Private Companies Will Take Money Public Companies Don't Want
One of my favorite simple dumb models of corporate finance goes like this:
- Each company is good at one thing. 1
- Early in the company's life, it asks investors to give it money, which it invests in doing the thing.
- Later in the company's life, the thing is profitable, and the company generates more money from doing the thing than it needs to reinvest in doing more of the thing.
- The company has a choice of what to do with the extra money.
- It can invest it in doing different things, which -- in this simple dumb model -- it is bad at. This reinvested money mostly disappears, and shareholders are sad and angry. 2
- Or it can give the money back to shareholders.
This model is, like I said, really simple and dumb! Most companies can do more than one thing, and many companies successfully evolve over time. And the choice of investing in the thing versus giving money back to shareholders is actually way more complicated than that; companies can choose to pay workers more or cut prices for consumers or otherwise proceed along dimensions that aren't perfectly captured in that simple binary choice.
Still here's a chart: 3
That chart is based on Monday's news release from S&P Dow Jones Indices, which notes that, for S&P 500 companies, "total shareholders’ returns, through regular cash dividends, as well as buybacks, continues to increase and set records." In 2014 those companies' combined earnings were about $950 billion, dividends were about $350 billion, and buybacks were about $553 billion. So total cash handed back to shareholders was about 95 percent of profits, up from 88 percent in 2013 and 72 percent in 2010. The trend has been pretty consistently up, and people expect it to continue:
“Don’t count on it holding the record too long,” said Howard Silverblatt, senior index analyst for S&P Dow Jones Indices, who remains bullish about the trend.
We're rapidly approaching the point at which big U.S. companies will, collectively, just hand back all the money they make to shareholders. 4
There is a lot of discussion about what has driven this trend, 5 but one simple explanation is that investors want it. So increasing focus on shareholder-friendly corporate governance, the rising clout of activist investors and the robust market for corporate control are all manifestations of the fact that shareholders want big companies to give them back their cash, and that companies are increasingly willing to do so. "Shareholders" here, of course, means mostly "investment professionals": asset managers and hedge funds and pensions and whatever. And their reason for demanding capital return has to be something like: "Investment professionals are better than companies are at allocating cash to new ideas."
Is that correct? I mean, it seems plausible, right? 6 But even if you believe it, you are left with a problem, which is that the investment professionals keep getting handed bags of cash, and what will they do with it? Reinvesting it in S&P 500 shares seems to rather miss the point, 7 not only because the S&P 500 doesn't need any more money, but also because that reinvestment doesn't fulfill the goal of allocating capital to productive new businesses. If there's any economic logic to making companies disgorge their cash to shareholders, it must be that the shareholders can then put it somewhere more useful -- somewhere with better or at least more interesting growth prospects -- than back into the same companies that gave them the cash in the first place.
We talked Monday morning about the New York Times and Bloomberg News articles about investment professionals allocating capital to big start-ups, or whatever you call private tech-ish companies with 11-digit valuations. 8 One worry is of course that the big investment professionals might lose money on these investments, since the professionals are perhaps not experts at private company investment, and since the investments are made at pretty fancy valuations. 9 My view is that you can lose money on public investments too, and there are lots of reason not to worry too much about your pension being invested in Uber. As Dan Primack points out, mutual fund investments in private companies are pretty small as a percentage of assets; as Aswath Damodaran points out, illiquid private companies are probably less vulnerable to bubbles than public markets are; and as Noah Smith points out here at Bloomberg View, today's tech valuations might be high, or even too high, but they don't look like a bubble: They don't have the greater-fool characteristics of the late-90s tech bubble. 10
The other worry in these stories seems to be that these investors are somehow doing the wrong thing, straying outside of their proper category, by investing in private rather than public companies. If you think of the job of mutual-fund and hedge-fund managers as "investing in public companies," then, yes, this sort of wandering looks bad. But if you think of their job as "allocating capital to productive equity investments," what else are they going to do? The public stock markets are increasingly about capital return rather than capital raising. Companies are going public later, and initial public offerings are now often about cashing out earlier investors rather than raising money for productive enterprises. And the interaction between big S&P 500 companies and their shareholders consists mainly of the companies giving money to the investors, not the other way around. Those investors have to do something with that money, if they want to keep calling themselves investors. If they can find growing companies that actually want their money, no wonder they're excited to invest.
Trivially, some companies are good at zero things, but they are not of much interest to this model.
You can extend this model to allow some companies that are good at two or more things. That extension is really required to allow for this sort of conglomerate-building: If all companies really were good at only one thing, it would be hard to justify the empire-building. But if there are a few exceptions then everyone gets to pretend that they're exceptions too. This is related to my simple dumb model of hedge fund fees. I don't have that many models.
I guess sort of imagine this being an area chart? Like, dividends + buybacks add up to an increasing percentage of earnings. The data are on a trailing-12-months basis, and from S&P's news release.
A few caveats:
- Collectively. Some big old low-growth companies pay out more than their earnings. Some growing companies in the S&P pay out less. Adding up to 95 percent, or 100 percent or whatever, of aggregate earnings is just a nice coincidence.
- This relies rather blindly on accounting "earnings." Obviously many things that reduce earnings look like "reinvestment"; e.g., most people's models of Amazon treat its extremely low net income as being driven by reinvestment-in-the-form-of-low-margins rather than just, like, low margins.
- S&P -- and others -- have also pointed to the fact that companies "had a record amount of cash reserves at the end of 2014." Even profits that aren't being returned to shareholders are often being just plopped into checking accounts, not reinvested into productive enterprises.
J.W. Mason's writings on "Disgorge the Cash" are a sort of lefty touchstone on the topic, and Lynn Stout and others have also written on related themes. In the text I stick to my own dumb model and don't discuss various good corporate-finance-y reasons -- low interest rates, tax shields, etc. -- that might encourage capital structures that involve more shareholder buybacks. Those reasons are probably important though.
Certainly it corresponds well with my simple dumb model in which each company can do one thing, though I guess my model does not strictly require the assumption that investment professionals can do any things. Perhaps no one can allocate capital.
For another angle, though, the always-interesting pseudo-Jesse Livermore is writing fascinating stuff about renormalizing the S&P 500 for dividend payout ratios. His use of terminology is interesting:
A common criticism of Professor Robert Shiller’s famous CAPE measure of stock market valuation is that it fails to correct for the effects of secular changes in the dividend payout ratio. Dividend payout ratios for U.S. companies are lower now than they used to be, with a greater share of U.S. corporate profit going to reinvestment. For this reason, earnings per share (EPS) tends to grow faster than it did in prior eras.
In his usage, "reinvestment" includes (indeed, is modeled as) share buybacks, which is why his model of "a greater share of U.S. corporate profit going to reinvestment" is consistent with the fact that 95 percent of S&P 500 profits are now handed back to shareholders.
From Bloomberg News:
Companies now valued at 16 times future revenue could easily lose a third of their value in a market pullback that Weber and others say may occur in the next three years. The other people asked not to be named because they didn’t want to be seen criticizing competitors’ deals.
I am not sure why anonymous sources were required for the proposition that the market might go down? I feel like financial television is full of people saying that on the record?
On the other hand: One often touted advantage of private markets is the absence of short sellers. Short sellers tend to be a good safeguard against bubbles.
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Matt Levine at firstname.lastname@example.org
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