OECD: Activist Shareholders Are Bad for Investment

The OECD has just released its new Business and Finance Outlook for 2015. A lot of interesting stuff there. We’ll want to take a closer look at the discussion of the problems that low interest rates pose for pension funds and insurance companies — I’ve thought for a while that this is the most convincing form of the “reaching for yield” argument. But what I want to talk about now is the OECD’s apparent endorsement of the “disgorge the cash” thesis.

Chapter 2, “Corporate Investment and the Stagnation Puzzle,” has a very interesting discussion of shareholder activism and its effects on investment. The starting point is the puzzle that while participants in financial markets are willing to accept unprecedentedly low returns, the minimum returns on new investment projects remain high, as evidenced by depressed real investment despite sustained low interest rates. I think this apparent puzzle is, precisely, a rediscovery of Keynes’ liquidity premium. (Perhaps I will return to this in a subsequent post.) There are a number of ways to think about this, but one dimension is the pressure corporate managers face to avoid investment projects unless the returns are rapid, large, and certain.

Stock markets currently reward companies that favour dividends and buybacks and punish those that undertake more investment … which creates higher hurdle rates for investment.

Here in one sentence is the disgorge the cash argument.

Private sector companies in market-based economies allocate capital spending according to shareholder value. Earnings may be retained for capital spending and growth, but only if the return on equity exceeds the cost of equity. If this is not the case then … they will choose to use their operating cash flow in other ways (by issuing dividends, carrying out cash buybacks…) … and in the limit may close plants and shed labor.

The bolded sentence is puzzling. Is it description or prescription? (Or description of a prescription?) The rest of the section makes no sense if you think either that this is how corporate investment decisions are made, or if you think it’s how they should be made. Among other reasons, once we have different, competing discount rates, the “return on equity” no longer has a well-defined value, even in principle. Throughout, there’s a tension between the language of economic theory and the language of concrete phenomena. Fortunately the latter mostly wins out.

The last decade has seen the rising importance of activist investors who gain the support of other investors and proxy advisors to remove management, to gain influential board seats and/or to make sure that company strategy is in the best interest of shareholders… The question arises as to whether the role of such investors is working to cause short-termism strategies [sic] at the expense of long-term investment, by effectively raising the hurdle rate… Activists… favour the short-term gratification of dividends and share buybacks versus longer-term investment. Incumbent managers will certainly prefer giving in to shareholders desire for more ‘yield’ in a low-interest world to taking on the risk of uncertain long-term investment that might cause them to be punished in the share market. …

To test this idea, an index of CAPEX/(CAPEX + Dividends & Buybacks) was created for each company, and the following investment strategy was measured: sell the highest quartile of the index (capital heavy firms) and buy the lowest quartile of the index (Dividend and Buyback heavy firms). … Selling high capital spending companies and buying low CAPEX and high buyback companies would have added 50% to portfolio values in the USA, 47% in Europe, 21% in emerging economies and even 12% in Japan (where activists play little role). On balance there is a clear investor preference against capital spending companies and in favor of short-termism. This adds to the hurdle rate faced by managers in attempting to undertake large capital spending programmes — stock market investors will likely punish them. … it would be fairly logical from a management point of view to return this cash to shareholders rather than undertake uncertain long-term investment projects… The risks instead would be born more by host-country investment in capacity and infrastructure.

This is a useful exercise. The idea is to look at the ratio of investment to shareholder payouts, and ask how the stock price of the high-investment firms performed compared to the high-payout firms, over the six years 2009 through 2014. What they find is that the shares of the high-payout firms performed considerably better. This is  important because it undermines the version of the disgorge argument you get from people like Bill Lazonick, in which buybacks deliver a short-term boost the share price that benefits CEOs looking to cash in on their options, but does nothing for longer-term investors.  In Lazonick’s version of the story, managers are on one side, shareholders, workers and the rest of society on the other. But if high-payout firms perform better for shareholders over a six-year horizon (which in financial-market terms is almost geologically long term) then we have to slice things differently. On one side are shareholders and CEOs, on the other are us regular people.

The other thing that is notable here is the aggregating of dividends and buybacks in a single “shareholder payout” term. This is what I do, I think it’s unambiguously the right thing to do, but in some quarters for some reason it’s controversial. So I’m always glad to find another authority to say, a buyback is a dividend, a dividend is a buyback, the end.

Another way to see these two points is to think about so-called dividend recapitalizations. These are when a private equity firm, having taken control of a business, has it issue new debt in order to fund a special dividend payment to themselves. (It’s the private equity firm that’s being recapitalized here, not the hapless target firm.) The idea of private equity is that the acquired firm will be resold at a premium because of the productive efficiencies brought about by new management. The more or less acknowledged point of a dividend recap is to allow the private equity partners to get their money back even when they have failed to deliver the improvements, and the firm cannot be sold at a price that would allow them to recoup their investment. Dividend recaps are a small though not trivial part of the flow of payments from productive enterprises to money-owners, in recent years totaling between 5 and 10 percent of total dividends. For present purposes, there are two especially noteworthy things about them. First, they are pure value extraction, but they take the form of a dividend rather than a share repurchase. This suggests that if the SEC were to crack down on buybacks, as people Lazonick suggest, it would be easy for special dividends to take their place. Second, they take place at closely held firms, where the managers have been personally chosen by the new owners. It’s the partners at Cerberus or Apollo who want the dividends, not their hired guns in the CEO suites. It’s an interesting question why the partners want to squeeze these immediate cash payments out of their prey when, you would think, they would just reduce the sale price of the carcass dollar for dollar. But the important point is that here we have a case where there’s no entrenched management, no coordination problems among shareholders — and Lazonick’s “downsize-and-distribute” approach to corporate finance is more pronounced than ever.

Back to the OECD report. The chapter has some useful descriptive material, comparing shareholder payouts in different countries.

[In the United States,]  dividends and buybacks are running at a truly remarkable pace, even greater than capital expenditure itself in recent years. There has been plenty of scope to increase capital spending, but instead firms appear to be adjusting to the demands of investors for greater yield (dividends and buybacks). … [In Europe] dividends and buybacks are only half what United States companies pay … While there is no marked tendency for this component to rise in the aggregate in Europe, companies in the United Kingdom and Switzerland … do indeed look very similar to the United States, with very strong growth in buybacks. … [In Japan] dividends and buybacks are minuscule compared with companies in other countries. …

Here, for the US, are shareholder payouts (gray), investment (dark blue), and new borrowing (light blue, with negative values indicating an increase in debt; ignore the dotted “net borrowing” line), all given as a percent of total sales. We are interested in the lower panel.

OECD_fig
from OECD, Business and Finance Outlook 2015

As you can see, investment is quite stable as a fraction of sales. Shareholder payouts, by contrast, dropped sharply over 2007-2009, and have since recovered even more strongly. Since 2009, US corporations have increased their borrowing (“other financing”) by about 4 percent of sales; shareholder payouts have increased by an almost exactly equal amount. This is consistent with my argument that in the shareholder-dominated corporation, real activity is largely buffered from changes in financial conditions. Shifts in the availability of credit simply result in larger or smaller payments to shareholders. The OECD report takes a similar view, that access to credit is not an important factor in variation in corporate investment spending.

The bottom line, though the OECD report doesn’t quite put it this way, is that wealth-owners strongly prefer claims on future income that take money-like forms over claims on future incomes exercised through concrete productive activity. [1] This is, again, simply Keynes’ liquidity premium, which the OECD authors knowing or unknowingly (but without crediting him) summarize well:

It was noted earlier that capital expenditures appear to have a higher hurdle rate than for financial investors. There are two fundamental reasons for this. First, real investors have a longer time frame compared to financial investors who believe (perhaps wrongly at times) that their positions can be quickly unwound.

From a social standpoint, therefore, it matters how much authority is exercised by wealth-owners, who embody the “M” moment of capital, and how much is exercised by the managers or productive capitalists (the OECD’s “real investors”) who embody its “P” moment. [2] Insofar as the former dominate, fixed investment will be discouraged, especially when its returns are further off or less certain.

Second, managers … operate in a very uncertain world and the empirical evidence … suggests that equity investors punish companies that invest too much and reward those that return cash to investors. If managers make an error of judgement they will be punished by activist investors and/or stock market reactions … hence they prefer buybacks.

Finally, it’s interesting what the OECD says about claims that high payouts are simply a way for financial markets to reallocate investment spending in more productive directions.

It is arguable that if managers do not have profitable projects, it makes sense to give the money back to investors so that they can reallocate it to those with better ideas. However, the evidence … suggests that the buyback phenomenon is not associated with rising productivity and better returns on equity.

Of course this isn’t surprising. It’s consistent with the academic literature on shareholder activism, and on the earlier takeover wave, which finds success at increasing payments to shareholders but not at increasing earnings or productive efficiency. For example, this recent study concludes:

We did not see evidence that targets’ financials improved… The targets’ leverage and payout, however, did seem to increase, suggesting that the activists are unlocking value by prompting management to return additional cash to shareholders.

Still, it’s noteworthy to see a bastion of orthodoxy like the OECD flatly stating that shareholder activism is pure extraction and does nothing for productivity.

 

UPDATE: Here’s James Mackintosh discussing this same material on “The Short View”:

 

 

[1] It’s worth mentioning here this interesting recent Australian survey of corporate executives, which found that new investment projects are judged by a minimum expected return or hurdle rate that is quite high — usually in excess of 10 percent — and not unresponsive to changes in interest rates. Even more interesting for our purposes, many firms report that they evaluate projects not based on a rate of return but on a payback period, often as short as three years.

[2] The language of “M and “P” moments is of course taken from Marx’s vision of capital as a process of transformation, from money to commodities to authority over a production process, back to commodities and finally back to money. In Capital Vol. 1 and much of his other writing, Marx speaks of the capitalist as straightforwardly the embodiment of capital, a reasonable simplification given his focus there and the fact that in the 1860s absentee ownership was a rare exception. There is a much more complex discussion of the ways in which the different moments of capital can take the form of distinct and possibly conflicting social actors in Capital Vol. 3, Part 5, especially chapter 27.

12 thoughts on “OECD: Activist Shareholders Are Bad for Investment

  1. Isn’t this a micro explanation for a macro phenomenon? Aggregate investment should be determined by (expected?) aggregate demand. It is pretty clear that aggregate demand has been relatively lower in 1980 till present, than asy 1950 – 1980, and this would explain a reduction in real investment.

    Maybe their could be macro effects of investor activism but I don’t see the argument being made here.

    P vs M having power wouldn’t seem to have Macro effects for instance. Current companies with P in charge, like apple, just run up huge corporate savings.

  2. A H-

    This is an interesting question.

    On the one hand, you are right, a simple accelerator model explains a great deal of the variation in business investment. The OECD report makes this point clearly.

    But on the other hand, I don’t think we want to entirely give up on the idea of an independent investment function. I mean, there has to be some component of expenditure that varies independently of income. And we have to give up the heart of both Keynes’s and Marx’s macro dynamics if we exclude any important role for business expectations, credit conditions or profitability in aggregate investment. I don’t think I want to go that far.

  3. I like your point about dividends versus buybacks. I also wonder why people get so worked up about buybacks. The only issue I see is that as a shareholder, if you do not sell yourself when the company is buying, you can be hurt if the buybacks occur at above “intrinsic value” of the shares.

    I have not closely read your earlier articles (yet), but I am concerned with the following question – what can corporations invest in, given massive overcapacity in practically everything? In an ideal world where we had wage-led growth, investment creates a feedback loop of higher growth. In the current environment, heavy investment would likely be suicidal step for an individual firm. But even if a whole sector participated, I would be biased to think that it would burn out with epic overcapacity added quite quickly.

  4. I like your point about dividends versus buybacks. I also wonder why people get so worked up about buybacks.

    Glad to hear it. I wish I understood why smart people like Bill Lazonick, rsj/windyanabasis, and Steve Randy Waldman (who has been going nuts on this on Twitter) insist so much on the difference between buybacks and dividends.

    if you do not sell yourself when the company is buying, you can be hurt if the buybacks occur at above “intrinsic value” of the shares.

    But presumably the marginal holder always thinks they are fairly valued. And even if we think there is “true” distribution of future earnings to be distributed to shareholders, the per-share value of those distributions will depend on the number of shares outstanding.

    I am concerned with the following question – what can corporations invest in, given massive overcapacity in practically everything?

    I don’t think there’s really a problem here. After all, investment is well above zero now. If we take a list of possible projects and rank them according to their value by the criteria currently used by managers, we find some set that cross the threshold and are undertaken. If a different set of criteria were applied, for instance giving less weight to near-term distributions to shareholders, then a different, and in this case, presumably larger, set would be undertaken. But there isn’t really a puzzle about “what would they invest in?” — they’d invest in the same kind of stuff they do now, only more of it.

    Now there is a related issued, which is whether we think autonomous managers are a better judge of “value” by whatever normative standards we want to apply, than shareholders are. I think they are, actually! But it doesn’t matter here because we are talking about conditions of high unemployment, below-target inflation, below-trend output, excess capacity. So there isn’t really an opportunity cost for “excess” investment.

    1. The reason I insist (most likely foolishly) about a difference between buybacks and dividends is because dividends come with an expectation that the dividend will be maintained. Buybacks do not. We talk about about “cutting” a dividend. No one talks about cutting a buyback. By it’s very nature, a buyback is authorized for X shares — the legal mechanism by which they occur is different.

      If you abstract away from that, there is no difference. But it’s ingrained to market participants that there *is* a difference, so abstracting away is hard to do.

      1. This is right to some extant (though like most people you are ignoring portfolio effects), but it is really highlights the weirdness dividends.

        Consistent dividends are worse for a shareholder because they happen regardless of share price relative to the price of other capital, they introduce interest rate risk to equity and are much worse tax wise.

        The comparison with bonds is instructive. Bond buybacks only happen when it is advantageous to equity holders and therefore they tend to be bad for the bond holders. Stock buybacks should happen when they are advantageous to equity holders, so the risks are totally different. The yield price curve of equity looks nothing like a callable bond.

        One of the main advantages of equity is that firm cash flows and capital structure should be structured to maximize equity value. This is done better through discretionary flows like buybacks rather than fixed flows like normal dividends. Because of their superior tax effects, share buybacks are the best way to preform discretionary cash flows.

        1. I guess I don’t understand your argument here. The market punishes firms with variable payments relative to firms that have stable payments to shareholders.

          Therefore by definition the fixed flows are preferred. They may not be preferred by you, but ultimately this is just a function of utility.

          Moreover the dividends have a tax advantage over share buybacks, because a dividend payment is always a long term capital gain, whereas as the individual receiving an equivalent payment via share buybacks has to sell shares and risk short term capital gains. I can buy stock tomorrow before the ex-dividend and get long term capital gains. If I buy the stock tomorrow before the share buyback then to get the equivalent amount in cash I have a short term gain.

          Of course you can choose not to sell, but then you don’t get the same benefit and cannot compare the two cashflows (because only the dividend gives you a cash-flow. To compare cash-flows of the share buyback to the dividend you have to assume you are selling your stock to the firm in the same amount and at the same time as the dividend)

        2. Also, I was not talking about callable bonds. Many firms when they sell (non-callable) bonds enter into covenants not to repurchase them on the open market. There is no advantage to the bond holder in such a covenant except from the general belief that the firms should pay coupons with operating earnings, yet the credit markets often demand such covenants.

        3. Article hits the nail on the head by pointing out that stock buy-backs pmlrariiy benefit MANAGEMENT, not the sharaholders. I’m surprised it has never occured to any of the brains running our govt (both parties) that this is a bread * butter economic issue stock buy backs are like burning money; wouldn’t that money be better spent either investing in jobs/ RD, paying down debt, or paying dividends that will recirculate real CASH (not paper profits) through the econom- as opposed to pumping up our rapidly devolving casino economy. Previous comment sites Exxon; Cummins Engine is another good example. A modest proposal to restart our economy: make it a cause of action by shareholders that, where any Board of Directors approves any compensation package to its executives based on stock price AT THE SAME TIME A STOCK BUYBACK PLAN IS IN EFFECT, both the approving board members and the receiving executives are personally liable to return to the shareholders all corporate funds expended both on the stock buyback AND any stock price based compensation. It seems obvious that there should be no CEO entitlement to stock price based compensation where the corp is artificially goosing up its stock price using profits that belong to the shareholders. Such a law would stop this eggregious practice in its tracks.

    2. And one can also make the same point about a firm buying back its bonds. Why are there covenants preventing that from occurring? If I am a bondholder, what do I care if a firm buys back some bonds? If I think the bonds are worth more, no one forces me to sell back to the firm. If I think the bonds are worth less, I should be happy.

      Yet bondholders really like to see the obligation for coupon payments extinguished by operating income and not by repurchasing the bonds.

      Similarly, shareholders really don’t like when a firm issues more stock. They lobbied to have the GAAP rules effectively double count the expense of doing this. You would think that the earnings per share metric is sufficient for taking into account the cost of issuing more stock. It makes no sense other than a sort of punishment.

      There are certain ways that a firm is expected to behave that go beyond the instant dollar earned per dollar of market value. It is assumed that these customs and expectations arose as a result of some type of genetic wisdom. Possible the types of firms that do these things are worse deals for investors, overall, than firms that don’t.

  5. The “intrinsic value” I referrred to was the NPV of future dividends (actual, not expected). For example, if a company keeps buying back shares, and then goes bust, people who did not sell receive $0, whereas they would have received dividends. I wrote about this in article on my site awhile ago.

    I am wrestling with the issue of investment at the moment.

    Also – when I view this site using my new iPad, I do not see the comments. I only see them on my creaky old iPad (version 1), which has a heavily out-of-date (Safari) browser.

  6. Exxon-Mobile used 32 BILLION of the 40 BILLION they made in profits in 2007 to bcuyabk their stock. Republicans blater on about how oil companies need their profits to explore, drill and refine. That is pure bull. Oil companies don’t give a damn about exploration or they would have drilled on the hundreds of thousands of acres they have in America or offshore. Oil companies don’t even have drilling equipment to drill on land or offshore because they haven’t spent a dime on drilling equipment. Republicans actually believe oil companies are engaged in developing alternate forms of energy. That is a damned lie! They spend 100 million out of their hundreds of billions in profit on alternate forms of energy. They spend five times that amount advertising that they are developing alternate forms of energy.Oil companies don’t give a damn about our country’s future. All they care about is money and stealing as much as they can from the American people and people around the world. I wish people would wake up and start to vote out every republican from every office in this once great country. They are unfit to govern and they have proven themselves to be nothing more than whores and prostitutes to corporations and oil companies. Republicans say To hell with human beings as long as they can remain as prostitutes to their corporate pimps.The government needs to seize every dime of the profits from corrupt oil companies and use that money to develop alternate forms of energy. If Bush hadn’t lied our country to war every American family would have $36,000 dollars they could have used to put a solar panel on their homes making each family energy independent from corrupt energy companies. Or they could have used part of that money to buy a high MPG car. But republicans don’t think creatively. They just like to go to war to kill and destroy. They don’t like using our country’s resources to help Americans. Wake up Americans and stop being duped by republican propaganda.

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