- Governance at the end of the cycle
- From neat theory to messy practice
- Governance decisions, shareholder headaches
- The complexities of capital allocation
- Why are buybacks pro-cyclical?
- Why corporate activity happens when it can, not when it should
- An underused strategy: Disposals
- The remarkable power of incentives
Governance at the end of the cycle
When announcing a buyback, the executive team will invariably claim that ‘it is the best use of capital at the time’. However, the passage of time and events can suggest otherwise and before we accept management’s word as gospel, we should understand what was given up. We should also look for the possible motivations behind the decision and whether it was influenced by business fundamentals, market levels or misaligned incentives.
When measured over a longer time horizon, governance decisions like Wal-Mart’s buyback can play a critical role in determining the effectiveness of capital allocation and corporate strategy, as well as physical footprint (# of stores), corporate sustainability, and total shareholder return.
From neat theory to messy practice
In theory, there is an implicit contract between investors and company managers that is based on the idea that the interests of both parties are aligned. It follows that managers make decisions designed to bring about increases in long-term shareholder value, which also leave a positive impact on society and the environment (or at least not a negative one).
Well, bang goes the theory, since the reality is often very different. In practice, corporate decision making can become skewed by an over-bearing focus on short term earnings and misaligned incentives (including the possibility of personal gains if executives can shoot for gearing in their compensation plans). This is particularly the case at the late stage of business and market cycles, where we invariably see a pick-up in trend-following behaviour, higher levels of buybacks struck at cyclically-high valuations and value destructive M&A.
The finding that 80% of CFOs would sacrifice critical R&D spend (required to sustain long-term business growth) just so they could meet quarterly earnings targets demonstrates just how overbearing the short-term focus on earnings has become.
Add to this the revelation that CFOs themselves believe 1 in every 5 firms is guilty of mis-representing their financial positions in company accounts and it is clear that investors have to exercise considerable caution. This is especially the case at the late stage of the cycle when executives may be tempted to resort to aggressive accounting tactics to relieve the relentless pressure on them to beat quarterly earnings targets.
Governance decisions, shareholder headaches
CEOs have five main choices for deploying capital:
- Invest in existing operations (capital spending and R&D)
- Acquire other businesses or divest assets (M&A activity or divestitures)
- Issue dividends
- Pay down debt
- Repurchase stock (share buybacks).
Contrary to what theory or intuition might suggest, cyclical factors and fashions greatly influence the shape of capital allocation over time. There is considerable variation in the use of different capital levers (see chart for US corporate sector). Capital spending will typically flex with the underlying business cycle but it has also generally drifted lower as less risky, yet shareholder friendly uses of capital - M&A and buybacks - have crept higher. Notably, both these uses of capital are pro-cyclical - increasing in the late 90s, mid 2000s and more recently, while contracting in the bear markets triggered in 2000 & 2008.
The complexities of capital allocation
Capital allocation is a dynamic process that is incredibly difficult to appraise. Good or bad decisions only become apparent after a significant time lag and the bad decisions may only be understood as such in the light of counter-factuals (i.e. what would have happened had we decided to invest 10 years ago instead of doing that M&A? Something that ex-RBS CEO Sir Fred Goodwin may still be pondering to this day after his purchase of an MBS-laden ABN Amro at the top of the market was instrumental in precipitating a government bail-out).
“The first law of capital allocation—whether the money is slated for acquisitions or share repurchases—is that what is smart at one price is dumb at another.” Warren Buffett
Sometimes acquiring makes sense and other times divesting is the better alternative. There are times to issue equity and times to retire it. Often this will vary by industry and by individual firm. Yet in practice, trend following is evident. Why?
Warren Buffett suggests this is due to something called the institutional imperative; an unseen yet powerful force that causes executives to act sub-optimally. Buffet believes it is the institutional imperative that causes companies to mindlessly imitate one another whether it is in M&A or in executive compensation. The time that we see these corporate fashions and fads most prominently is, of course, at the end of the cycle.
Let’s now work through a few of these red flag behaviours in turn and discuss them from an end of cycle perspective:
Why are buybacks pro-cyclical?
In theory, buybacks should happen when a company believes its shares are undervalued, so we should expect to see more buybacks at the early stage of the cycle, when prices are lower. In reality, this is not the case and we typically see more buybacks as markets trend higher. In Wal-Mart’s case, the share price is currently at an eighteen-month high and has only been marginally higher for a brief period over the last five years.
One of the main reasons that buybacks tend to be pro-cyclical is they have the effect of improving a number of financial ratios - the exact same metrics that executives come under increasing pressure to improve as the cycle matures and the market grinds higher.
One sure-fire way to improve earnings per share if the fundamental business drivers are moribund is to reduce the amount of stock in circulation. Since cash is an asset on the balance sheet, when it falls other important financial metrics improve, such as return on assets (ROA) and return on equity (ROE), while key valuation measures like the PE ratio also become more attractive to professional buyers.
So if buybacks boost earnings, does it make sense to invest in the stocks of companies doing buybacks? The evidence suggests this is not a good strategy. The performance of two ETFs that invest in ‘buyback stocks’ has materially lagged the broad US market (see chart). It seems like markets are not fooled by mechanical increases in earnings if there is not also an improvement in fundamentals. Perhaps Wal-Mart’s buyback will offer some support in a trending market, but it leaves a nagging doubt: could that capital have been put to even better long-term use in addressing the threat from online shopping and Amazon specifically?
Why corporate activity happens when it can, not when it should
M&A is the largest use of capital but like buybacks, its extent follows the stock market closely. More deals happen when the stock market is up. As a result, companies frequently do deals when they can, rather than when they should.
Corporate activity can be a significant source of both value creation and destruction for shareholders. Investors should be wary of deals done simply to enhance short-term earnings. WorldCom offers a great example of the dangers of rapid growth by acquisition.
After buying MFS (for $12.5bn in stock) and MCI Communications (for $37bn), it attempted to acquire Sprint for $129bn but was denied by the US Justice Department. The company then began to fraudulently enhance its earnings by removing hundreds of millions of operating costs from its income statement by capitalising them as assets on its balance sheet. Its bankruptcy ultimately destroyed billions in shareholder value.
An underused strategy: Disposals
Most CEOs see deal-making as a one-way street. Yet the evidence on asset sales and spinoffs indicates these create more consistent value than M&A. In practice, asset disposals also tend to be pro-cyclical, happening when business conditions are difficult and market valuations are low, rather than when the best values can be achieved for shareholders.
Ideally, we should see disposals late in the cycle but we rarely see this in practice. Rather, we see highly-priced acquisitions. Contrarian executives are those who swim against the tide, spinning off non-core assets at the top of cycle and buying distressed assets at the bottom when values are low. Such executives do exist but they are rare- so rare that William Thorndike made them the subject of his excellent book called ‘The Outsiders: Eight unconventional CEOs and their radically rational blueprint for success'.
The remarkable power of incentives
While some of the counter-intuitive behaviours at the end of the cycle can be explained by simple economics - this is when companies are throwing off the most cash - there are other factors at play which investors should look out for. Some of the decisions of executives can be understood via the power of incentives. And one of the prime incentives that executives respond to is how their remuneration is structured.
In the 90s, stock options became a popular way to encourage CEOs to improve firm performance. Yet the nature of these schemes meant some CEOs could go for broke in the short-term and aggressively present their accounts to give the illusion of success, boosting the share price and taking the profits from their share options. This is exactly what happened in a spate of turn-of-the-century accounting scandals in WorldCom, Enron & Nortel Networks.
As investors, we need to be alert to where there is gearing in remuneration structures since executives will naturally shoot for that gearing. Long-term incentive plans (LTIPs) are a key part of the solution, but they do need to be genuinely long-term. At Fidelity, we have been vocal in recommending, and voting for, holding periods of a minimum of five years so that executives hold more shares for longer. This helps to create better alignment between executive pay, the longer-term performance of the company and the shareholder.
"Cash is a fact, profit is an opinion." Alf Rappaport
Lastly, a key ‘tried and tested’ measure of a company’s long-term focus is its dividend record. This record essentially belongs to the board; it outlasts the tenure of individual CEOs and offers a measure of cultural continuity. While earnings can be massaged, dividends and total shareholder returns do not lie.
- Contrary to what theory or intuition might suggest, cyclical factors and fashions greatly influence the shape of capital allocation over time.
- There is considerable variation in the use of different capital levers.
- Capital spending will typically flex with the underlying business cycle but it has also generally drifted lower as less risky, yet shareholder friendly uses of capital - M&A and buybacks - have crept higher.
- Both these uses of capital are pro-cyclical - increasing in the late 90s, mid 2000s and more recently, while contracting in the bear markets triggered in 2000 & 2008.
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