How the pursuit of shareholder value weakened the economy

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Joe Biden gets it..

Short-termism—the notion that companies forgo long-run investment to boost near-term stock price—is one of the greatest threats to America’s enduring prosperity. Over the past eight years, the U.S. economy has emerged from crisis and maintained an unprecedented recovery. We are now on the cusp of a remarkable resurgence. But the country can’t unlock its true potential without encouraging businesses to build for the long-run. Private investment—from new factories, to research, to worker training—is perhaps the greatest driver of economic growth, paving the way for future prosperity for businesses, their supply chains and the economy as a whole. Without it robust growth is nearly impossible. Yet all too often, executives face pressure to prioritize today’s share price over adding long-term value.

The origins of short-termism are rooted in policies and practices that have eroded the incentive to create value: the dramatic growth in executive compensation tied to short-term share price; inadequate regulations that allow share buybacks without limit; tax laws that designate an investment as “long-term” after only one year; a subset of activist investors determined to steer companies away from further investment; and a financial culture focused on quarterly earnings and short-run metrics.

How Short-Termism Saps the Economy - WSJ

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Barclays Warns The Party Is Almost Over As Payouts Exceed Cash Flow By $115 Billion

From ZeroHedge

by Tyler Durden
Oct 11, 2016 1:13 PM

Over the past several years, there have been two primary sources of upside for the stock market: trillions in corporate buybacks, as companies themselves engaged in record repurchases of their own stock, often at price indiscriminate levels in a bid to not only raise the stock price but also the stock-linked compensation of management , and a similar amount of dividend payments which in a time of negligible yields, became one of the main drivers for buyers to scramble into the "safety" of dividend paying stocks. Collectively these account for an unprecedented amount of payouts to shareholders.

Today, Barclays' head of equity strategy Jonathan Glionna quantifies just how much corporate cash flow has and will be used to fund these payouts.

Glionna finds that in aggregate the companies within the S&P 500 are returning a record amount of cash to shareholders through dividends and buybacks. Since 2009 dividends have increased by more than 100%, reaching $98 billion in the most recent quarter. Meanwhile, gross buybacks have tripled and Barclays forecasts that they will reach $600 billion in 2016. In fact, buybacks plus dividends could surpass $1 trillion in 2016, for the first time ever.

Just like Goldman Sachs, Glionna says that "we believe the substantial increase in distributions is one of the primary justifications for the gains in the price of the S&P 500 during this business cycle (Figure 1).



However, this unprecedented surge in distributions may be coming to an end and as Barclays puts it, "alas, nothing continues forever. The growth rate of payouts, which has averaged 20% since 2009, will all but disappear in 2017, in our opinion."

While companies have "taken advantage of a recovering economy and generous credit market to enhance both dividends and buybacks" for six years, they may not be able to push them higher much longer.

And here is a fascinating statistic: over the last few years payouts have exceeded earnings for the S&P 500, which is rare. It almost happened in 2014, when the total payout ratio was 99%. In 2015, it did happen. It will happen again in 2016, based on Barc estimates, as net income is likely to be less than $900 billion against $1 trillion of dividends and buybacks. Prior to 2015, companies in the S&P 500, in aggregate, had paid out more than they earned only six other times during the last 50 years. It has never happened more than two years in a row (Figure 2).


In addition, cash outflows for dividends and buybacks have been exceeding cash flow from operations after capital expenditures. We discussed this in The end of financial engineering? (February 29, 2016), which highlighted the S&P 500’s growing reliance on the investment grade credit market to cover its cash flow deficit. Based on our measure, companies in the S&P 500 have spent more than they generated in free cash flow every year since 2013.

The kicker: Glionna estimates that non-financial companies in the S&P 500 have a cash flow shortfall of more than $115 billion per year (Figure 3). In other words, companies will spend promptly send every single dollar in cash they create back to their shareholders, and then use up an additional $115 billion from cash on the balance sheet, sell equity or issue new debt, to fund the difference.


Why does Barclays believe that 2016 will be the last year with an unprecedented surge in payouts? Two reasons: insufficient cash flow creation, and too much debt to lever up meaningfully higher from existing levels. Here is the full explanation:

For the S&P 500 dividends plus buybacks exceed net income. After funding capital expenditures, dividends plus buybacks also exceed cash flow from operations. This is true even after accounting for equity issuance. But so what? Why can’t companies continue to pay out more than earnings, even if it reduces book value? Why can’t companies continue to spend more than their cash flow if the investment grade credit market is willing to provide cheap financing? We see a compelling reason–leverage ratios will get too high.

Companies have been able to spend more than they generated in cash flow because leverage measures were low coming out of the financial crisis. But they are not low anymore. Since 2013, the total amount of debt owed by non-financial companies in the S&P 500 has increased by almost $1 trillion. Net of cash the increase has been even more meaningful, as the growth rate of debt has exceeded the growth rate of cash and equivalents.

Meanwhile, EBITDA has stagnated. As Figure 4 shows, the median ratio of debt-to-EBITDA for companies in the S&P 500 (excluding financials) was just 1.53x in 2010. Now it stands at 2.33x, the highest point in at least 20 years. The total ratio of debt-to-EBITDA for the S&P 500 (rather than the median ratio) has reached 2.56x, excluding financials. And the increase has not just been caused by the Energy sector. If Energy is excluded in addition to Financials, the total debt-to-EBITDA ratio is 2.50x and it too has been rising rapidly.

As Figure 4 shows, leverage measures are quickly passing key thresholds. The dashed lines represent the median debt-to-EBITDA ratio of companies in the investment grade credit market by rating category. To be sure, the credit rating agencies take many factors into account when setting corporate ratings, but leverage measures such as debt-to-EBITDA are among the most important.



Figure 5 shows the number of companies in the S&P 500 that have a debt-to-EBITDA ratio above 2.5x. It too is increasing rapidly. This is leading to lower coverage ratios, as shown in Figure 6. These trends are unlikely to continue for the same reason why we predicted that IBM's formerly ravenous buyback appetite would grind to a halt: the vast majority of companies in the S&P 500 are investment grade rated and they want to stay that way. Being investment grade brings with it access to cheap, reliable, and plentiful funding. Few investment grade companies, in our opinion, would be willing to adopt a high yield leverage profile just to facilitate buybacks. Therefore, the increase in leverage ratios must soon come to an end. 


But, as Barclays notes, the rapid increase in debt-to-EBITDA ratios will not stop unless the growth rate of payouts declines. In other words, if companies keep increasing payouts then debt-to- EBITDA will continue to go up. This is displayed in the sensitivity table shown in Figure 7. In fact, it will take a decline in payouts just to stabilize the S&P 500’s debt-to-EBITDA, based on our estimate of 2% EBITDA growth. While we do not expect payouts to decline this sensitivity table showcases that continued rapid growth is likely unsustainable. The table provides estimates of debt-to-EBITDA measures for the S&P 500 excluding financials based on various growth rates of payouts and EBITDA.



To be sure, there is always the possibility EBITDA will increase faster than expected, allowing more flexibility to add debt. For example, if EBITDA increased by 5% in 2017, which would bring it towards an all-time high, then debt-to-EBITDA would likely stabilize at 2.56x or below.

* * *

What the above analysis means, stated simply, is that even assuming no material increase in rates, companies will have no choice but to moderate their aggressive payout practices, the same practices that were instrumental in pushing the S&P to its all time highs. The constraint: balance sheets levered to the gills with record amounts of debt. And unless a new cash flow impulse emerges that sends EBITDA surging, CFOs and Treasurers will cut down on shareholder friendly activities, instead focusing on cash harvesting. This has already been observed in the recent sharp decline in stock buybacks, which however at least for the time being has been offset by an increase in dividends.

As we said, all of the above assumes no increase in rates. However, if as the Fed warns rates are set to rise, however gradually, all of these trends will simply accelerate, resulting in a revulsion toward risk and leading to liquidation of risky assets.

Or, as Barclays would put it, the "party is almost over"

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It isn't actually so complex:

• Shareholder capitalism has skewed companies to financial engineering, witness the high pay-out ratios.
  
• Rather than investing in new capacity, companies prefer financial engineering, stuff that has a fairly immediate impact on the stock price. After all, much of their compensation is tied to the stock price one way or another.
  
• This situation dampens investment demand, hence new capacity, jobs, productivity all suffer.
  
• It also produces a savings glut as the payout (stock buybacks, dividends, executive compensation) goes to people with a high savings rate whilst business investment is dampened.
  
• The savings glut (which is a world wilde phenomenon) produces the low interest. There is very little 'artificial' about it. Yes, central banks keep the short-end low, but they don't control bond yields and QE has had little effect on these. 
  

Two additional remarks:

• The low interest rates have very little to do with the central banks , it's a by-product of the financial system shifting money from low savers to high savers.
  
• The low interest rates are also not to blame. Whether interest rates are high or low, that isn't really likely to affect whether companies decision to pay out their profits in dividends and/or buybacks, rather than invest in new production capacity. 
  

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SHAREHOLDER VALUE & INNOVATION

Shareholder value, said Jack Welch, “is the dumbest idea in the world.” I was reminded of this by Tim Worstall’s reply to Liam Byrne’s demand to “reject once and for all the tired and increasingly flawed orthodoxy of shareholder value.” Tim says:

Increasing income, and/or wealth, is driven by technological advances that lead to greater productivity. And only societies which have had some at least modicum of that shareholder capitalism have ever had that trickle-down which drives the desired result.

This, however, overlooks an important fact – that shareholder-owned firms (in the sense of ones listed on stock markets) are often not a source of technological advances. Bart Hobijn and Boyan Jovanovic have pointed out that most of the innovations associated with the IT revolution came from companies that didn’t exist (pdf) in the 70s. The stock market-listed firm is often not so much a generator of innovations as the exploiter of innovations that come from other institutional forms – not just private companies but the state (pdf) or just men tinkering in garages.

This fact seems to have become more pronounced in recent years. David Audretsch and colleagues show that innovative activity has come increasingly from new firms rather than listed ones. And Kathleen Kahle and Rene Stulz show that listed companies today are older, less profitable and more cash-rich than those of years ago. They say:

Firms’ total payouts to shareholders as a percent of net income are at record levels, suggesting that firms either lack opportunities to invest or have poor incentives to invest.

There are, of course, many possible reasons for this lack of investment. One might be that outside shareholders are so short-termist that they discourage firms from investing (though personally I doubt this). Alternatively, they might be too ill-informed to distinguish between good and bad projects and so often err on the side of caution.

A third possibility is that both investors and bosses have wised up to a fact pointed out by William Nordhaus – that innovation yields only scant profits because these get competed away*. It might be that Schumpeter was right: innovations tend to come from over-optimism and excessive animal spirits and that the listed firm, in replacing buccaneering entrepreneurs with rationalist bureaucrats, thus diminishes innovation.

From this perspective innovation is against the interests of the shareholder-owned firm, as it threatens their market position: the creative destruction of which Schumpeter wrote is by definition bad for incumbents. It’s no accident that the most successful stock market investor, Warren Buffett, looks not for innovative firms but ones that have “economic moats” – some kind of monopoly power that allows them to fight off potential competition.

Tim might therefore be taking too optimistic a view of shareholder capitalism: shareholder value might now be a restraint upon technological advances more than a facilitator of them**.

I don’t say this merely to criticise Tim, but to highlight a mistake made by many of capitalism’s cheerleaders – that they fail to see that the threat to a healthy economy comes not so much from lefties with silly ideas (or perhaps even from presidents with them) but from capitalism itself. For many reasons – of which the pursuit of shareholder value is only one – capitalism has lost some dynamism. In underplaying this, capitalism’s supporters are making the mistake of which Thomas Paine accused Edmond Burke: they are pitying the plumage but forgetting the dying bird.

* Apple is a counter-example here: Steve Jobs genius was not so much in fundamental innovations as in the ability to create products so beautiful that they had brand loyalty and hence monopoly power.

** The strongest counter-argument here might be that the prospect of floating on the stock market (often at an inflated price) incentivises innovation by unquoted firms.

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And then they blame Obamacare for bad and expensive healthcare in the US

Are you angry about your health insurance premiums? You should be. Last year, $130 billion of your private health insurance money was spent — wasted, mostly — on administrative costs. That’s 12% of your total bill, and just over $1,000 per American household. Those figures come from the independent Kaiser Foundation. 

So how nice it was that Stephen Hemsley, CEO of UnitedHealth Group stopped by for some glad-handing with the president. Last year his company billed its customers $35.5 billion to pay for administrative costs and stockholders’ income. That’s before paying for a single pill, doctor, scalpel, or CAT scan. 

That represents one-fifth of the company’s $185 billion in revenues and a quarter of the $144 billion its customers paid in insurance premiums. No wonder Hemsley has been paid $15 million a year in recent years. Indeed, last year’s proxy statement shows Hemsley has accumulated 3.2 million UnitedHealth Group shares. Total value today: $528 million. You read that right.

Does Trump really know how to fix Americans’ health care? - MarketWatch

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Long live shareholder capitalism, where pharma companies can gouge patients without abandon and shift the profits to management:

Chairman Robert J. Coury received about $98 million in compensation in 2016, but that is not including the $66.3 million he received in a retirement benefits package as he transitioned from executive chairman to his non-employee chairman role. 
All told, Coury received about $164 million in compensation last year even as his company came under heavy scrutiny for drastically raising the price of its life saving EpiPen..

Mylan Chairman Received Compensation Totaling Nearly $100 Million in 2016 - TheStreet

That EpiPen's price, a critical life saving instrument for people suffering from allergies, was raised 600% or so in a couple of years.

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Another demonstration

The bank's reputation took a severe hit last year after employees created as many as 2.1 million accounts without customer authorization to hit aggressive sales targets. Scrambling to contain the fallout, Wells Fargo stopped paying branch workers based on how many products they sold and increased its minimum pay rate to between $13.50 and $17 per hour, depending upon the market in which they work. "Turnover now in our retail bank is the lowest it's been, that I can recall, in my 30 years at the company,"

Sloan said Monday at the Milken Institute Global Conference in Beverly Hills, California. Sloan, who got a battlefield promotion to the top job in October after his predecessor, John Stumpf, resigned under fire, said the bank has not had trouble attracting new employees since it changed its policies. "When you put your shareholders first – I hope Warren Buffett isn't listening by the way – but when you put them first, then you're going to make mistakes. Because you're going to make short-term decisions that aren't focused on creating a long-term, successful company," Sloan said.

WELLS FARGO CEO: 'When you put your shareholders first ... you're going to make mistakes' - Business Insider

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We featured Mylan, the maker of the life saving EpiPen earlier in this thread. It's the company that hiked the price of the EpiPen in epic proportions, all the while when top management is raking in vasts amount of money. This is how they respond:

Numerous drug companies have been criticized for the increased prices of some medications in the past few years. According to a new report by The New York Times, the outrage had been a long time coming — Mylan employees were concerned about the price increases in as early as 2014.

At one point, the employees brought it up with Mylan's chairman, Robert Coury. Here's how that went, as reported by Charles Duhigg at The Times:
"Mr. Coury replied that he was untroubled. He raised both his middle fingers and explained, using colorful language, that anyone criticizing Mylan, including its employees, ought to go copulate with themselves. Critics in Congress and on Wall Street, he said, should do the same. And regulators at the Food and Drug Administration? They, too, deserved a round of anatomically challenging self-fulfillment."

How Mylan's chairman responded to EpiPen pricing concerns - Business Insider

And then there is this:

So I was surprised when my pharmacist informed me, months after those floggings and apologies had faded from the headlines, that I would still need to pay $609 for a box of two EpiPens. Didn’t we solve this problem? Not quite.

What’s more, Mylan is back in the news. On Wednesday, regulators said the company had most likely overcharged Medicaid by $1.27 billion for EpiPens. The same day, a group of pension funds announced that they hoped to unseat much of Mylan’s board for “new lows in corporate stewardship,” including paying the chairman $97 million in 2016, more than the salaries of the chief executives at Disney, General Electric and Walmart combined.

Regulators missed an opportunity to reform Mylan in 2012 when the company produced a television commercial showing a mother driving her son to a birthday party and implying that he could eat whatever he wanted, despite his nut allergy, as long as an EpiPen was nearby to counteract a reaction. The commercial also suggested that an EpiPen was a sufficient treatment on its own.

Mylan knew neither of those was true, according to executives from that period. In fact, Mylan had recently started a major lobbying effort to encourage schools to stock EpiPens by arguing that people with serious food allergies are always at risk, and that EpiPens were a necessary supplement to emergency medical treatment.

Before the birthday advertisement aired, the ad went through multiple internal review processes. Mylan executives told Ms. Bresch that the commercial was improper. One employee went so far as to send an internal email saying the advertisement would increase the frequency of allergic reactions, according to a person who saw the correspondence.

Ms. Bresch disagreed. She said it was better to act boldly, according to a former executive who participated in that conversation.

Outcry Over EpiPen Prices Hasn’t Made Them Lower - The New York Times

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This drama is taking place in part because these directors have insane compensation packages — they're massive, despite the fact that the company has been engulfed in scandal for the last year.   Mylan makes EpiPen, the life-saving anti-allergy medication, and since it bought the drug in 2007, it has raised the medication's price over 500%. During the public outcry that followed, CEO Heather Bresch was called to testify before Congress in fall 2016 and Mylan's stock price was hammered. Still, the price of an EpiPen didn't change, and Chairman and former CEO Robert Coury walked away with $97 million that year.

So these shareholders, who collectively own $170 million worth of Mylan shares, are mad. They include three of the four biggest pension funds in the United States.  "Last year was a new low for the Mylan Board. At its core, the EpiPen price-hiking controversy was the costly consequence of a Board with a history of oversight failures," said NYC Comptroller Scott Stringer. "From allegedly overcharging both the government and consumers for its life-saving EpiPen to approving exorbitant pay for its deeply entrenched Chairman, Mylan’s Board has repeatedly enabled self-serving executives at shareowners’ expense. The New York City police officers, teachers, firefighters and other City employees who rely on our pension funds for their retirement security deserve better."

EpiPen maker Mylan shareholder meeting on compensation - Business Insider

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Deregulating financial markets is dangerous enough, but it looks also to have very little upside. Again, shareholder capitalism is to blame..

If Donald Trump gets his way in overhauling banking regulation, it would free up some of the billions of dollars in capital that banks were forced to amass after the financial crisis. Less clear is what they’ll do with it.

After the administration released a highly anticipated 150-page report this week, Wall Street analysts spent two days churning out notes digesting its proposals. Researchers at Goldman Sachs Group Inc. calculated the five largest banks, excluding their own employer, have $96 billion in excess capital. Bank of America Corp. said the plan might unleash as much as $2 trillion in additional lending.

But is that how the money would be used? President Trump would like banks to plow their windfall back into the economy by making more loans to home buyers, small businesses or companies looking to expand. Some on Wall Street predict a lot will flow straight into the pockets of shareholders. One measure would ease annual stress tests, giving firms leeway to increase dividends, Credit Suisse Group AG analysts wrote in a May 24 note anticipating the proposals.

“These are shareholder-driven entities, first and foremost,” said David Hendler, the founder of New York-based researcher Viola Risk Advisors. “They will turn on a little more dividend or buy back stock, mostly.”

One problem is that qualified borrowers have ample access to financing and aren’t demanding more -- a slump that bank executives have bemoaned. And delinquencies on credit cards and auto loans already are rising. The loss rate on car loans made to people with good credit and packaged into bonds, for example, was the highest in the first quarter since 2008, S&P Global Ratings said in a recent report..

If Trump Unlocks $2 Trillion at Banks, Here’s Who May Get It - Bloomberg