Rogue Missives Friday, August 01, 1997

In theory, at least, the stock market is a way of allocating capital to companies that can put it to efficient use. In that sense, it is supposed to play a key role in shaping the productive capacity of the economy. Due to the great ease with which people who buy stocks can get in and out of the market, the stock market performs the miraculous feat of financing long-term company investments (like Netscape Communications using the proceeds from its IPO to expand its physical plant) with money that investors are able to withdraw at any time. The point of the stock market in this context is not, or at least should not be, the stocks themselves. The point is what the market allows companies to do that they would not be able to do otherwise.

It follows that an individual company should not be preoccupied with its stock price, except insofar as that price serves as a signal to management that the course they're pursuing may not be the right one. (Presumably a quick look at a balance sheet or at an earnings graph would be able to tell managers the same thing, but it can concentrate the mind wonderfully to find out that speculators across America are skeptical of your strategy.) Even so, a company's health is not determined by its stock price. If it were, then over- and undervaluations would never occur. The market's short-term judgment on a company does not necessarily reflect anything about its underlying value. Therefore, worrying about how to affect the market's judgment is energy ill-spent.

Benjamin Graham and David Dodd made this point in the very first edition of their classic Security Analysis when they wrote: "The market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities. Rather we should say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion." The price can tell us what the market thinks at a particular moment, but it can't tell us whether the market is right.

It's here -- in this potential gap between a company's real assets and real performance and its stock price -- that the difference between investors and speculators can be seen most clearly. Investors are not concerned with what the market says today, because their focus is on the company, not on the market's judgment of the company. They believe, because of historical experience, that in the long run a profitable and successful company's stock price will rise and they are willing to be patient. Speculators, on the other hand, are interested only in what the market thinks of the company. They want the company to do all it can to improve itself -- not in real terms, but in the eyes of the market. Given the choice between one strategy that will improve revenues and profitability three years down the road and another strategy that will raise the stock price in the short term, speculators will choose the second.

What the speculators' approach does is reduce the stock market to a quasi-pyramid scheme. If I buy a stock today just because I think someone will pay me more for it tomorrow -- without any consideration for why the stock would be worth more tomorrow -- then I'm gambling on others' willingness to gamble. If companies begin adopting business strategies designed to ensure that their stock price will be higher tomorrow, then they become accomplices in the same game.

This is the dark side of corporate America's newfound emphasis on "shareholder value," an emphasis forced on them over the last decade by a curious combination of corporate raiders and shareholder activists. The call for shareholder value has had a number of beneficial effects: it's made companies more efficient, it's brought new attention to the problem of executive compensation, and it's tightened the link between ownership and control. But that same call has also encouraged a corporate focus on the short term, too-deep cost cutting, and most importantly, a shift in managerial focus from the bottom line to the ticker.

All to the good, some would say. If shareholders are the owners of a company, it should be run in their interests, and their interests begin and end with the day's closing price. But this is only true if one adopts the most narrow and, indeed, perverse conception of what an owner is. If you own a company, generally your first concern is your company's actual performance, not what everyone else thinks of that performance. Are you making what you want to make? Are you as profitable as you can be? Are you running the business in a way that allows you to sleep at night? These, surely, are the criteria by which most owners judge their companies. These should be the same criteria shareholders use to judge the performance of managers. Only speculators look to the stock price before they look at anything else. It's not the emphasis on shareholder value that's wrong, then, but rather the tendency to define shareholder value purely in terms of stock price.

The practical consequences of corporations being too concerned with Wall Street are real. Executives spend too much time each month in meetings with analysts. A recent study estimated that CFOs spend as much as 20% of their time courting analysts and fund managers, time that presumably could be better spent figuring out how the company could be more efficient. That doesn't even include the time spent trying to manage earnings so that estimates are hit.

More strikingly, corporations have greatly expanded share buyback plans. Between 1985 and 1995, firms bought back $504 billion of their own stock, which means we've reached the point where more corporate shares are now retired each year than are issued. Considering that the stock market is supposed to be a market for allocating capital, the fact that no new capital is being allocated makes the whole thing seem like a machine that makes lots of noise but doesn't ever move. (It's more complicated than this, because all of the trading in the secondary market probably does create a more welcome climate for new issues, but in aggregate no capital is being added to the U.S. industrial base.)

As Doug Henwood reports in his compelling book Wall Street, between 1980 and 1996, new stock offerings were a net -11% of corporate capital expenditures. In other words, investment is not being financed by outside investors, but entirely by inside earnings. Moderating these numbers, though, is the fact that a sizable percentage of that negative result stems from companies' ability to pay cash to acquire other firms. If mergers make American business more efficient, then that negative number may not be as important as it seems.

In many cases, of course, the justification for share buyback plans is eminently practical: corporations have come to rely on options to pay their employees, and in order to avoid dilution they need to buy back the shares they'll eventually have to issue to their employees. In this case, buybacks are a kind of accounting necessity that, if done right, saves the company money over the long haul.

In many other cases, though, share buybacks are nothing more than an attempt to placate investors and reassure the Street by adopting a short-term strategy that's almost guaranteed to drive prices up. Take these startling numbers: in the last two weeks, more than twenty different companies announced new buyback plans. NORTEL <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NT)") else Response.Write("(NYSE: NT)") end if %> is buying back 4 million shares. RYDER SYSTEMS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: R)") else Response.Write("(NYSE: R)") end if %> is buying back 7.7% of its outstanding stock. CHAMPION <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CHB)") else Response.Write("(NYSE: CHB)") end if %> is buying back 8.5% of its stock, while SUN MICROSYSTEMS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: SUNW)") else Response.Write("(Nasdaq: SUNW)") end if %> has allocated $150 million to a buyback plan. DIGITAL EQUIPMENT <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: DEC)") else Response.Write("(NYSE: DEC)") end if %>, QUAKER OATS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: OAT)") else Response.Write("(NYSE: OAT)") end if %>, and AMERICAN AIRLINES <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AMR)") else Response.Write("(NYSE: AMR)") end if %> all have announced major plans. GENERAL ELECTRIC <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GE)") else Response.Write("(NYSE: GE)") end if %> has now bought back $8.1 billion, or 218 million shares, of a planned $13 billion buyback.

Some of these buybacks will help companies meet their options obligations, and others may help what some companies consider excessive dilution. But a surprisingly large number of these are explicitly justified by corporate managers as a way of buoying up the stock price or of expressing management's confidence that the stock is undervalued. We have come, in the 1990s, to accept these as reasonable justifications for the diversion of profits away from either reinvestment in the company or from dividend payments. It seems far more reasonable to ask why, if a company's management is confident that they're doing a good job running the company, they care that the market hasn't realized it yet. If you believe that value will come out over the long run, then short-term gimmicks like buybacks don't seem necessary unless you are only concerned about appeasing the speculators.

But isn't buying back stock a good investment if the stock price is going to continue to rise? It is if you're going to need that stock, as options-driven companies do. In other cases it's more of a gift to shareholders than a real investment, and it's not a real gift to the shareholders that matter -- the long-term investors -- but to speculators. There is, in any case, something troubling about a company that thinks it can make more money buying its own stock than investing that money in productive enterprise.

This does not mean that companies should look for new acquisitions at all costs or should diversify as a way of deploying capital. Certainly there are times when profitable in-market investments are not to be found. On the other hand, as the experience of MICROSOFT <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MSFT)") else Response.Write("(Nasdaq: MSFT)") end if %> suggests, it's not clear that keeping large cash reserves on hand is less sensible than dumping capital into your own stock. The real problem is that too many companies now look to buybacks as their first option because their short-term stock price is their first concern. In doing so, they risk forfeiting long-term stability and growth to reward those whose time horizons extend only until the end of the trading day.

"Shareholders aren't the purpose of the market game, industry is," wrote Louis Lowenstein in What's Wrong With Wall Street. "The stock market is a mechanism to marshal savings for private enterprise and to allocate them to those who use capital most profitably.... [W]hat may be efficient pricing for one purpose and one market (day-to-day trading) may not be efficient for another (the negotiated, whole-company market.)" The move from speculator to owner is the move from the day-to-day to the whole-company market. It's a move that entails a shift away from the ticker and toward the balance sheet, away from short-term gimmicks toward long-term investment. It's also a move that, in the long run, will make American companies healthier entities.

-- Jim Surowiecki (Surowiecki)

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