How Rich Investors Use All That Buyback Cash
Big U.S. corporations have given tons of money to shareholders in recent years, mostly in the form of stock buybacks. That you already knew. But where does the money go after that?
This turns out to be pretty hard to answer, but it's fair to say that the dominant view since sometime in the 1990s has been that, wherever it's going, the money is being put to better use than it would if the corporations hadn't given it to shareholders.
The basic reasoning behind this was laid out nicely in the "simple dumb model of corporate finance" that my Bloomberg View colleague Matt Levine offered up a few months ago:
1. Each company is good at one thing.
2. Early in the company's life, it asks investors to give it money, which it invests in doing the thing.
3. 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.
4. The company has a choice of what to do with the extra money.
5. 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.
6. Or it can give the money back to shareholders.
If you look at it that way, big, profitable corporations should of course be giving lots of money to shareholders. Those shareholders, one would expect, will then reallocate that money to more promising investments.
This happened in the 1990s, as money flowed out of long-established big companies and into the technology sector. But it doesn't seem to be happening lately. Among publicly traded companies, the technology sector's share of overall investment has been falling since 2000. And while billions of dollars have flowed to closely held tech startups -- the unicorns, in particular -- this actually doesn't amount to much in the great scheme of things:
Total shareholder payouts in 2014 were more than $1.2 trillion, but money moving from investors to businesses in the form of IPOs and venture capital is less than $200 billion.
That's J.W. Mason, an economics professor at City University of New York's John Jay College, writing in a recent report from the Roosevelt Institute titled "Understanding Short-Termism." Mason also shows that overall capital investment has been growing more slowly than in any other post-World War II recovery :
Instead of being invested, Mason figures, much of the cash being handed to investors is going into increased consumption by the wealthy. "Stock ownership is significantly concentrated," he reports, "with just 4 percent of households owning a majority of all shares." Meanwhile, recent research from Barry Z. Cynamon of the Federal Reserve Bank of St. Louis and Steven M. Fazzari of Washington University in St. Louis, shows that households in the top 5 percent of the income distribution went from spending just over 80 percent of their incomes in 1989 to 88 percent in 2012 (for the rest of households, the consumption-to-income ratio actually declined slightly during those years). Obviously, that consumption spending still flows into the economy, but it is likely to go to less productive use than if it were being directed into investment.
On the corporate side, one explanation for what's going on could be that perverse incentives are leading chief executive officers to give money back to shareholders even when they stand a good chance of earning high returns by investing it internally. There have been many examples over the decades of corporations that turned out to be good at more than one thing, after all. Still, those returns on internal investment are likely to be years off, while activist investors are clamoring for buybacks. Even more important, those buybacks can boost CEO pay right now. In a companion report to Mason's, the Roosevelt Institute recommends buyback limits and CEO pay reforms as a way to counteract this.
But why have rich people been putting their buyback windfall into private jets, expensive real estate, political campaigns and the like instead of investing it in business enterprises? Even people with lots and lots of money generally want to have more money, don’t they?
One possibility is that it's mainly peer pressure: "Look, I have a new apartment with a view of Central Park." "Well, that's nice, but I have my own presidential candidate." Another is that these people expect low returns from business investment, at least compared with investment in real estate or political access. In any case, we are living in a really strange world at the moment.
This became the dominant view in academic finance decades before then, but the idea only seems to have conquered corporate America in the 1990s.
I took this from a recent blog post by Mason because it's easier to read than the chart in the Roosevelt report.
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