Friday, December 3, 2010

Buybacks to avoid dilution

Two more reasons (that I hadn't mentioned in my last post) why giving your CEO options (besides being a bad idea in general) will also give him or her strong incentives to prefer buybacks to dividends (if any "return cash to shareholders" action is contemplated).

First, as a ("call") options holder, the CEO receives no benefits from dividends declared today -- call owners don't accrue dividends, holders of <i>stock</i> do.  For the identical decrease to the firm's enterprise value (due to the departure of cash), buybacks should at least increase the options' present value (by the amount the buybacks increase the value of common stock, times the options' "delta" -- the latter can be pretty close to 1 if the option is, at this time, substantially in-the-money).

Second, the very granting of options produces likely risk of stock dilution -- those options are going to be exercised if they are in the money at some time between when the vest and when they expire, creating new stock in addition to what current stock-holders presently own.  Just as buybacks should increase the value of common stock, so dilution should decrease it -- and, the market is a forecasting device, so, <i>impending</i> dilution (dilution that's reliably forecast to happen in the future) should also reduce the value of common stock (by some fraction of what it would be reduced by as and when the options get exercised, multiplied by the probability that options will expire out of the money -- roughly equal to delta -- and further diminished by the discount rate to apply due to the delay between now, and the time of the options' exercise).

Decrease in common stock value also decreases the value of the options the CEO holds (again, by the amount the dilution decreases the value of common stock, times the options' "delta") -- again, this is incentive for the CEO to have the firm do the buybacks.

If options are to be granted at all, buybacks (one grudgingly has to admit), in about the amount needed to avoid dilution, have reasonable returns to shareholders (mostly due to the tax treatment of various possibilities -- which, of course, is a very volatile thing;-).

And, in fact, there are industries where it's just about mandatory to give your employees options if you want to retain the top talent -- mostly industries in which your likely competitors for said top talent are likely to try to lure them away by dangling wads of options at them.

Employee options are relatively cheap to the firm granting them (and in particular, differently from just about any other form of compensation, require no outlay of cash by the firm at this time... nor at any future time either, necessarily, except that if and when the options are exercised buybacks costing cash will become desirable... but, still, not mandatory!).

Since call options give great leverage compared to owning stock (esp. restricted stock), they're particularly attractive to optimistic, "high-roller", "top talent" employees who are particularly desirable.

<i>And</i>, the crazy accounting treatment (by GAAP) of granting employees options is yet another motivation for the company to employ them in industries where they're culturally common.  Note that each of the three points makes granting options as compensation <i>particularly</i> rewarding to start-up companies (who desperately need to preserve cash today, desperately need to attract and motivate over-performers, <i>and</i> really need accounting help to make their statements look decent in the difficult early times of low revenues, high outlays, and negative-if-any earnings;-).  So, options are most commons in industries with large numbers of start-up companies, such as high tech; in those industries, options are usually found as part of compensation even in larger and more established companies, who'd otherwise risk having their best performers lured away by startups.

In addition, it's become customary to award options, in just about every industry, to at least the "cream" of top management (though often not to rank-and-file employees or even to middle management).  This one new cultural trait I really deplore... it's certainly desirable to give top management a strong incentive to behave like stockholders, but, options don't do that -- stock does, even restricted stock (e.g. stock that cannot be sold for years after vesting -- enough years to hopefully allow the market to properly evaluate the company's value resulting from management's strategy, vision, and execution).  Only startups (where volatility <i>is</i> desirable -- and the firm's not publicly quoted yet, so there are no shareholders to be damaged;-) should generously award options to top management (and all other employees... and suppliers, too, if they will take some reasonable amount in lieu of cash... remember, a startup's first commandment is to <b>conserve cash</b>!-).

Restricted stock, like options, would also require buybacks to avoid dilution, of course... but typically much less actual cash than needed to compensate for options of equivalent value when granted (the premium, or value, of a call options that is at the money when acquired -- as typically done for options granted to management or other employees -- is invariably lower than the underlying stock's price... except maybe for companies so wildly volatile they had <i>better</i> be startups!-).  Accounting-wise, seeing that at an expense at time of granting -- or, at worst, of vesting -- rather than delaying it to exercise time, makes a lot of sense (but of course that's in part because it makes a company's financial statements a better match for reality, rather than "pretty them up" a bit... which no doubt is exactly why most companies dislike that!-).

Beyond the amount needed for dilution avoidance, buybacks are really a lottery at best, and in my view they're really undesirable for stockholders as a general rule -- as I hope to show in a future post.  Absurd tax and accounting rules making buybacks (or options) "look good" should really be reformed, to avoid having the tax system provide distorting incentives to firms and their top management!

Monday, November 29, 2010

The problem with buybacks... and, with granting options to CEOs!

Peter Lynch -- an investor whose historical realized performance we should all be hoping to emulate! -- was just gaga about stock buybacks: i.e., he just loved being long companies who used some of their accumulated earnings to buy back some of their stock.  So, if I admire Lynch, and he was the hottest fan of buybacks... why am I so, overall, "meh" about owning stocks of firms that do a lot of buybacks...?

"Anno Domini", my dear sir... the eternal problem of time!-).  Lynch's great books, and great performance, are from the 1990's... it's now the 2010's, 20 years later.  Companies' management has had plenty of time to figure out that stock buybacks are "costly signals" to the market, and therefore ones with a lot of intrinsic credibility... but the cost, if any is to be paid, is not from their pockets, but, the shareholders'.  (Agent-principal issues potentially emerging again;-).

When a company buys back its own shares it clearly signals (costly, thus credibly) it believes shares are undervalued - contrarywise, stopping or delaying a buyback plan would signal it believes shares are fairy valued, or overvalued.  CEOs typically hold far more in ("call") options than in shares -- a terribly badly designed incentive that makes them participate fully to the upside, but not at all to the downside.

Let me expound simply on why options (vs, e.g., restricted stock) are a terrible way to provide incentives to top management.  Suppose you owned stock of ABC, currently trading for $100 a share. A certain move has 50% probability of moving ABC stock to $90, 50% probability of moving it to $110.  As a shareholder, would you like that move?

Surely not -- it leaves you with the same expected returns while increasing your volatility, AKA risk... a crazy tradeoff!  Normally, you'd demand higher expected returns to withstand an increase in risk (volatility).

But -- say you didn't own the stock itself, but a call option at strike 100 close to expiry.  What would you think of the 90-or-110 move now?

You should be all in favor -- going down from at-the-money 100, to out-of-the-money 90, for the underlying, doesn't decrease the value of your expiring options... it stays at 0 either way.  But, should the underlying soar to 110, you're making a 10% profit.  "heads I win, tails I break even" is a superb bet, so of course you'll just love such a move which increases risk but not (shareholders') expected returns!

If you give your firms' CEOs options (rather than restricted stock), you're giving them strong incentives to increase the stock's volatility.  Increasing future expected value would be great, too, of course... but, increasing risk with no increase in expected returns is clearly way easier... and by granting the CEO who works for you options rather than restricted stock, that (increase volatilily) is exactly the incentive you're giving him or her.

So that's problem #1 with buybacks (and acquisitions too): if they increase volatility but not expected returns, they're a great idea for your options-incented CEO... yet a bad bargain for you, the shareholder.

This is a general problem with giving top management options-centered bonuses.  Buybacks have more specific issues, too... but, I guess that's a theme for a future post!-)

How would you like your cash back, sir?

We have examined how, despite Modigliani-Miller's theorem, in the real world we should prefer most firms, under most circumstances, to return to their shareholders some (a sustainable fraction) of the free cash flow resulting from operational earnings -- not to the point of incurring avoidable debt (except in cases where some debt can be had under very favorable conditions, and be wisely used to leverage the firm up in sectors requiring high capex but with a very steady and predictable cash flow as the result -- regulated utilities being the prime, classical example of this situation), but also avoiding excessive accumulation of cash hoards which yield very little (except in rare cases where a company has a proven track record of profitable acquisitions, with successful integration of the acquired firms, and requires substantial cash reserves to continue on that strategy going forward).

If you're still a Modigliani-Miller fan, I'd recommend taking a look at  this article.  By the way, as an aside, I do strongly recommend the site -- it's very cheap and really chock-full with interesting and directionally-right information, even if you're a more experienced investor than they aim to.  (if you're a  beginning investor, AAII membership is really, truly, seriously, I-mean-it a must, BTW;-).

So anyway, back to the AAII article I just pointed to, which summarizes and discusses Arnott's and Assness's immortal 2003 article in "Financial Analysts Journal".  To summarize the summary of the summary: companies that pay dividends have better (not worse, as M-M would predict) capital gains returns, too.

One of the possible explanations is that "high earnings retention and a low dividend payout may signal an attempt at empire-building by current management" -- in other words, such a high retention with low dividends is a negative signal, pointing at the risk of out-of-control acquisition spreads.

Some companies (a very few, with a proven historical track record) can retain earnings and use them to fund acquisitions in a way that's accretive of value to shareholders; by far the greatest majority just can't, and history proves that clearly.  Arnott and Assness's "screen" may screen out companies likely to go on shareholder-negative acquisition binges -- and that may explain a lot of why it's predictive.

So, let's accept (for the sake of discourse) the overwhelming evidence that companies who do return some (reasonable, sustainable) fraction of earnings to shareholders, overall (i.e., always excepting many possible exceptions, which, in real-life, do abound), outperform those who hoard that cash.

There remains a problem -- per the title of this article: as an owner of some part of the company, accepting that it should return some of its cash to you, how would you rather get it back?

The main possibilities are, share buybacks, and dividends (which can take many forms).  Dividends are "all the rage", lately... and, as a contrarian, I'm always especially wary when I find myself agreeing w/the hoi polloi... but in this one case I have to admit I can't really, credibly, disagree, either;-).

So, I'll follow on with posts on buybacks (when are they good, when are they a problem) and dividends (and the various forms they can take... though today's typical US investors may not realize dividends' multifarious possibilities and their pros and cons!-).

Saturday, November 27, 2010

are acquisitions good for you?

If you're a shareholder in the company being acquired, probably so; if in the company doing the acquisition, usually, not so much.  Why is that?  Because acquiring a company generally requires the acquirer to pay a "control" premium over the market's stock price -- that premium goes right into the pockets of the acquiree's stockholders (good for them!)... but it requires justification from the viewpoint of the acquirer's stockholders.

Say company BUY wants to buy out company SEL -- SEL's market cap just before the bid, $2 billions -- bid value, $2.5 billions (a pretty modest premium of 25%).  What's SEL actually <b>worth</b>?  If it's worth more than 2 billions, why was Mr Market silly enough to be happy to sell us shares at a $2 billions valuation?  Well, Mr Market undoubtedly is prone to temporary follies, no doubt about it... but, if I'm the one supposed to finance this buyout (i.e., a BUY shareholder), you still have to show me that this is indeed the case in this specific instance.

If SEL's own assets (book value) are worth $1 billion, the remaining $1.5 billion of the acquisition price will go in BUY's asset account as "goodwill" -- always something worth looking out for: an intangible asset which just means "we paid so much more for some acquisitions than we can prove the acquired assets are worth"... not usually a good sign from my skinflint, value-oriented viewpoint.

From the viewpoint of optimistic, aggressive BUY's management (the kind of people you probably do want in charge of companies you own, overall), acquiring SEL is undoubtedly going to be a triumph -- it will grow their little empire, increasing their power (and likely their compensation in proportion), and it's just sure to work out great as their superior strategic vision strengthens SEL's direction (BUY's managers are of course totally certain that they're better than SEL's... and everbody else;-).

You could see this as a principal-agent incentive conflict problem, I guess, because there are cases in which the acquisition will benefit BUY's managers (increase their power and compensation) but not BUY's shareholders (reduce their overall returns on equity).  However, I think that (for the typically forthright and honest -- but often overconfident! -- people who end up in top management) this is not a major consideration -- such cases are somewhat marginal.  Normally, when the acquisition's a flop, BUY's management will not be happy either -- and when it's a triumph, both BUY's management and shareholders will benefit thereby... maybe not quite in the same proportions (in either case, win or lose), but that's a second-order consideration.

Rather, I think the natural "can-do" optimism (and, likely, overconfidence) of BUY's management is more likely to skew their vision in favor of acquisitions that would be better avoided (from BUY's shareholders' perspective) than any seriously distorted incentives.

That being said, the way-overused word, "synergy", sometimes does apply.  Maybe SEL's bursting with brilliant people and ideas but just can't get capital enough to fund their projects, for example, while BUY can get abundant capital cheap, just because it's bigger and financially sounder.  Maybe SEL, being a smaller company, suffers avoidable amount of overhead in supporting functions (such as, say, HR), which can be saved by merging the companies (maybe with some layoffs).  Maybe SEL's wonderful products just can't get enough distribution, while BUY's excellent access to distribution channels can help those products make a real impact on the merged companies' top and bottom lines.

All of these situations (and more) are possible... just very hard to evaluate (in terms of probability of playing out, and likely returns if they do) for anybody who's not deeply enmeshed in the specific industry (as management of course will be, but many shareholders, even the "investor types" like me who do tons of due diligence, usually won't).

So, my own rule of thumb is to let past performance be predictive of future results -- I know everything about there being no guarantee there, but, hey, surely there is some correlation!-)  I look at some companies and see a great track record of successful acquisitions over years and decades -- whether acquisitions play a supporting role in their overall company strategy (like, say, for AAPL), or a more central one (like, say, for MDT, or, even more, ORCL), they've repeatedly shown that they can successfully integrate newly acquired companies, and regularly do.  I look at most companies and I see a track record of disaster, or, at best, a very mixed picture -- e.g., look at EBay's acquisition of Paypal (now arguably the brightest part of the company, with the very best growth prospects)... but also that of Skype (with the huge write-downs of goodwill and the need to hive that part off again in just a few years)...!-)

So, if I was a shareholder or considering buying into AAPL or EBAY (neither is true at this time, nor have I been in either company's stock for years), and a proposed acquisition by said company was announced, I'd react very differently.  In AAPL's case, based on past performance, I'd give management enough credit to assume the acquisition won't be a bad hit against the firm's performance, and just might work out awesomely well.  In EBAY's, again based on past performance, I'd be much more skeptical -- unless the underlying business logic is crystal-clear enough even to a duffer like me (in which case I'd dig deeper into the financials' entrails), like, say, Paypal's acquisition was, I'd be prudentially assessing the likelihood that management's about to play another Skype on me... and looking for an opportunity to get out of the stock (or just avoid getting into it in the first place).

The fact that the vast majority of mergers and acquisitions don't work out, is part of why I'm dubious about the possibilities of most companies hoarding big treasure troves of cash -- they enable management to perform more and more acquisitions that I, as a BUY shareholder, would rather see not happen.  All of this applies to acquisitions in cash, BTW -- if you have incredibly overvalued stock, and can acquire real value in that weirdly inflated currency (like AOL did to Time Warner a few years ago), hey, more power to you (and then I'd be more worried as a shareholder of SEL!-).  But, cash is still worth $1 per buck (despite the Fed's best attempts to the contrary;-), so, as a BUY shareholder, I'd usually rather see that cash in my own pockets, than in those of SEL's shareholders!-)

Tuesday, November 23, 2010

Paper money: a Faustian bargain?-)

I've been enjoying Weatherford's delightful History of Money as an audiobook (that's the one plus of having to commute by car, now that I've moved to Sunnyvale so can't really walk to work in Mountain View as I used to -- in the 20+ minutes of drive each way, instead of radio which at any time might be speaking about interesting things or inane ones [or playing ads -- or thanking sponsors or hustling for donors, if it's NPR;-)], you can listen to cool audiobooks of your choosing!-).

Among its many charming details is a sound "monetary" (and literary) analysis of Goethe's Faust (Part Two) -- remember the immortal verses (in Lange's popular translation to English, cfr Google's version) in which Faust, alternating with Mephisto, pleads to the Emperor in favor of paper money...?
The excess of treasure frozen in your lands,//Deep in the soil awaiting human hands,//Lies there unused. The furthest range of thought//Cannot define such riches as it ought
...and therefore the Emperor should solve his monetary problems by issuing abundant paper money backed by all the yet-unextracted gold, silver and gems in the land belonging to the Empire?  I had always taught of that as the typical "Faustian bargain" -- a devil-inspired one.  However, Weatherford's reading is different: Mephistopheles' ends are of course evil (it's definitely possible, even easy, for paper money to be abused to evil, greedy, selfish ends by the State's rulers)... but, not Faust's own!

What Faust does with the newly abundant paper money is -- try to drain marshes, build roads, propel the Empire to new, real prosperity, which the scarcity of species previously held back.  And (in W's reading) that is why the Angels in the end shield Faust from the devil "for his unending striving"... because that's what the economy is, whether it's held back by scarcity of species or propelled forward by abundance of paper money -- an unending striving to make things better (albeit beset by rogues and  Madoffs...), to build real prosperity.  The great Poet is not just sounding a worried, backwards-looking alarm against the easy excesses of paper money, as he's usually read -- he's also, in the same breath, pointing to the positive, creative "unending striving" it makes possible (despite all the selfish rogues), for those who really do want to "unendingly strive" to build a better world for all.

In other words (and that's my own parallel, thinking of the "news of today") -- Bernanke is Faust.  The superficial observers (most of us) only see the "pact with the Devil" aspect, and want to take away the original part of the Fed's mandate (the one about full employment) to make it focus entirely on keeping the currency sound (as it did in 1929... fat lot of good it did back then, hm? only as nations, including the US, dropped the gold standard, and roughly in the same chronological order as they did so, did each of them manage to start the monumental task of draining the swamp of Depression -- only paper money enabled that, just like only it, the understandably maligned Continentals, enabled the thirteen colonies to finance their terrible wars against England...!).  But -- Bernanke's fighting to promote the "unending striving" that's the only possible path to prosperity.  In the end, even though the Devil may prevail, the Angels will come in to defend him and save him!-)