Greed in the Executive Suite?Monday, September 15th, 2014
Deciding how to allocate capital is one of management’s most important responsibilities. Such decisions impact not only the company’s short- and long-term performance, but the overall economy as well. Share buybacks, a topic we have discussed several times in the past (see “Thoughts on Share Repurchase Activity Levels,” “Dividends vs. Stock Repurchase,” and “Financial Engineering and Share Repurchases”), represent one way in which management allocates capital. We have not discussed the broader economic impact of such activity previously. A study by William Lazonick, an economics professor at the University of Massachusetts at Lowell, looked at the 449 companies listed in the S&P 500 every year from 2003 to 2012. He found that they devoted 54% of their net earnings to buying back their shares and another 37% to dividends. That left only 9% for increased investment in research and development (R&D), business expansions, or raises for employees.
Dividends, Share Repurchases, and Economic Growth
There is nothing inherently wrong with companies returning cash to shareholders via dividends and share repurchases. However, at least some of that capital could have been reinvested in the economy in ways that would spur job growth and create jobs. Such reinvestment could help spur economic growth. For example, if wages increase, then consumers have more money to spend. When consumers have less to spend, the economy grows more slowly. As a result, a significant portion of the weakness in the job market and the sliding prospects of the middle class can be explained by the capital allocation decisions of corporations.
What has caused corporations to tighten their belts? The most common response is they have become more risk averse in a rapidly changing world. A second explanation could be that management teams are focusing more on the short- rather than long-term impact of their decisions. The result is lower spending on such important activities as long-term research or maintenance. This makes it easier to reach earnings targets and keep share prices up. Heavy share repurchase activity also supports the share price.
Over time, the role of stock-based compensation as part of the overall pay package for corporate executives has increased dramatically. This change has likely increased management’s focus on share price. Given the correlation between share prices and current company earnings, management’s strategic focus has become increasingly short-term. Cost-cutting is the easiest way to boost near-term earnings. As a result, companies are more likely to cut R&D, lay off employees or downsize their operations.
An important question is how can these issues be better addressed? Legislative change could help. For example, Congress could make it harder for companies to buy back stock (such activity was much more limited until changes made in 1982 during the Reagan administration). Lawmakers could also limit the ability of companies to use stock options as a key element of executive compensation.
BWFA Investment Approach
At BWFA, we favor companies with management teams that take a long-term approach. We also pay close attention to how companies allocate their capital. Given our investment time horizon, we think companies with a long-term view are most appropriate for client portfolios. At the same time, it can be relatively hard to find companies that truly think long term. We believe changes in corporate thinking are also needed, so that management places greater import on the long-term impact of its decisions on both society and the company’s operations.