Lyle Stein

In the September edition of Harvard Business Review’s magazine, William Lazonick writes an intriguing article called “Profits Without Prosperity”. To read the article preview, please click here.

First (and in my view, foremost) this is as much a religious article as it is an economic one.  Much of what was written has been pre-cooked with the rhetoric of the left, but enough said. Let’s get into the issues.

Buybacks in General

Companies are in business to make money. The question is how companies return the money they make to shareholders. Historically, this has been through dividends, but as the author notes, as of late it has been through share buybacks.  Note that buybacks are  more of an American phenomenon than a Canadian one.  In the US, dividends are double taxed, whereas in Canada the dividend tax credit offsets the double taxation of personal dividends. In the US, the buyback eliminates the taxation of the return on capital that befalls an individual owner. Given the double taxation of dividends in the US, it is little wonder that buybacks are the preferred route to return earnings to shareholders. The problem is less the buyback than it is the tax code.

Short-termism

The author goes a long way to attack options as a form of executive compensation. The proof of the pudding is in the eating, and here the author has a bit of a point. The way options have been handled in the US has been to reward executives more on the movement of the market over a short period than the long-term success of a company’s decision making. I will get on my soapbox here and suggest that a better way of option compensation is to require the option holder to keep the after-tax value of any gain in the shares acquired as long as the grantee remains employed by the grantor. We did this at Sceptre while I was employed there and I held the model up to every company in which we invested. What options should do is provide a vehicle whereby managers can obtain a substantial ownership position, not a significant salary enhancement.

That said, the author really identifies the bigger problem which is the short-termism of linking compensation to short term performance.  A company that buys back shares can increase EPS by pure math. If compensation is linked to EPS growth, then there is a real incentive to do whatever it takes to increase short term EPS. Buybacks would exacerbate this problem.  The solution to short-termism is the ownership model vs. the compensation model.

Return of shareholder funds is bad for growth

The author is clearly against the role of maximizing shareholder value (MSV). This is religion, so I won’t address the issue. However, the premise that monies paid out (via dividends or buybacks) are monies that could be reinvested in the business is fallacious.  Good stewardship dictates that managers should only invest in projects that can return above the cost of capital. If that is not the case, then the managers should return the monies to shareholders. If this is not adhered to, overinvestment occurs, and ultimately capital is destroyed. Let the owner, the shareholder, decide what to do. The author suggests that $2Trillion or so could have been invested in the economy had monies not been used for buybacks or dividends. This is fallacious. Monies were invested in the economy, just not by the companies that earned the profits. Thank heavens that GM paid a dividend; even more monies would have been wiped out had they built even more capacity in the ‘80s and ‘90s.  The GM money, conceptually, financed the capital raised by Apple on its IPO. That is a pretty good thing.

Dividends are not bad

Today, the demographic demand for income is greater than ever. Companies that return monies regularly have achieved increasingly higher valuations. There is consumer preference for dividends, so let the consumer have what the consumer wants.

Today’s dilemma

We live in a low cost of capital environment. With government bonds yielding 2%, conceptually there should be lots of projects which could earn such a low cost of capital.  The problem is there is very little demand for the products that would be created by the investment. Hence, companies are not investing. In theory, they are concerned about a write-down of any spare capacity created. So, they don’t invest.

I would love to elaborate further, but I will leave my thoughts here.

 

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