stock options and stock buybacks

I first became aware of the crucial relationship between stock option grants and stock buybacks in the late 1990s.

I was on a research trip to San Francisco, where I had dinner with the new CEO, a turnaround specialist, of a chip design and manufacturing company with a checkered history.

In the course of our conversation, he said that one of his objectives was to ensure he retained top talent.  He went on to mention, as if it were a matter of course, that he would do so by having his firm issue enough stock options to transfer ownership of 6% of the company each year to workers (I’m pretty sure 6% was the number, but it could have been 8%).

I was shocked.

My first thought was that after eight years (six years, if the 8% is correct), there’d potentially be 50% more shares out.  This would massively dilute the ownership interest of any shares I might buy for clients.

My second was that I would have to evaluate the potential for massive positive earnings surprises that would make the stock skyrocket if the turnaround were successful, against the steady erosion of my ownership interest through stock option issuance.  (I decided to bet on skyrocket, which ended up being the right thing to do).

My third was that eventually suppliers of equity capital like me would have to question whether the kind of ownership shift this CEO was presenting as normal tilted rewards too far in the direction of management.

 

After this experience, I began to look much more carefully at the share option schemes of companies that might potentially be in one of my portfolios.  I noticed that in many cases companies had stock buyback programs–pitched as a “return to shareholders” of profits, sort of like dividends–that almost exactly offset the dilution from the issuance of new stock to employees.

This isn’t the case for all companies, but my observation is that it is for many.  I don’t think this is a coincidence.

Part of the rational for buybacks, it seems to me, is simply to prevent dilution of earnings per share, which would arguably help no one.  But at the same time, for the casual observer who looks only at share count and at earnings vs. eps, it obscures how big the corporate stock option issuance plan is.  I don’t think this is an accident, either.  Yes, the information is all in the SEC filings, but the reality is that even many investment professionals don’t read them.

That’s what I find problematic about stock buybacks–that I feel they’re misleadingly described as a shareholder benefit, while their purpose is to play down the level of key employee compensation.

 

 

should corporate stock buybacks be banned?

This is becoming an election issue.

Elizabeth Warren, deeply suspicious of anything to do with finance, regards them as a form of stock manipulation.

Many more mainstream observers note that $7 trillion (according to the New York Times) spent on buybacks by S&P 500 companies has consumed a large chunk of their cash flow at a time when both wage growth and new investment in physical plant and equipment in the US have been paltry.  They argue, without further elaboration that might have the argument make some sense, that the latter are being caused by the former.  Therefore, they think, if only stock buybacks were eliminated, employment and wages would rise and the US would reemerge as a global manufacturing power.  I imagine the same people are saving their old calendars in case 1959 should come back.

There are instances where, in my view, stock buybacks are clearly the right thing to do.  Imagine a publicly traded company that has a profitable business that generates free cash flow, and that has no liabilities plus $1 billion in cash on the balance sheet.  Let’s say the firm’s total market capitalization is $500 million.  In this situation, which actually happened for a lot of companies in 1973, stock buybacks would accommodate shareholders who wanted to liquidate their holdings and create $2+ in value for remaining shareholders for every $1 spent.  I can’t see any reason to outlaw this.

There are also cases—IBM comes to mind–where continual buybacks make investors think that this is all the firm has left in the tank.  So though buybacks keep on generating increases in earnings per share, by shrinking the number of shares outstanding, they no longer support the stock price.  The generate selling pressure instead.  In theory, and provided management understands it can’t play with the big boys any more, the firm should liquidate and return funds to shareholders rather than to continue to destroy value.  Like that’s ever going to happen.  But investors will vote with their feet.  While maybe management conduct should be different, I can’t see how that could be legislated.

My big beef with stock buybacks is that the main purpose they serve is to disguise the gradual transfer in ownership for a company from shareholders to employees that happens in every growth company (more about this tomorrow).  This could be/ should be made clearer.

I also think managements should show more backbone when “forced” into buybacks to satisfy activist investors, in what is the 21st century equivalent of greenmail.

But the idea that barring stock buybacks will cause corporations to make massive capital investments in advanced manufacturing in a country that has a sky-high 35% corporate tax rate, a shortage of skilled labor and rules that bar a firm from bringing in needed technical and management employees from outside is loony.  It isn’t clear to me that removing legislative impediments to investment will be enough to roll back the clock and make the US a manufacturing power.  It isn’t clear, either, that we should want to return to an earlier stage of economic development.  But outlawing buybacks won’t achieve that goal.

Georgetown: Good Jobs Are Back

Georgetown University’s Center on Education and the Workforce published an interesting analysis on the growth of employment during recovery from the recent recession.

The report counters what it describes as media portrayals of the recovery as being built on the creation of low-playing, low-skilled, benefitless, no-advancement positions as, say, baristas, Uber drivers and hamburger flippers.  Georgetown points to both the New York Times and the Wall Street Journal as among the culprits, citing articles written from 2012-15.  While this characterization may have been true in 2008-2009, the opposite has been the case during the five years since.

Over the past half-decade, job growth has been driven by “good jobs,”  which Georgetown defines as being in the upper third of their occupations by median wages.  Such positions pay $53,000/ year, or 26% more than the median for all full-time workers.  86% of “good jobs” are full-time, 68% offer health care benefits and 61% an employer-sponsored retirement plan.  Such benefits are typically add 30% in ecnomic value in addition to wages.

How can the media have been so wrong?

It’s because reporters have examined employment data by industry–looking at the types of products and services provided–rather than by the position being filled.  In other words, the reporters ended up counting a software engineer, an accountant or a marketing executive hired by Starbucks as a barista.

Looking at positions instead of industries, paints a different picture.

“Good jobs” have accelerated sharply since 2010.  Comprising 2.9 million out of 6.6 million total new jobs, they are dominating the recovery.  There are more “good jobs,” and more low-paying ones, today than there were in 2008.  Middle-wage jobs, however, are still 900,000 below their pre-recession levels (no explanation given by Georgetown for this).

 

The Georgetown report also shows that from 2010 on, workforce participants without at least some college have actually lost jobs across all wage categories–high, average and low–even though employment was expanding rapidly.  There are 39,000 fewer workers in “good jobs” who have high school diplomas or less (during a period when 3.1 million net new employees were hired), 280,000 fewer in average-paying jobs (2.1 million hired), and 159,000 fewer in low-paying ones (1.9 million hired).  It’s unclear how much of this replacement is due to employees upgrading their credentials, how much to changes in the labor pool, how much to changes in hiring practices…  In addition, college graduates made up 97% of the “good job” hires, 62% of the average-job hires and 39% of the low-paying hires.

 

I’m mostly interested in the economic implications of the Georgetown study.  But I find the report’s comments (p. 6) on the implausibility of the media articles to be interesting, and a little disturbing, as well:

“We find these media stories to be counterintuitive because they disagree with the well-established cyclical patterns of economic behavior. The consensus among economic researchers is that the economy has seen a strong shift toward college-educated workers since the early 1980s. The long-term shift in hiring, the increased economic value added, and the wage premium of college workers have persisted and strengthened for more than 30 years in periods of both recession and recovery. If the reports that the economic recovery was only producing low-wage, low-skill college jobs were true, they would suggest a profound reversal of structural trends in technology and globalization in place for decades. This seems unlikely given the weight of continued evidence to the contrary.”

I read this paragraph as addressing the issue of whether reporters just wrote pieces off the top of their heads or whether they may have simply been repeating the results of interviews with informed sources in the world of economics or government.  Georgetown seems to be saying pretty strongly that no credible person could possibly have told them anything remotely like they were printing.

 

 

 

 

capital raising by Tesla (TSLA)

the offering

Last Friday, TSLA filed a final prospectus with the SEC, indicating that it is selling up to 3.099 million new shares of common stock (including underwriters’ over-allotment) at $242 a share.   This will net the company close to three-quarters of a billion dollars, which it needs to fund ambitious expansion plans–the Gigafactory to make batteries the chief among them.

I presume the precipitous decline of TSLA shares over the past ten days or so was triggered by underwriters soliciting indications of interest in this offering from hedge funds and other institutional investors.  Two bullish signs:  the offering was initially pitched as being 2.1 million shares, but raised to 2.7 million on Friday (not counting the underwriters’ allotment, which will have been bumped up as well).  As I’m writing this prior to Monday’s open, TSLA shares are trading at around $255 each.

my thoughts, (somewhat) randomly presented

  1.  TSLA made what I consider a firm-transforming offering of $3 billion in convertible bonds (at a conversion price of $350 (!!!) a share) last year.  This says something about how professional fixed income investors feel about the attractiveness of straight bonds.  More important for TSLA, the successful offering took talk of building the Gigafactory out of the realm of fantasy and placed it solidly into reality.
  2. The automobile world has changed significantly over the past year, with the plunge in oil prices and the rise of ride-sharing services like Uber.  The former may mess up the economics of electic vehicles; the latter calls into question the highly operationally leveraged corporate structure of traditional car companies (translation into English:  if they need to run at, say, 80% of plant capacity to break even, will that be possible if Millennials en masse use Uber instead of buying a car themselves.  Will the car industry be a replay of the current commodities debacle).
  3. My guess is that these shifts: (i) increase TSLA’s attractiveness to stock market investors vs. conventional car companies, and (ii) make Teslas relatively more attractive abroad, where petroleum products are more expensive than in the US.
  4. It seemed clear to me from the outset that the 2014 bond offering didn’t totally solve TSLA’s need for capital.  Another offering had to happen in 2015.  I’d expected more bonds.  Why stock instead?  Market etiquette says that a new offering should be at a higher price–here meaning a higher conversion price–than previous ones (otherwise last year’s buyers look like idiots).  Also, potential lenders periodically want companies to prove that they still have enthusiastic equity backers.  This is a combination of lenders not wanting financial leverage to be too high, their not wanting to be the only ones holding the bag if things go sour, and their knowledge that bonds are going to be under pressure as interest rates begin to rise.
  5. Last year’s offering signaled a near-term top for TSLA shares.   My instinct is to think that this offering establishes a near-term bottom.  I own a small position in the stock, however, so I may have an interest in thinking this is the case.

 

a strange story involving the business cycle and being wrong

I once had a young colleague with lots of potential, whom I liked very much and who was an excellent securities analyst  …but who had only limited stock market success despite loads of potential.

Ass an apprentice portfolio manager, this person came to me with the idea of building a significant position in a company that made carpets.  The firm was well run, apparently had sustainable earnings growth momentum and was trading at a low price earnings multiple.   In this instance, I didn’t do my job as a supervisor well, more or less rubber-stamped the idea and okayed the purchase.

Soon after that (this was 1993), the Fed began to raise interest rates.  This is something I had been anticipating but–maybe because this wasn’t crucial to the structure of my own portfolio–was information I failed to bring to bear on the carpet company idea.  Higher interest rates slow down both residential and commercial construction, something which is bad for, among other things, sales of carpets.  Replacement demand slows down, too.

I went to my colleague, explained the situation–including the source of my mistake, and urged selling the stock.  We did, with a modest loss.  The issue ended up losing almost two-thirds of its value in subsequent months.

Now the weird part.

Eight years or so later, my colleague came into my office to rehash this trade–which I had long since forgotten.  The point was not to suggest that we buy the stock again–which would have been a fabulous idea, since business cycle conditions were finally very favorable.  Instead, it was to say that my colleague had in fact been 100% correct in recommending the stock all those years ago (apparently the stock has finally reached the point where its cumulative performance matched that of the S&P 500.

I didn’t know what to say.  This was somewhat akin to my aunt Agnes explaining that she was switching from natural gas to oil because the gas burner in the basement was really a malevolent space alien.

Why am I recalling this strange story–much less writing about it–now?

Two reasons:

–we’re coming very close to another period of Fed-induced interest rate hikes.  This is bad of early business cycle companies, including housing, commercial construction and related industries in the US, and

–it’s a life lesson about investing.  My former colleague had extreme difficulty in recognizing an analysis was wrong or that a stock, for whatever reason, wasn’t working.  But portfolio investors in the stock market are always acting on very imperfect information.  And economic conditions, both overall and in inter-firm competition, are changing all the time.  So having what one thinks is a better analysis than the other guy simply isn’t enough to ensure success.   Recognizing when things aren’t going well, stepping back to regroup and seeking out possible sources of mistakes are all crucial, too.  Denial may salve the ego, but it makes us poorer, not richer.

 

looking at yesterday’s stock market movement

on the wheel or off?

Japanese financial institutions have a reputation as being pretty awful stock market investors.  My experience is that this reputation is well-deserved.  Still, there’s an old-time Japanese stock market saying that I like a lot.

It’s that trying to trade based on the daily movement of stocks is like being on a wheel that’s spinning rapidly.  If you stay on the wheel, you won’t be hurt.  If you stay off the wheel, you’re safe, too.  It’s only when you try to be on the wheel sometimes and off the wheel at others, jumping back and forth between the two strategies, that you can do big damage to yourself.

Most of us are (I hope) off the wheel with the bulk of our savings.  We lay long-term plans that we review periodically and mostly own index-like products.  Some of us, though, myself included, like to have a small amount of our assets that we actively managed.  Even so, we don’t want to turn into day traders, who are totally consumed with life on the wheel.

studying the spin

Nevertheless, there are some days where price action can be highly revealing because trading is very emotionally charged.  Sometimes buying and selling are motivated by greed.   More often, fear is the driver.  In either case, however, traders show their most deep-seated beliefs.  Such days are also typically marked by wide swings in the prices of individual stocks, and often by sharp intraday momentum reversals for the market as a whole.

Yesterday was that kind of day, in my opinion.

I think anyone interested in actively managing part of his own holdings should look carefully at how each active position performed yesterday, both in morning trading, when the S&P fell by 1.5%, and in the afternoon, when the index rebounded to close up slightly for the day.

Of course, company fundamentals and price are the key long-term determinants of investment success.  But seeing what the market thinks can’t hurt, either.

what to look for

  1.  The ideal pattern to see in an individual stock would be outperformance during the decline, followed by outperformance during the rebound.

The worst would be underperformance during both phases.  I’d begin to think carefully about my rationale for keeping this latter kind of stock.

2.  Does a day like this signal a purging of market fears–and therefore the end of near-term downward market pressure?  I don’t think so (not enough pain, either in time or in depth of fall).  If it were, however, the strongest stocks during the rebound may well become the leaders during the next market up movement.

3.  At the very least, though, the stocks that led the afternoon rally are probably the ones the market will continue to feel the most comfortable with when it’s feeling bullish.  The ones that fell the least in the morning will likely continue to exhibit a defensive character (I was mildly surprised that Intel was one of these).

4.  Follow-through over the next few days can add more evidence to conclusions drawn from yesterday.

 

 

 

 

 

 

 

the Chinese currency and the Chinese stock market

Throughout my financial career I’ve found that in sizing up currency markets traders from the big banks have always been ten steps ahead of me.

I’ve hopefully learned to live with this–meaning that because I’m never going to outthink them I believe my best currency strategy should have two parts:

–to avoid making future currency movements a major element in constructing my portfolio, and

–to be a “fast follower” if I can–that is, to figure out from a trend change what the banks must be thinking and to consider getting on board if I think the trend is going to have legs.

 

China has moved the price at which it will buy and sell renminbi down by 1.9% yesterday and by another 1.6% today.  Informed market speculation seems to be that another couple of downward moves of the same magnitude are in the offing.

From a domestic policy perspective, China would prefer a strong currency to a weaker one.  As I mentioned yesterday, the country has run out of cheap labor and must, therefore, transition away from the highly polluting, cheap labor employing, export-oriented basic manufacturing that is the initial staple of any developing country.  This kind of business has been the bread and butter of many Chinese companies, some of them state-owned, for decades.  Many are resisting Beijing’s call to change.  The strong currency is a club Beijing can use to beat them into submission.  In this sense, the fact that the renminbi has appreciated by 10%+ against other developing countries’ currencies over the past year, and by around the same amount against the euro, China’s largest trading partner, is a good thing.

On the other hand, the developed world has made it clear to China that if it wants to be included in the club that sets world financial policy, and in particular if it wants the renminbi to be a world reserve currency, the renminbi cannot be rigidly controlled by Beijing.  It must float, meaning trade more or less freely against other world currencies.  So China has a long-term interest in doing what it has started to do yesterday–to allow the currency to move as market forces drive it.

Why now, though?

World stock markets seem to be thinking that a severe erosion of China’s GDP growth is behind the move toward a currency float–that it’s backsliding from a committment to structural reform.

I’m not so sure.

I think what currency traders have concluded is that Beijing has enough money to prop up its stock market and enough to keep its currency at the present overvalued level–but not both.  So they’re borrowing renminbi  and selling it in the government-controlled market in the hope of pushing down the currency and buying back at a lower price.  Understanding what’s going on, and realizing the risks in defending a too-high currency level, Beijing is bending in the wind.  Doing so limits the amount of money that can be made this way, effectively short-circuiting the strategy.

Offshore renminbi, which can’t be repatriated into China, trade about 5% cheaper that domestic renminbi.  That’s where we should get the next indication of how far renminbi selling will go.

As far as my personal stock investing goes, my strong inclination is to bet that renminbi-related fears are way overblown.  I’ like to see markets calm down a bit before I stick a toe in the water, though.