A random sampling of the stupid.

Wednesday, July 23, 2008

No, stock buybacks are not a scam

I normally agree with the angry rants posted at lewrockwell.com, so I was surprised at the most recent article entitled Stock Buybacks are a Scam, by Eric Englund. The gist of his argument is summarized thusly: a bunch of large financial institutions underwent major buybacks over the past 6 years*, and now all of their stocks are tanking. Therefore, stock buybacks are bad for shareholders. Stated that way, it sounds stupid, to anyone who remembers that correlation does not necessarily equal causation.

He makes other points, such as that if buybacks are so good for companies, shouldn't management execute them when times are so tough? But of course that would be stupid, because during tough times a company should watch it's balance sheet and hold on to cash for dear life. Therefore, stock buybacks are always evil. This type of paranoid ranting bothers me, because it distracts from more deserving paranoid rants.

When a company earns money, it has 2 basic choices: re-invest to grow the company, or distribute the earnings to shareholders (or maybe employees). In order to distribute the earnings, the company can just pay the money out in cash as a dividend, or repurchase shares to drive up the price and value of remaining outstanding shares. Prior to the Bush tax cuts, the latter choice was clearly optimal because dividends were taxed at a much higher rate than capital gains; nowadays they're usually taxed at the same rate, so the choice is less clear.

The basic idea of a stock buyback is that a company believes its shares are undervalued, and thus shareholder value can be increased by buying shares. The understand this, lets say that the shares were exactly correctly priced at 1 share = present value future earnings. Buying 1 share at $100/share doesn't gain or lose the company anything, it pays $100 for $100 of future earnings. If the shares were undervalued, say at $90, then the company pays $90 for $100 of earnings. Of course, the company is only likely to be undervalued during "tough times", so management needs to make sure they have enough working capital (as always), but any surplus should be invested as profitably as possible.

Seems like a good idea to me. The act of the buyback will drive up the share price, benefiting current shareholders. Englunds argument about weakening the balance sheet is true of any business activity which requires capital, also known as any business activity. Still, buybacks are only a good idea if shares are undervalued, and the capital used could not be reinvested more profitably somewhere else.

Englund closes with a story told by Buffett (how could anybody disagree with Buffett?), about a CEO who uses share buybacks to drive up the share price and hide the declining earnings of the company. This is a valid concern, but Buffett's point relates to executive compensation, and gave an example of a CEO making a killing even though the company's earnings declined, because the CEO drove up the share price through buybacks.

This is an example of how stock buybacks can be used to hide declining performance. Most investors only care about a companys' share price. As long as it goes up, they're happy. A company which spends all of its' earnings on buybacks to drive up the price is not growing, and what investors are losing is opportunity. This is a real cost, and an investor should not be happy about a CEO sacrificing opportunities for long-term growth to create short-term stock gains.

A buyback is intended to transfer earnings from shareholders, and that's exactly what it does. Dividends do the same thing, but I'd be surprised if anybody would call massive dividends a scam. Usually the opposite is claimed, since payout ratios have been decreasing over time. They're ways to return earnings to shareholders. Obviously, management needs to strike a balance between retaining earnings for growth and paying out earnings to shareholders.

Yes, buybacks can be used to cover up declining earnings, and as such, they can be used to mislead shareholders. That doesn't make them bad in general, just like hammers aren't inherently evil because you can use them to kill people. They're a tool, simple as that.

Error rating: 3. The entire argument is based on 7 companies which are going through hell right now, assuming correlation equals causation, generalizing from 7 companies all in a single industry to the entire stock market, and mis-interpreting an example from Buffett. On second thought, all that together adds up to a 4.


* He gives figures for J.P. Morgan, Citigroup, Lehman, Merill Lynch, Morgan Stanley, Wachovia, and Washington Mutual

Saturday, July 12, 2008

The time to worry about creating a moral hazard is when it's hardest

The most recent casualty in the never-ending credit crisis is IndyMac (times like this I'm glad the FDIC exists). There has been a great deal of talk of Freddie Mac and Fannie Mae going under. As Steve Pearlstein over at the Washington Post says, "We're nearing that delicate point in the cycle when even the usual cheerleaders have hung up their pompoms...".

However, the overall gist of his article culminates in one final paragraph:

"A financial crisis is not a morality play. What matters most isn't the precedents that are set, the amount of taxpayer money that's implicated or whether people are made to suffer fully for their financial misjudgments. In the end, what matters most is that we get through it as quickly as possible with an economy and a financial system intact."
I somewhat agree. There's no point in going out of your way to punish people for what you see as excessive greed. However, that's not really the concern. The concern is that taxpayer resources, either explicitly taken through taxation or implicitly through Fed money creation, are used to bail out institutions which brought destruction on themselves.

Nobody likes to hear it, but TANSTAAFL (there ain't no such thing as a free lunch).
During any crisis, there is a real temptation to do whatever is necessary right now and forget about the long term consequences. That is what Pearlstein is advocating. That type of attitude might lessen this crisis, but it inevitably bring about another one (check out this article on how this happened with Fannie Mae and Freddie Mac). It is shortsighted and frustrating.

The "bailout" of Bear Stearns is roughly how these things should go. The employees, and especially the shareholders, got royally screwed. Many employees obviously had no hand in the activities which led to a downfall, but when you work at a company you know your job security is dependent on more than just your performance, and the shareholders knew what risk they were taking. Whether the cost to the taxpayer (up to $29 billion) was justified remains to be seen, but there was no moral hazard created by this action*.

The only time when new structures can be put in place to minimize the boom-bust cycle is during the bust. During the boom, it's called anti-business. Now is the time when we need to focus our efforts on maintaining the long-term health and well-being of our populace, and if that means the complete destruction of our present financial system (it almost certainly doesn't, but painful reforms are likely necessary), so be it.

So, Mr. Pearlstein, I give you an error rating of 2. I know you mean well, and you're not totally wrong, but your priorities are a bit out of whack.


*What many don't realize is the only people who got bailed out were Bear Stearns bondholders, i.e., people that lent them money. This is what will happen if the GSEs need bailing out. However, since the GSEs have $5 trillion of debt owned or guaranteed, that's basically everybody. For reference, the value of all publicly traded companies in the US was $20.5 trillion as of March 2007 (Seeking Alpha), so we're talking real money here.

Wednesday, July 2, 2008

Common Misconception

I, and many other people, have been trying to erase the historical basis for the calendar of much of the western world. From Conservapedia:

The term "Common Era" (CE) is an attempt to erase the historical basis for the primary calendar dating system in the Western world. "Common Era" has no real meaning, and even the origin of this term is unclear. The 1972 Webster's Seventh New Collegiate Dictionary has no entry for "Common Era."

Before going further I should point out that Conservapedia is basically full of shit on every article it contains. The talk page of this particular article contained many statements of people pointing out that this article is basically BS, and gets facts wrong to try to create a conspiracy which isn't there. Conservapedia appears to many conservatives a bad name.

According to Wikipedia (if you think it has a liberal bias, just check the references), C.E. has been used sporadically since 1615, first use by Kepler, although he used a latin phrase "anno aerae nostrae vulgaris", which roughly means "year of our common era" (I could be wrong with the translation).

My main problem, though, is with the idea that people who use the abbreviation C.E. are trying to destroy Christian culture in some way. The alternative to C.E. is A.D., which stands for "Anno Domini", or "the year of our lord". By using this abbreviation, you are implying that your lord is Jesus Christ. For any person not Christian, this would be blasphemous.

Yet there are many non-christians in the western world, who use the Gregorian calendar because it is the cultural norm. Any if C.E. stands for "Christian Era", you are rightly attributing the source of the calendar to the Christian religion. Everybody's happy. No need to start a crazy website, promoting this crazy conspiracy theory as well as Barack Obama being the first Affirmative Action President. So really, C.E. is perfectly fine.

Error Rating: 8. Would've only been a 6 for crazy conspiracy inventing, but they didn't even get basic facts right.