Saturday , December 7 2019
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Sneak Preview

Summary:
I was invited by the Financial Times to write a guest post on my recent windmill-tilting exercise of calling attention to how corporate management is using increasingly large stock buybacks to mask increasingly large stock-based comp packages issued to themselves. That post should appear in the Market Insights column online next Monday and on the back page of the paper next Tuesday (possibly this Friday), but I thought I would give you all a sneak preview today! I think (hope) that it’s the sort of article that can create a bit of a stir on its own, so I’ve toned down some of my more incendiary language on stock buybacks that I might use on Twitter. At the bottom of the piece, I’ve also appended my notes to the FT editor so that you can see the math behind the “Lycroloft”

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I was invited by the Financial Times to write a guest post on my recent windmill-tilting exercise of calling attention to how corporate management is using increasingly large stock buybacks to mask increasingly large stock-based comp packages issued to themselves. That post should appear in the Market Insights column online next Monday and on the back page of the paper next Tuesday (possibly this Friday), but I thought I would give you all a sneak preview today!

I think (hope) that it’s the sort of article that can create a bit of a stir on its own, so I’ve toned down some of my more incendiary language on stock buybacks that I might use on Twitter. At the bottom of the piece, I’ve also appended my notes to the FT editor so that you can see the math behind the “Lycroloft” example. MSFT 10-K available for download here.

If you’ve missed any of the notes I’ve written to date on the topic, here are the links:

Yeah, It’s Still Water (Texas Instruments)

When Was I Radicalized? (Boeing)

The Rake (JP Morgan)

OK, Boomer (FedEx … not directly on this topic, but of somewhat related interest)

As always, I’m keen to get your take on this. And if you happen to run through your favorite company’s 10-K and find something interesting to relate, I’m all ears! – Ben

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In poker, the rake is the cut that the casino dealer takes out of every pot. It’s usually a couple of dollars per hand … barely noticeable, certainly not to a donkey poker player like me.

But what if the dealer started taking 10% out of every pot? Would you notice then? How about 20%? How about 70%?

That’s what many large public companies are doing today, taking a rake of anywhere between 10% and 70% from the “pot” of stock buybacks – the hundreds of billions of dollars that these corporations make as a “return of shareholder capital” every year.

And no one is noticing.

This is the agency problem, a classic conundrum of economics, where shareholders’ agents – corporate management – find ways to enrich themselves at the expense of shareholders by gaming the system.

How does this latest incarnation of the agency problem work? Through massive stock issuance programs, masked and sterilized by even more massive stock buyback programs.

When a company issues new shares to employees with one hand (at a low price) and buys back those shares on the open market with the other hand (at a higher price), that price difference multiplied by the number of wash-traded shares equals value that never reaches shareholders at all, but is entirely captured by the recipients of the new shares. Please note that this value is lost to shareholders and captured by the employees whether or not their new shares are sold back to the company in the open market buyback operation. It’s an accounting identity. As the “Yay, stock buybacks!” crew likes to say, it’s just math.

For example, let’s say a company whose name rhymes with Lycroloft trumpets a big stock buyback program in their year-end earnings call, where they “returned capital to shareholders” in the prior 12 months by spending $16.8 billion to buy back 150 million shares of common stock on the open market. Sounds great, right? Very shareholder friendly!

But let’s also say that same company issued 116 million brand new shares to employees over those same 12 months as a result of employees exercising their stock options or vesting their previously restricted stock units (RSUs). The company receives some cash from their employees as these options are exercised and RSUs are vested (about $1.1 billion in this case), but obviously these new shares are being issued to employees at a dramatically lower average price than the average price of the same year’s open market buyback activity.

As a result, more than 60% of the total buyback “pot” that we donkey investors thought was coming to us as shareholders, close to $12 billion for this one company in this one year, is actually being raked by management to distribute among themselves.

Is this rake widely distributed among corporate employees? There’s no clean data on this, as – quelle surprise! – companies provide next to zero detail on the recipients of new stock issuance in their 10-Ks. What’s clear, however, from even a cursory review of the stock holdings of “insiders” at any big public company (Form 4 in SEC-speak), is that senior managers have done particularly well in this new regime of more stock issuance sterilized by more stock buybacks.

It’s not only CEO billionaires like Jamie Dimon, who owns more than 7 million shares of JP Morgan stock, or near billionaires like Tim Cook, who sold $114 million of freshly granted Apple stock just this August. It’s not only independent directors like Al Gore, who was issued 80,000 shares of Apple stock over the past two years, worth $21 million, after selling $38 million worth of stock in 2017. It’s the centimillionaire COOs and CFOs. It’s the legion of decamillionaire vice presidents and business line managers.

I think it’s a historic wealth transfer from shareholders to the managerial class. Not to founders or entrepreneurs or risk-takers. To managers.

What’s to be done? Here are three suggestions to start changing the incentives of rake-taking dealers.

  1. Separate the CEO and Chair positions of publicly traded companies. When the Chair of JP Morgan, Jamie Dimon, says in his 60 Minutes interview that the board independently sets the salary of the CEO of JP Morgan, also Jamie Dimon, we may be forgiven our incredulity. Let’s remove this obvious vehicle for the agency problem.
  2. No stock-based compensation for independent directors. Cash only. Let’s not give guardians of the shareholder hen-house any fox-like incentives.
  3. No exercise of stock-based compensation by ANY directors, independent or not, while they serve on the board. Again, hen-house. Again, fox-like incentives.

We’re never going to eliminate the agency problem, and the dealer deserves a proper rake. But we better start making this casino fairer to shareholders and less of a wealth transfer engine to the managerial 1%. Or someone is going to burn the casino down.

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Notes to FT editor …

  1. On Microsoft …  see page 72 of 157 in the PDF (pg 44 of the original doc) for the FY 2019 open-market share repurchase of 150 million shares for $16.8 billion. Note that some sources like Bloomberg show total share repurchases for FY 19 were $19.5 billion, but that includes $2.7 billion that MSFT used to repurchase stock directly from management for tax withholding purposes, NOT open-market buyback operations. The note on the $2.7 billion (as well as more info on the open-market buyback) is on page 132 of 157 in the PDF.
  2. Also on Microsoft … see page 131 of 157 in the PDF (pg 85 of the original doc) for the FY 2019 new share issuance of 116 million shares. The $1.1 billion in funds received for that issuance is on page 85 of 157 in the PDF.
  3. The math on Microsoft is as follows … $16.8 billion spent on open-market buybacks divided by 150 million shares is an average price paid of $112.00 … $1.1 billion received on 116 million shares in an average price received of $9.48 … the difference in price per share paid and price per share received ($102.52), multiplied by the number of wash-traded shares (116 million), is the value received by employees ($11.9 billion). The total buyback “pot” is $19.5 billion ($16.8 b in open-market purchases + $2.7 b in direct-to-mgmt purchases), and $11.9 billion is 61% of that.
About Ben Hunt
Ben Hunt
He is the chief investment strategist at Salient, a $14 billion asset manager based in Houston and San Francisco, and the author of Epsilon Theory, a newsletter and website that examines markets through the lenses of game theory and history. Over 100,000 professional investors and allocators read Epsilon Theory for its fresh perspective into market dynamics.

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