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”.

Warren Buffett on Dividends and Management Capitalism

Every year I wait eagerly Warren Buffett´s letter to Berkshire shareholders to benefit from his wisdom on investment. I consider him one of the great champions of shareholder-oriented policies and usually agree with him. However, this year I fundamentally disagree with his contradictory statement on dividends. Let me explain why.

Although concluding that “We like increased dividends, and we love repurchases at appropriate prices”, he relegates the payment of dividends for last, after share repurchases (a form of earnings distribution that he opposed in the past). His view replicates the logic of the so-called pecking order theory of financing which states that firms prioritize the various sources of funds on the basis of how easily they can be accessed. Likewise, Buffett advocates that CEOs should first look to deploy the company earnings on current operations, after look for acquisitions unrelated to their current businesses, then consider repurchasing their own shares if the price-to-book value is below 1.2 and finally pay a dividend.

This use of earnings will inevitably transform CEOs into asset managers and strengthen what I call management capitalism. I define management capitalism as a system where managers may choose the investors rather than the other way around.

Management capitalism is mostly found in the regulated sectors of the economy (banking, transportation, utilities and other former state-owned companies), but also among public companies where capital has been so diluted that the former owners or their heirs no longer have a controlling interest in the business. For example, Berkshire is the single largest shareholder in Coca-Cola but owns only 8.98% of the company and appoints 2 of the 22 directors.

To simplify we may include in the management capitalism sector all public companies whose float exceeds 80% and the largest shareholder owns less than 15% of the total stock. Using these criteria, 3/4 of the 41 companies in Berkshire´s portfolio of listed companies are in the management capitalism sector. This bias in his portfolio is partly explained by the fact that he only invests in large cap stocks. Equally, his preference for CEOs with the profile of a private equity fund manager may be reasonable in his special case. Since he runs his huge portfolio with a team of only 23 people (including support staff) it is obvious that he has to rely on his CEOs as a kind of portfolio managers.

However, managerial capitalism is inferior to market capitalism because it relies on collusion with government policies (namely to inhibit the payment of dividends and distort competition), carries excessive governance costs, is highly exposed to agency problems, undermines competition and has fewer shareholder-oriented CEOs. Those that do not pay dividends often aggravate these problems.

Unfortunately, the alternative to dividends advocated by Buffett does not solve these problems. He argues that instead of receiving an annual dividend, investors pursuing an income objective would be better off by selling annually the number of shares needed to cash in an amount equivalent to the desired dividend. He gives an example assuming no-taxes and constant returns on equity and price-to-book ratios. Under such conditions the sell-off is obviously better. He adds two more advantages of sell-offs, namely that sell-offs do not impose a cash-out policy upon all shareholders and are more tax-efficient.

However, with rising capital expenditure one must expect diminishing returns on equity. For illustration, in the Buffett example, if the return on reinvested earnings after 10 years had fallen to ¼ of the starting return, the sell-off advantage over dividends (about 4%) would be halved. Given the overriding tendency to grow big at all costs there is a major danger that such returns may even turn negative.

Buffett himself, in his 1989 letter, recalling the lessons learned in his first 25 years as an investor, alerted that: “(2) Just as work expands to fill available time, corporate projects or acquisitions will materialize to soak up available funds; (3) Any business craving of the leader, however foolish, will be quickly supported by detailed rate-of-return and strategic studies prepared by his troops”.

There is a possibility of controlling this trend, acknowledged by Buffett in his 2012 letter as the pursuit of intrinsic value. That is, to require that net worth grows faster than investment. I checked how his current portfolio of listed stocks had performed on this count over the past four years and the result is not brilliant – less than half (17/41) had a positive elasticity of net worth in relation to capital expenditure and only two companies had an elasticity greater than one. So, if a major shareholder like Buffett cannot enforce this rule imagine how hopeless the average investor is.

Overall, the (uncertain) advantage of sell-offs over dividends is too small to compensate for the greater inefficiency of management capitalism in relation to market capitalism (the present value of his 4% estimated advantage is less than 1.6%). Moreover, it does not justify complacency with the frequent collusion between management capitalists and tax authorities to discriminate against dividends.

So, I am left wondering whether the recent softening of Buffett’s stance in relation to share repurchases and dividends has contributed for his weakening performance and if we risk losing a supporter of shareholder-oriented managers. However, I still hope that he will prove me wrong.

Should Warren Buffett look for a successor or return the money to his investors?

This weekend takes place the annual Woodstock for Capitalists (officially called the Annual Meeting of Berkshire Hathaway Inc). Warren Buffett expects that attendance will exceed 35,000. What will be in the mind of all these investors? I guess that a popular topic will be: Has Warren chosen a successor?

Finding a successor is normal for most companies when their founder chooses to retire. But, Berkshire is not a normal company. Berkshire is a bit like Cerberus, the three-headed dog of Greek mythology. To simplify we may say that it is one-third insurance group (a typical corporation), one-third private equity firm and one-third investment fund. A typical corporation requires a complex bureaucratic organization which takes many years to assemble and will become self-perpetuating. This is not the case with investment funds.

You may see collective investment vehicles (funds) as a pool of money looking for a manager to invest the funds pooled together by many independent investors. Or the other way around, you may see fund managers as promoters trying to persuade investors to trust them with their pool of money. Whatever way people see collective investment schemes, most investors never see the pooling of money as a perpetual commitment. Indeed, many funds even have a mandatory termination date.

So, should the independent co-owners of a diversified portfolio part their way or try to find another fund manager? Fund managers are a bit like artists, each one with his unique style. In that sense they are irreplaceable. For instance, when Pavarotti died his admirers did not try to find another Pavarotti. They simply turned their loyalty to another artist. He could be an opera singer, a rock star or even a painter.

At 86, Warren Buffett is the unquestionable master of value investing. Should his co-investors be in the look-out for a new master of value investing (which may not turn up for many years) or should they simply search for today’s masters of various other investment styles? Warren has always advocated the need to look for talented and honest people to run his operations, while stressing that he must not delegate risk control.

In the end, will the master investor surprise us on which Cerberus head leads Berkshire?