Whatâs
Wrong Today:
The recession is over for corporations. We have reached the highest level of GDP since WWII.
The Wall
Street Journal cites a report from Moodyâs that US non-financial firms held
$1.48 trillion in cash as of June 30th. Cash stockpiles were up 81%
from $820 billion at the end of 2006.
So, you would think that
businesses must be investing like crazy to take advantage of all those great
opportunities. Sadly, they are not.
Business investment as a ratio of GDP
remains close to the lows in previous recessionary cycles, and is lower than it
was in the 1950s. What has picked up is
share buy-backs. From The
Economist:
are handing cash back to shareholders, a tactic once reserved for executives
who had run out of ideas. In 2011 the value of American share buy-backs was
equal to 2.7% of GDP; in Britain, the figure was 3.1%.
For
instance, Apple recently announced the
largest stock buy-back program in history, about $50 billion. This from a
company that has $147 billion in cash reserves.
The Economist reports that in the early 1970s, American companies
invested 15 times as much cash as they distributed to shareholders; in recent
years the ratio has dropped to below two times (see chart).
What
has driven this change? In his new book, âThe Road to Recovery: How and Why
Economic Policy Must Changeâ, (Wiley UK, 2013, due out next week) Andrew
Smithers, an economist, argues that the main cause has been management
incentives.
Most executives now receive
more in bonus compensation than in salary. These bonuses are often tied to share price, which in turn depends on the ability of the company to meet its
quarterly earnings-per-share target. Share repurchases tend to boost earnings
per share while investing in the future of the business may depress them.
Mr. Smithers writes:
result of the increased importance of bonuses and the use of these measures of
performance is that managements are now less inclined to take short-term risks,
such as cutting profit margins, and more inclined to take the longer-term risks
involved in lower investment and the possible loss of market share that will
result from higher margins.
He isnât alone in
this view: A 2013 study by John Asker (NYU), Joan Farre-Mensa (Harvard),
and Alexander Ljungqvist (NYU) found that public companies where executive
compensation is linked to the stock market, invest considerably less than
private firms and are less responsive to new investment opportunities. The authorsâ
state:
results are most consistent with the view that public firmsâ investment
decisions are affected by managerial short-termism
There is more evidence:
The National Bureau of Economic Research (NBER) found in a 2004 survey that
the majority of managers questioned would not proceed with a profitable
long-term project if it meant that the company would miss the consensus
forecast of profits in the current quarter: (emphasis by the Wrongologist)
preference for smooth earnings is so strong that 78% of the surveyed executives
would give up economic value in exchange for smooth earnings. We find that 55% of managers would avoid initiating a
very positive NPV [Net Present Value] project if it meant falling short of the current quarter’s
consensus earnings
In todayâ s business
landscape, many executives receive stock options for meeting targets. Since
share prices are affected by trends in profits, executives have an incentive to
pursue strategies that increase profits.
Salaries and cash
bonuses are paid regularly. But once stock options are vested, they can be
cashed in at any time thus presenting executives with an irresistible incentive
to maximize short term share price, so that their options have more value. They
can then cash out large option holdings, benefiting themselves at the expense of the company’s long
term market value. Preferential tax treatment of options further exacerbates
this problem. And if the worst happens and the company hits hard times, the
executives get fired and/or leave to do the same thing at another company. Without
repercussions or consequences, they can just take the money and run.
The
combination of the corporate bonus culture (for those who need bonuses the
least) and the short-term focus of the financial markets account for the negative
impact on corporate investment and over time, it will impact corporate competitiveness.
Short term
goals/profiteering also contributed to the financial meltdown, particularly at the top level
financial firms, executives not only were unscathed, they reaped big bonuses. The public is now wise to company leaders
who amass their own bundle, leaving other stakeholders holding the bag. Most
executives are in it for the money, very few are in it for the economic benefit
of their employees, never mind their consumers.
We
say it a lot around here; without more customers earning wages there are too few left
to spend on products/services being produced. This is economics 101
folks.
What
to do about the bonus-option incentive is more difficult.
Government
can change the tax code to eliminate the tax incentives that come with holding
options, taxing the profits from holding shares that were originally stock
options as ordinary income. This type of Pigovian tax would help,
but it is unlikely to change corporate culture.
Corporate
interests are so entrenched it’s very unlikely the current bonus-based
“incentive ” structure will change – what is fairly certain however
is that the views Smithers expresses in his book will be both condemned and
criticized by those most likely to benefit from the status quo being
maintained.
His
point is that we will not resume the kind of economic growth that creates jobs
as well as profits until we more equitably resolve the corporate focus on
short-term profits.
