Monday, April 21, 2014

"Disgorge the Cash" in The New Inquiry

The New Inquiry, an excellent new online magazine some readers may be familiar, has published an article I wrote based on the various disgorge the cash posts on this blog. Thanks to the superb editing of Mike Konczal and Rob Horning, the article develops the argument more cohesively than I've been able to on the blog. Go read it there, and then, if you like, comment here.

UPDATE: Matt Levine at Bloomberg calls me "the world's leading Marxist analyst of the capital structure of the modern corporation." That's very flattering, but not remotely the case. What little I've written about this is all based on things I've learned from Jim Crotty, Dumenil and Levy, and Doug Henwood. (Including the phrase "disgorge the cash," which I got from Doug.) Any of them might be contenders for that title (I won't pick one), but not me. I'm just developing their ideas. And of course the original source of all this stuff is Part 5 of Volume III of Capital, especially chapter 27.


  1. Insightful article! A few of my initial thoughts if you are interested:

    First, the trend of corporate borrowing to increase shareholder payouts seems unsustainable. If borrowed funds account one-for-one with shareholder payouts but yet corporations pay interest on borrowed funds, it seems this can’t go on forever without starting to deplete the corporation’s capital.

    Second, the lack of sensitivity of investment to borrowed funds is disturbing. This observation suggests one of the channels to stimulate private investment has narrowed if not closed. It also suggests Krugman and Summer’s negative real interest rate argument in regard to secular stagnation would not in fact stimulate corporate investment, but may exacerbate the issue by enhancing the flow of funds to shareholders.

    Third, “you can’t have an ongoing business unless people are oriented toward doing their job for its own sake...”. If by “people” you mean managers that are in charge of allocating business funds you can disregard this comment but otherwise I’d argue businesses can and do run when most of the employees don’t care. I think this has to do with the changing nature of jobs (shift from manufacturing to service) and the lack of better options. Big corporation service and retail jobs are so detached from the big picture of “producing a great product”. In any fast food place or retail job I’ve worked at, I never had the big picture in the back of my mind- just counting down the minutes until my shift was over.

    Fourth, I’m highly skeptical of the conscious capitalism movement but I think it is related to the “socialization of investment” discussion in many ways. One of its goals is to orient businesses towards increasing value for all stakeholders therefore increasing shareholder return as an effect. I can imagine conscious capitalism managers being more interested in the long-term sustainability of the company versus short term gains (if they walk the walk).

  2. One thing that strikes me is that share buybacks are a lot more complex in how they distribute funds amongst shareholders than dividends are. I thought a large part of the motivation for share buybacks was to ensure that the proceeds from the companies did NOT just go equally to all shareholders but rather passed by pension savers and such like to instead all go to those who astutely traded the shares especially to management who have stock options. The key is to pass on profits by way of share price volatility that can be captured by some but pass others shareholders by. The crucial point is that share buybacks happen mostly at market peaks and over time just as many new shares get reissued as shares get bought back. So the money is being spent on inducing the share price to bob around. Furthermore, leverage causes earnings to fluctuate more dramatically (because debt repayments are fixed) and that again allows more volatility capture opportunities. It is as much ensuring that "dumb money" pension savers get passed by with the profits going to hedgefunds and option holding CEOs as it is about ensuring that money isn't invested in research etc.
    I had a going posting about it in the appendix "A zero interest rate policy does not reduce the financial overhead" at the end of this post:

    1. Good point. It depends in the extent to which buybacks are reflected in the share price. If they are fully priced in, the gains go equally to those who do and do not tender their shares, just like a dividends. Now in the real world, buybacks tend to come at the top of the market (which of course is perverse if you think if the stock market as a source of financing), which means that, yes, the gains go to the sellers more than the long-term holders. You could even think if this as another layer if liquidation, creating an exit option for large shareholders. William Lazonick makes a big deal about this, but from my point of view it's a second-order question. Pensions only hold about 20% of corporate equities, and I think this is far from the biggest way they get ripped off. And other than them I don't see any interesting conflicts among shareholder.

    2. I'd be very interested to know whether share buy backs really do make a significant contribution to liquidity -what proportion of volume do they account for and is it liquidity providing volume (ie buying when there is otherwise a preponderance of selling). JP Koning might know- he often posts about how shares get a price premium for stocks for which it is possible to sell off a billion dollars worth over the course of a month rather than a year or whatever without suffering a severe price impact.

      I'm still struggling with the idea that borrowing money to fund share buybacks is really explicable in any way other than as a conflict between shareholders.
      If the explanation is not liquidity then I guess it must be a conflict between shareholders (I know you are saying that it is liquidity)? Buybacks would be nonsensical for a privately owned company where one person owned all of the shares? It can't lead to long term dividend growth if shares are constantly being issued and being bought back as is the case.

      Is it really true that the bulk of stock ownership isn't by dumb money that can be ripped off? I guessed insurance companies also don't have the ability to avoid losing out to those trading options etc to capture the proceeds of share buybacks most astutely. I guessed it was activist hedgefunds, investment banks and management option recipients who got the bulk of the pie.
      The people who advocate share buybacks are not trying to fund personal consumption are they? They are ploughing the money straight back into their asset portfolios to gather more with it. They may even be buying the bonds that fund the buybacks.
      One thing that has struck me is that if a company typically lasts for say 30 years and, as often as is the case, the shares do not ever pay a dividend, then ALL of the returns to shareholders are by way of "volatility capture". Basically the shareholders pay for something that ultimately has a price that will go to zero. They must trade in the meantime or else will lose it all. Trillions of dollars get distributed in that way I guess.

    3. I guess the key point is that share buybacks typically DO happen at market peaks and the issuance of new stock typically keeps the total amount of shares from decreasing over time and yet doesn't fund the buybacks so the company is in effect buying high and selling low as a way of distributing profits.

    4. I don't think that stock buybacks are primarily driven by conflicts between shareholder classes. The main motivation for distributing profits as buybacks rather than dividends is that buybacks can be taxed at the capital gain rate, rather than ordinary income. (Although stockholders could realize capital gains by selling their shares on the open market, doing it through a buyback keeps the volume of shares sold from depressing the price.) To the extent that buybacks are funded by corporate borrowing, they are driven by the theory that shareholder value (for the remaining shareholders) is maximized when there is a non-zero risk of bankruptcy (allocating some of the risks of unfavorable business outcomes to the creditors/bondholders rather than purely among the stockholders, while the stockholders retain 100% of the upside value). Thus I think stock buybacks are better seen an attempt by the stockholders as a class to extract additional value from the government and the bondholders, rather than being primarily driven by conflicts among the stockholders.

    5. Dave W, I agree that tax avoidance is a big part of it. I think tax avoidance probably also motivates the shift from equity to debt financing. The debt can be held in a low tax country and debt servicing costs can reduce exposure to corporation tax. Companies such as Starbucks and Amazon can then claim that they make no profit in the UK for example.
      I'm struggling more with your idea that corporate borrowing shifts risk away from shareholders. To me it looks as though for a given amount of company revenue, the shareholders are left with less of the cash flow (because they have pledged a fixed amount as debt servicing) and most of the risk (because the shareholders stand first in line to take the losses). The more leveraged a company is, the more share price volatility there will be. I don't see how volatility benefits buy and hold type investors at all. It obviously benefits option holders/traders -that was my point.

    6. Well, here's a highly oversimplified example that may explain the idea. For purposes of this example, I'm assuming no corporate income taxes, no transaction costs or legal fees, a 0% interest rate, no house edge on the pass line at craps (so it's a simple coin flip), a 20% capital gains rate and a 28% ordinary income rate (as it was in the mid-eighties), and no waiting period for that long-term capital gains rate to kick in.

      Let's say a buddy and I have the idea to form a corporation. He puts up $4000, I put up $1000, and we distribute the stock accordingly. Our business plan is exceedingly simple, although rather idiotic: once a month for two months, we plan to visit Las Vegas and put the whole company treasury on a single pass-line bet at craps. At the end of two months, we plan to cash out whatever profits are left. As luck may have it, we did the first of these two trips last month, and were successful with our bet, so we now have $5000 of original capital and $5000 profits in our corporate treasury.

      Scenario 1: We repeat the trip this month, betting $10,000 and then liquidate the company, distributing the profits (if any) as ordinary dividends. Expected payout to the shareholders: .5(5000+15000*.72) + .5(0) = $7,900. Expected tax to the government: .5(.28*15000) = $2,100. Since our business activity this month has an expected profit of $0, these two sum to our current capital, $10,000.

      Scenario 2: We borrow $8,000 and use it to repurchase my buddy's 80% of the stock, leaving $10,000 in the treasury. Then I go on this month's trip to Vegas, and proceed as above. If successful, I will repay the $8000 loan, and distribute the remaining $12,000 as $1,000 return of my original capital, plus $11,000 profit through another stock repurchase, rather than an ordinary dividend. If my bet loses, the firm declares bankruptcy and I walk away.

      In this scenario, my buddy gets $4000 + .8($4000) = $7,200 for certain, from the stock repurchase. I get an expected .5(0) + .5(1000 + .8(11000)) = $4,900. The government gets .2(4000) + .5(.2*11000) = $1,900. And the poor bondholders lose their investment half the time, and just get their money back the other half for an expected loss of .5(0) + .5(-8000) = -$4000. Add it all up, and you get the same $10,000 that is currently in the treasury. Collectively, the two shareholders walk away with $12,100 on average after taxes in scenario 2 vs $7,900 in scenario 1. In effect, what the stock repurchase has done has been to transfer $200 from the government and $4000 from the bondholders, and distribute it between the shareholders. Note that I, as the buy&hold investor/management, do profit from the extra volatility in company value: before the buyback, my pretax share of the profits from a successful second bet was going to be $3000; after the buyback, it is $11000. My downside is the same, but my upside profit has increased substantially.

      Now in the real world, there are lots of extra complications, and bondholders try to attach all kinds of covenants and restrictions to the funds so that management finds it much harder to do something quite as risky and boldfaced as this. But if you understand how this toy example works, you have a pretty good idea of the motivation that was behind a lot of the leveraged buy-out mania of the 1980s (that, plus looting/restructuring some "overfunded" company pension funds, many of which turned out to not be quite so overfunded after all.)

    7. Dave W, thanks for your explanation! Trying to unpick it -am I right in understanding that it basically stems from the fact that limited liability laws mean that shareholders can put part of their wealth in a company that dices with bankruptcy whilst keeping the rest elsewhere? So a shareholder can "lose more than everything" for a particular shareholding whilst simultaneously having plenty in reserve to start over.
      I tried to grapple with just that kind of idea in post:

    8. Sort of. It is certainly an artifact of limited vs. unlimited liability on the part of the shareholders that allows some of the risk to be transferred to the bondholders. But the example doesn't really depend on how much the shareholders have in reserve, except to the extent that they are willing to be part of such a risky enterprise in the first place. The example holds the business activity (and its attendant risk) constant, and shows that given that, the buyback benefits both shareholders.

    9. DaveW, I guess what I was meaning was that in a counterfactual hypothetical world with unlimited liability, the money (and any subsequent re-investments) received from the buyback by the shareholders would be exposed to losses from the bankruptcies that sooner or later would occur. The shareholders and not just the company they owned would always go bankrupt whenever they lost. They would not have the means to proceed.
      I think I'm understanding what you are saying and that you are pointing out that for as long as the shareholders are on a lucky run, any takings they consume will be consumed and the fun will continue until the first bankruptcy.

    10. Is there some truth in the notion that the bond holders are not stupid and so are going to be demanding interest rates that over the long term end up compensating them for the occasions when bankruptcy causes them losses? So over the long term once the strategy becomes established; the real transfer is not so much from bond holders to share holders but from "captive creditors" such as workers owed wages and from suppliers and that the share holders and the bond holders benefit at the expense of those "captive creditors" who have no say in how capital structure is organized or bonds are priced etc.

  3. I don't have time to fully engage this right now but I think you may be confused on a basic point. New stock is NOT issued on a significant scale. Net issuance is negative and has been for many years. If the number of shares outstanding looks stable, that is because of splits, not new issues. It is perfectly possible for a company to distribute all its profits to shareholders in the form of buybacks and never pay dividends.

    1. I thought that employee stock options entailed shares being issued (and so dilution that needs to be countered by buybacks). Sorry if I'm in a muddle.

  4. They do. But buybacks are much bigger.

    1. Is the phenomenon mentioned in this link simply due to stock splits then?

    2. I use two sources for this. One is Compustat, which gives you the total buybacks reported in the 10Ks of all US corporations. The other is the Flow of Funds, which gives net new equity issues. Both show net equity issuance as consistently negative. In the case of the FoF, net equity issuance has been negative in every year since 1984 except for 1991-1993. Now, that latter number includes shares retired through acquisitions as well as through buybacks. But if we are interested in the corporate sector as a whole, that's appropriate. It's still cash flowing out of firms to shareholders, even if they are shareholders of a different company.

      I don't know exactly where that article is getting its numbers from. But yes, stock splits are presumably the answer.

      Someone pointed this out on twitter just now:

    3. That Apple share split is a very clear example of the point you're making. Thanks!

      I'm also wondering about the phenomenon of companies buying back stock and then, rather than retiring the stock, instead keeping them as treasury stock. Can stock options for management cause shares to be resupplied using such stock that was previously bought back and "held in treasury"? So there would be no issuance of new equity reported in the flow of funds and yet the share count would not decrease despite buybacks because shares were revolving between company holdings in treasury and the publicly traded float of shares?

      That Forbes link said that its source was
      on page 10 of that:
      "Trends in Common Shares Outstanding
      While share repurchases are a large factor in determining the change in share count of a company, they do not capture such activities as exchange of common stock for debentures, conversion of preferred stock, convertible securities, or stock options, or the issuance of stock for acquisitions. Therefore, the charts below are included to show the aggregate change in shares outstanding.
      The first chart shows aggregate common shares outstanding in the S&P 500 using a rolling universe and a universe of only the companies that were in the index throughout the time series."

    4. If a company buys back stock, holds the stock in treasury and uses those shares from treasury whenever options are exercised. Then the float share count will not decrease over the long term but the company will not really be issuing equity as fast as it is retiring it (no money goes from investors into the company). Instead it will be diluting equity per share as fast as it is buying back. The financial transfer is from the company to those exercising the options.
      As you say, retiring stock followed by stock splits provide an alternative that instead maintains the ownership for all shareholders. It really seems so murky what the relative scale of those two processes is. Is the key factor what proportion of bought back stock gets retired versus what proportion gets held in treasury? It is clear that plenty does get held in treasury but I'm failing to find the exact numbers.

    5. Is this a typical example? Cisco say that they have not done a stock split since 2000

      This link says that the increase in the outstanding share count for Cisco is due to management options:
      "100% of Cisco's $550 million in Q3'FY12 stock buybacks supported John Chambers' dilutive management compensation practices..........
      If Cisco returned $550 million in cash during Q3'FY12 to shareholders by repurchasing 27 million shares, how could Cisco's common stock shares issued and outstanding during Q3'FY12 increase by +5 million shares?
      Furthermore, how could Cisco's shares used in its per-share basic calculation during Q3'FY12 increase by +20 million shares?
      Finally, how could Cisco's shares used in its per-share diluted calculation during Q3'FY12 increase by +55 million shares?
      Well, it's quite possible that I might have found at least one of the culprits based on Cisco's most recent Form 10-Q (page 37) filed on May 23, 2012 and previous Form 10-Q (page 34) filed on February 21, 2012:
      Total number of in-the-money Cisco employee stock options exercisable*
      4/28/12 1/28/12 Plus or Minus
      249 219 +30 "

    6. It's not true that "no money goes from investors into the company" when stock options are issued. The company gets the strike price of the option from the employee (in general; there are limited exceptions where an employee might be able to use additional option shares to fund the exercise). The strike price is presumably less than the company would get by selling the shares on the open market (or the employee wouldn't exercise), but it is not zero. Typically, the strike price for a publicly held company needs to be fairly close to the fair market price of the stock at the time the option is issued.

    7. Ok, I meant to say that money goes from investors into the company when the option is exercised. It doesn't go at the time the option is issued. But the money the company will ultimately get if the option is exercised is based on the price around the time the option is issued.

    8. Dave W, I totally agree with your correction.

  5. This is a great piece.
    There are many directions to develop it in - stone raises a point worth tracking down - do all shareholder benefit from the typical buyback?
    Another is to link up to Clayton Christiansen's recent thinking about finance being the engine that is reducing innovation. I think there's a lot of crossover here, but you have identified a vital mechanism.

  6. Stop it with the modesty Mr leading Marxist analyst on the capital structure...Great piece. Great historical narrative. But. Disgorging of cash vs capitals split personality you implied causality; isn't capitals split personality just responding to the nature of the new economy - short product life spans, social divergence and short attention spans (ironically reinforced by mentioned iProducts and the overrated Steve Jobs), extreme atomisation, extreme cash out fast. I would want my "iGetsomemoneyback" too given the speed of disruption in recent times.
    Add the huge amount of capital chasing investment (another recent phenomenon) why not play the borrowing game..."The challenge is keeping money from flowing out of the firm, not bringing it in." Indeed! "...At the moment, finance seems to be doing its job well..." I think they just been lucky...circumstances I think have made it easy. Which mean I have my doubts about your last paragraph..."the Sisyphean task faced by the other side" NOT under the current social and political economy . Radicals should fret because "transforming the existing organization of production" to borrow from Dean Baker writing about education in the Jacobin "likely to require deep structural change in society as well." Nah gonna happen.

    1. Glossary :)
      Lucky = positioned (fortuitously or fore-planned) to benefit from a change
      Deep Structural stuff = how/what as a society or just as a legal matter decide to count as work and what is 'capital' and how to tax what is earned from each. Then there is stuff like what are our responsibilities to each other: why do we care about bond-holders/debt-holders (at least on this page's comments ); why shouldn't managers - on behalf of stockholders - increase debt to fund a share buyback for tactical or strategic reasons...makes sense debt is tax deductible...which brings us back to luck.

  7. It's telling that Apple began listening to the Wall Street shareholders once Steve Jobs died. Steve Jobs was of course a founder and the largest shareholder, and Apple didn't really have to please the other shareholders. A lot of tech companies are largely owned by founders, which is one reason why many don't pay dividends. Founder want to see their baby grow up and succeed; they are not as inclined as other shareholders to treat the company as a cash machine. But over time the companies become more and more responsive to the shareholders who have no emotional attachment to them, which is perverse in a way because the longer a company has been around the more remotely related share trading is to the initial investment activity that the company benefitted from.

    Google's recent stock split is an interesting attempt to avoid this fate for as long as possible. There is now an explicit division between the shareholders who run the company and the ones who are just along for the ride. The move will make it cheaper for Larry and Sergey to remain in control for now, but it will also make it cheaper for someone else to take over in the future. For now, Google pays no dividends.

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