it), a 53% freefall. But the big have gotten bigger, with US market capitalization about $2.8 trillion in 1988 and $25 trillion today (rewind to 1950 and total market cap was $92 billion – equaling just, say, Biogen Idec’s market cap now).

Why are the companies our profession presents to Wall Street and Main Street in a feeding frenzy on themselves?  Hanauer says a rule-change by the SEC in 1982 diluted the definition of stock-manipulation that until then kept companies reluctant to buy their own shares. Evangelists of income-inequality say the problem is executive compensation emphasizing stock-based rewards.

TheAIRnet.org wants buybacks banned. Many repurchase critics say companies are paying shareholders at the expense of workers and the broader economy (the Investment Company Institute however notes that 70% of shares are owned by institutions representing about 95 million accounts – meaning the moms and pops of America in their 401ks and pensions).

Suppose companies had been barred from buying back shares the past decade.  Many say stocks are currently valued fairly versus historical norms, with the S&P trading near 16 times earnings. Where would the market trade if earnings were reduced by half?  Nobel-Prize-winning Yale economics professor Robert Shiller tallies an inflation-and-cycle adjusted 27 PE now, well over his long-run average of 17 but way off the 1999 peak of 44.

But what’s reality?  Should we devise a metric that compensates for equity shrinkage? And how do we account for worldwide central-bank policies that expand currencies at set rates regardless of output or consumption (soaring market caps are partly a product of diminishing purchasing power)?

What market multiple can we believe – or phrased another way: If we could ever define reality, what’s the discount rate on it?

Speaking of discount, our profession would be wise not to dismiss this anti-buyback fervor as ravings of lunatics. The contemporary and ubiquitous zeitgeist is that somebody is getting screwed but we’re not sure who’s doing the screwing or how the screwing is being done.

I think human behavior around money is always a reflection of its value. Because returns from long-term capital-deployment have been depressed through the commoditization of cash, companies engineer them instead in the stock market. And until further notice, this is a reality confronting our profession. We’d best have an answer.  Mine is that cheap money breeds short-termism.

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