Are share buybacks the rope that will hang the last capitalist?

Fortunately, the saying: “the last capitalist we hang shall be the one who sold us the rope”, attributed to Karl Marx and Vladimir Lenin, never materialized and communism is now discredited.

However, the capitalist system is exposed to built-in mechanisms that may lead to its demise. One serious candidate to ruin capitalism is the practice of companies repurchasing their own shares.

In 1980 the amount spent buying back shares in the USA reached 80 billion, but in 2018 the companies listed in the S&P500 index alone spent 806 billion in buybacks (and paid another 462 billion in dividends). Indeed, in 1999 buybacks used up to 75% of operating earnings and in 2008 had exceeded operating income by 25%. Although after the financial crisis that number was brought back to 60%, in 2016 buybacks reached 110% again and in 2018 still remain close to 100% of earnings.

Moreover, some well-known corporations (e.g. MacDonald’s and Starbucks) have been so aggressive buying back their stock that they now have negative equity. In the past such companies would be considered insolvent and in serious risk of bankruptcy, but today markets seem to disregard such risk and often value them handsomely.

How did we come to this situation? Basically, through the persistent attack on one key foundation of capitalism - the profit motive. In the past, Marxists, and anti-capitalists in general, were the main critics of profits as a form of exploitation or advantage to capitalists. However, in the 1960s some finance theorists provided a new weapon against profits by proclaiming that firms should aim at maximizing shareholder value rather than profits. This ambiguous metric opened the door to unscrupulous managers to try to manipulate stock prices through share buybacks to cover up their poor performance or to fill their pockets through stock options.

Regulators validated the practice by focusing exclusively on the risk of price manipulation, limiting repurchases to a maximum of 10% of the shares outstanding annually and some rules on how repurchases could be made in the open market. So, buybacks continued to grow for several reasons, including unchecked CEO greed and favourable taxation.

Most investors, seduced by the short-term view that stock prices would rise as the number of shares available for trading were reduced, also embraced the practice enthusiastically.

Among the few doubters, was Warren Buffett who alerted for the danger of adverse selection (buying high and selling low) and the risk of rewarding handsomely mediocre managers, notably on his famous parody of Mr. Fred Futile, CEO of Stagnant, Inc. I shall use his story to show that the danger of buybacks goes beyond rewarding mediocre management and endangers the future of capitalism.

In Buffett’s story, Fred Futile receives as compensation a ten year, fixed-price option, on 1% of the company. Quoting: “Under Fred’s leadership, Stagnant lives up to its name, and in each of the ten years earns $ 1 billion on $ 10 billion of net worth, which initially comes to $ 10 per share on the 100 million shares then outstanding. If the stock constantly sells at ten times earnings per share, it will have appreciated 158% by the end of the option period. That’s because repurchases would reduce the number of shares to 38.7 million by that time, and earnings per share would thereby increase to $ 25.80. Simply by withholding earnings from owners, Fred gets very rich, making a cool $ 158 million, despite the business itself improving not at all”.

Note that in this story, Fred Futile keeps to the regulatory limit of 10% and does not use debt to repurchase the stock. Thus, long term investors, like Mr Buffett, who declined to sell their shares would achieve a compound annual return of 11.11%. This is well below the 20% achieved by Mr. Buffett but is satisfactory to less skilled investors.

Now, let me introduce a variant to the story by assuming that Mr. Buffet owns 1% of Stagnant Inc and does not fear becoming its single shareholder, the regulators drop the 10% rule and that the 10-year borrowing costs of Stagnant Inc are 5%.

What would be now the best options for Fred Futile and Mr. Buffett?

First, Fred Futile should consider how to maximize his return. This could rise to a staggering 2.2 billion if he were to increase the annual repurchases to 40% of the outstanding shares. With this rate of repurchases Stagnant Inc would end up with a single capitalist, Mr Buffett, with 1 million shares, at the end of Fred Futile term as CEO. Now, Fred Futile had three options, to receive cash and leave, to receive 1 million newly issued shares or to receive 1 million shares bought from Mr. Buffett and own the company.

Having realized that Stagnant Inc had lived up to its name, Fred Futile would certainly prefer to cash-in, but the final decision belongs to Mr. Buffett. On the contrary, Buffett’s safest option would be to sell his holding at 10 times earnings to the company (with a compound annual return of 41.8%), because Stagnant Inc would be the only sure buyer of last resort at that price. I will ignore the other two options, because they are riskier for Mr. Buffett.

However, by selling the stock back to the company, Buffett would leave the company with negative equity of 7.5 billion. And, even if Fred Futile was naïve enough to believe that he could find a buyer for his company at 10 times earnings, the value of his stock would then be only 1170 million (i.e. 47% of the cash amount) because of the substantial decrease in earnings to 231 million. So, for Fred to secure a value equivalent to the cash-in amount, the company could only offer to buy Mr Buffett’s stock at a 90% discount (i.e. at 0.9 times earnings). That is, the last capitalist would be “robbed” of his company in exchange for a paltry return of 9.8%.

Still worse, it is questionable whether creditors would allow the company to build such a large negative equity without forcing a liquidation or restructuring. Therefore, the prospects for the last capitalist might be even worse.

Now, since Mr. Buffett is a clever investor one must admit that he would never allow management to “expropriate” the capitalists in just 10 years, or even the 43.7 years needed under the current 10% repurchase limit, but is willing to accept a 5% repurchase program as currently adopted by some of his investee companies (e.g. Apple). At this repurchase rate it would take 89.8 years to eradicate the last capitalist. Is this too far away to be of concern or for capitalists to become aware of the danger? Not really.

To understand why, let us admit that the astute Mr. Buffett decides to sell its holding in Stagnant Inc to Joe Blind, MD of the Workers Retirement Fund. True to his name, Joe lives and retires careless enjoying the bonus received on the rising, but unrealized, value of the fund holdings of Stagnant Inc. The same with Fred Futile, and both leave their jobs to their children who have no reason to doubt the wisdom of their ancestors and continue their policies.

Unfortunately, within two or three generations the Workers Retirement Fund becomes the last capitalist in Stagnant Inc and Joe Blind Junior will have to face the same dilemma as Mr. Buffett in the example above.

However, the consequences are much worse. While Mr Buffett is rich enough to live with a paltry return, the retirees that are the ultimate capitalists of the Workers Retirement Fund would have to survive on that miserable return. That is, the death of the capitalists and the profit motive will condemn workers to misery.

All in all, combining buybacks with stock options is a legalized form of deferred robbery of shareholders by management. And, neither investors’ myopia nor the merits attributed to buybacks justify endangering capitalism. So, its widespread practice and growth may indeed become “the rope that will hang the last capitalist”.

Nice job if you can get it!

Based on the Forbes chart reproduced below, one can see that the gravy train of CEO compensation has resumed its unstoppable acceleration.

Assuming the current average CEO pay and an average return of 5%, an investor would need to invest 200 million to achieve this level of income. Since there are no risk-free opportunities paying this type of return one must conclude that investors would be better off by “buying” a risk-free CEO job that pays this level of compensation.


Nevertheless, as shocking as these numbers are, they hide the true scale of the problem by mixing CEOs that are founders or significant investors in their companies (where compensation and dividends may be mingled) with CEOs that are simply managers. In particular, it hides the outrageous pay in the so-called managerial capitalistic sector.

This sector is run by the second type of managers. It includes all companies where control is exercised not by the owners but by incumbent management, and it can be divided in two broad categories – licensed monopolies/regulated firms and companies with a high level capital dispersion preventing individual investors from exercising control (typically companies with a float in excess of 95%).

The absurdity of such pay packages can be illustrated with reference to the greediest and the worst performing CEO, based on the Forbes list and SADIF Analytics rankings respectively. The first is John H Hammergren the CEO of McKesson´s, a drugs & biotechnology company, who earned a 6-year average compensation of $50.79 million. The second is Daniel R Hesse the CEO of Sprint Nextel, the telecommunications operator, who earned a handsome $.6.6 million last year. Their basic cash compensation and respective company´s stock price performance are depicted in the two charts below.

And, what have they achieved during their recent tenure? McKesson´s investors had a 6-year annual total return of 9% (a paltry 2% above the industry ETF), while Sprint´s investors total return was a huge loss of 31%. Another way to see what is at stake is to take the case of a large shareholder in McKesson´s, for instance the 8th largest (Glenview Capital Management, with a stake worth about $414.1 millions). They would need to have invested almost $250 million to earn an amount equivalent to just half of what the CEO made. That is, they would be better off by trying to “buy” the job for themselves.

Large organizations are bureaucracies whose short term performance is to a large extent independent of their leaders. Indeed, like governments, most would not notice if the CEO/President had taken a long leave of been replaced by a dummy. And, likewise those leaders who really shape their future would perform as well whether they earned 800k or 1600k.

So the sky-rocketing of management pay sparked by the rise of managerial capitalism in the 1980s is not a matter of performance reward but truly a case of CEO-Kleptocracy.

Is Finance Theory Responsible for the Rise in CEO-kleptocracy?

The unprecedented rise in the compensation of CEOs and other top executives in US listed companies began in the early 1980s. As documented in several studies, including that of Frydman and Saks (2007) from which we reproduce the following two charts. In the 1980s the average total compensation of the top three executives suddenly jumped from an historical multiple below 40 times the average worker compensation to a median multiple that is now close to a 120.

This trebling in relative compensation was achieved mostly by linking compensation to the stock performance during the strong bull market of the 1980s and 1990s. As shown in the next figure its contribution to total compensation now accounts for more than 50% of basic compensation (salary + performance bonus).

Since managers have little or no influence in the valuation of their companies, was their pay just a fortunate coincidence due to the exuberant valuations of the stock market during those two decades? Or, did finance theory legitimize in the eyes of the shareholders their hands in the till behavior? We can dismiss the first hypothesis by the fact that throughout the last seventy years managerial stock holdings remained always below 1% and by looking at Shiller's chart of the S&P Composite Real Price-Earnings Ratio.

Although the nine-fold rise in real valuations between 1980 and 2000 was unprecedented by historical standards we must notice that during the other two major bull periods ended in the crashes of 1929 and 1973 the median compensation multiple never exceeded 40 (despite a seven-fold valuation rise before 1929 and a four-fold rise before 1966).

Moreover, when valuations returned to their normal values after the stock market crash of 2001, executive compensation continued to rise instead of correcting downwards. For instance, in the period 2000-2005 the real value of total compensation of the three highest-paid officers in the 50th percentile almost doubled to 5.2 mllion while that of those in the 90th percentile more than doubled to 21.6 million dollars in today’s values.

So what led shareholders and the taxman to become so generous in overlooking this hands on the till behavior?

Until the 1950s the number of top executives holding share options was basically negligible. However, from 1965 to 1980 the fraction of those granted share options rose from less than 20% to more than 60% and by 2000 it had reached 100%.

Despite being traditionally indifferent to management issues, finance theory was seized by executives to demand and legitimize their new found wealth. The following is a short-list of the key developments in finance theory that played some role in this process:
1) The Modigliani and Miller theory on the neutrality of capital structures resuscitated the entity theory of the firm and provided the basis for a widespread belief that paying dividends was an inefficient way of making distributions (a view reinforced by the predatory tax regimes of the time);
2) It also created a tolerant attitude towards excessive leverage which was later used to drive buy-out strategies and risk arbitrage driven M&A transactions;
3) Modern portfolio theory, with its emphasis on diversification, promoted the wide dissemination o capital among minority institutional investors. This, in practice, left companies in the hands of their managers and investment bankers colluding on irresponsible corporate governance approaches sanctioned by ever obliging compensation consultants;
4) Financial innovation in the use of derivative instruments and the Black-Scholes formula to price stock options facilitated and ignited the recourse to dubious short-term market manipulations through earnings management and outright accounting fraud.

However, although finance theories were the facilitators of the process, what really ignited it was the replacement of previous values based on fairness and justice by the greed and no-taxes cultures promoted by the Reagan and Thatcher right wing revolutions. These were compounded by the subsequent corruptible nature of the regulated and regulatory industries brought in by subsequent left wing governments.

So, halting and reversing the hands on the till process will now require a change in political attitudes as well as a denouncement of the misuse of academic finance theories.

Why trade investors collude with managers to vote for star-like compensation

The star-like compensation of CEOs and other senior managers is undermining the trust of people in the fairness of capitalism. The spiraling of shocking compensation packages continues because the market system does not have built-in self-interest incentives that prevent collusive behavior between trade investors and managers. The problem is more acute in listed companies with high levels of float and with significant shareholdings by trade investors that do not compete to supply or finance the company.

A simple numeric example is enough to illustrate the problem. Consider the case of an investor who is contemplating investing in two almost identical companies—Companies A and B—trading at the same multiple of earnings, with the same expected risk and a rate of return on equity of 20%. Company B is a potential major supplier or financier of A, but is not currently trading with Company A. Both companies have the same asset turnover and leverage. After paying the current market rate of 1% of profits as management compensation, they each generate a net profit of 10%.

Prudence dictates that the investor should diversify by investing in both companies. However, given that A and B have the same expected return and risk, regardless of how the investor chooses to split his investment (whether 50/50, 10/90, or any other way), his expected return will be always 20%.

Imagine now that the CEO of Company A only needs 10% to control the board of directors and approve a pay raise that triples his compensation to 3% of profits. Management approaches the trade investor and asks him to invest 10% in company A and vote for the proposed pay rise in exchange for A giving B 10% in new business, provided that B matches the price of the suppliers replaced.

As long as the investor is able to lead a majority of shareholders in Company B, they will keep the Company B managers’ pay at 1%, so that his total return from both companies will now increase by 8.81% to an average return of 21.76%. Since there is no new value creation, the gains obtained by management and the new insider investor are made partly at the expense of the remaining shareholders in Company A, but mostly at the expense of the replaced vendor. The reduction in return incurred by the shareholders in A would be just 0.39 percentage points (i.e. 1.94%). This small loss could be either concealed or compensated if the other 40% of insiders supporting management protest.

It remains to be shown if there are any self-interest market mechanisms to prevent this predatory behavior. There are three candidates to oppose the insider investor’s actions in the above example: the managers of company B, the suppliers displaced, and the other investors in Company A—but none will be able to prevent such behavior. Here’s why:

The managers of B could try to get a similar pay raise by threatening to leave and bid for the job of A’s managers. If they were to get a similar raise, this would offset a large share of the investor’s gain. However, as a controlling shareholder, the investor can easily collude with A’s managers and other insider shareholders to stop such a bid. Thus, the managers of Company B can only threaten to shirk on their increased workload and ask for a modest raise. For instance, if they manage to get a 20% raise, this would only reduce the trade investor’s return to 21.72%.

The suppliers replaced may or may not be among the current group of insider shareholders. In the first case, they would try to fight the managers, but unless they can attract other shareholders to their cause, the only way they can retaliate is to sell their position to hurt the stock price. However, this would mean the supplier’s adding a self-inflicted capital loss on top of his business loss as a supplier, while simultaneously lowering the entry price for the new rival investor.

Next, imagine that the non-insider investors of Company A wished to retaliate against the managers’ pay raise by selling their stock. This would result in a self-inflicted loss for the late sellers. This loss could only be prevented if the insiders stepped in to buy the shares, or if management acted to offset a possible decline in the stock’s price by promising to pay an increased dividend or by introducing a share buy-back program. Forced to choose between certain loss and a promise, they will be more inclined to bet on the manager’s ability to avoid a decline in the stock price.

Finally, if the replaced suppliers were not yet shareholders, they might try to keep the business by outbidding the investor and invest the same amount while supporting A’s management in a bid to get an even higher pay raise. However, they could not outbid the rival investor. The pay incentive would only work if they could compensate the other insider investors, and their investment in A would have a lower return than that of the new investor since they would not gain from increased sales to their business.

The numeric example given above can be replaced by a model to work out the optimal investment allocation between A and B, including the more common situation where Companies A and B are different, but it is easy to see that the optimal outcome will also depend on the possibilities to switch suppliers and the greed of Company A’s management. It is nevertheless unquestionable that there is a large incentive for collusion between management and trade investors against other investors in A and its current suppliers.

Are the costs of this market failure large enough to damage the working of market capitalism? If so, then the question now is to assess if it is possible to correct this inefficiency through regulation.

The simplest way to regulate is to impose limits on the ownership of major suppliers, to limit their rights, or a combination of both. The first could be easily defined, but it can be easily evaded. In particular, in the case of shareholdings by suppliers of financial services, such limits could be easily circumvented by investing through investment funds managed by those financial institutions.

Limiting the voting rights of trade investors who are major suppliers of Company A is probably the best solution. It does not disrupt arms’-length trading relations, and it is more easily enforced. The only debatable issues would be about the qualification of trade investors and the voting restrictions. These should cover voting for the election of management and their remuneration, but they could also extend to voting in the Governance and Auditing Committees.

Regulation always has its own costs, which should not be disregarded lightly in a full assessment of this proposition. In particular, the possibility of discouraging trade investing may have its costs in terms of business intelligence and synergies. However, overall, limiting the voting rights of trade investors would be a market-perfecting policy that would contribute to achieving the ideal of true market capitalism.