General

A Post About Financialization

By Camilo on April 1, 2020 0 Comments

What is it? Generally, looting a large publicly traded corporation’s cash flow. There are many ways to do this but here’s one method: a stock buyback, followed by the transfer of some shares to senior management. This is added to salary and benefits. Sometimes, debt is used for the cash to buy stock.

There might be other kinds of financialization, but this is the basic form. Done this way, buybacks are used to opaquely give huge amounts of cash to senior management. This compensation is harder to see than salary or non-cash compensation like the use a company private jet, vacation homes, or the best seats at sporting events. You don’t have to dig through a company’s financial statements to find those things, as you would for the stock transfers.

A stock buyback isn’t bad per se. It can benefit shareholders. Ideally, repurchased shares are retired, reducing the share count (float), so the remaining shareholders own more of the company. They indirectly become richer by owning a greater share of the company’s earnings without having to spend money. Stock buybacks are seen as shareholder friendly, like dividends.

Speaking of dividends, a buyback improves the payout ratio, a measure of dividend safety (all other things being equal). Payout ratio is dividends divided by earnings – the lower the safer. With fewer shares requiring a dividend payment, the total dividend payout (numerator) decreases, while earnings (denominator) stay the same. Payout ratio goes down – again, shareholder friendly.

Lastly, if the stock price is low (however the company decides this is true), a buyback is smart because the stock is selling at a discount. If interest rates are low, it might make sense to take out a loan. A bean counter somewhere deep in the bowels of HQ will accomplish the justifying analytical jiu-jitsu (the corollary: the company should issue new stock when the price is high to retire loans).

So the rules for prudent stock buybacks are: retire the shares for owner concentration and dividend reduction, wait for a bear market, and watch debt carefully.

So, is it possible to break the rules? It’s as simple as looking at the prudential rules and doing the opposite.

Don’t pay a dividend? Then there is no benefit from the perspective of dividend safety. Your payout ratio of 0% goes to … 0%. I know that’s tautological, but lowering payout ratio is a real benefit that doesn’t even exist in this case, which is why it must be pointed out. Worse, if a company takes out a loan to buy back non-dividend paying shares, it’s incurred a monthly payment for nothing. Only the lender wins in this scenario. I have a hard time imagining anything dumber.

Unless I imagine buying back stock during a bull market. Almost all stocks follow the market. If the market is overpriced, there is no discount. Large corporations should have analysts who can evaluate the price of their own stock relative to the recent past and to sector valuation. If the price is high (or even fair), there should be no buy back. It can wait for the bear.

Lastly, if the shares aren’t retired, the major “shareholder friendly” aspect a buyback (shrinking the float) disappears. If those shares are given to employees, this is a transfer of wealth from the shareholder to the employee on top of the agreed-to compensation. This is backward; the employees are there to make the shareholders richer.

Counter argument: if those shares are given to employees, doesn’t that create an “owner mentality”? This is akin to the socialist revolutionary stance that the proletariat must own the means of production. A company that wants to motivate its employees has another lever: profit sharing and bonuses. If workers want to actually own shares, they can just buy them voluntarily (indeed, socialists ought to celebrate the existence of a highly liquid stock market). The difference is whether workers own shares in the company voluntarily (bottom up) or because a decision was made at the board level (top down). And one question: how much of an owner mentality is even possible when shares are gifted but not earned? People value things more when they work for them.

Leave a comment

Your email address will not be published.