n a remarkable turnaround, on March 27 the
German government sold — into heavy demand
—
2.4 billion euros of
ten-year bonds yielding their purchasers negative 0.05%, a
guaranteed loss. The first such sale since 2016, it is indicative of the
change in sentiment in the fixed-income markets just since the end of
2018. In the U.S., Federal Reserve action in short-term securities and
market adjustments in longer-term debt led to rate increases over the
course of last year, and heavy liquidation of fixed-income funds,
especially among the lower quality sectors. This year has witnessed an
about-face in market outlook for rates and bank policy action. Fearing
that overly-aggressive central banks were risking a slowdown in the
global economy, many investors fled to the perceived safety of sovereign
debt (and in the case of the U.S., to higher yielding securities),
resulting in the re-appearance of negative yields, as seen in the German
issue. The stock of debt in the world sporting negative yields expanded
once again and now stands at over $10 trillion. Significantly, even a
few corporate issuers have managed to raise debt capital with negative
yields, which is surprising given the fact that so many corporations
have debased their capital structures during the low interest rate
environment of the past decade, in many cases issuing debt in order to
buy back their own common stock at ever-higher prices. In fact, such
corporate capital account-shifting has contributed mightily to the rise
in the equity markets since the financial crisis.
One consequence of the renewed interest in
fixed-income was a rapid decline in U.S. mortgage rates, which generally
track the yield on ten-year treasury notes. During the final week of
March, average rates on standard thirty-year mortgages dipped nearly one
quarter of a percentage point to 4.06%, the largest weekly decline since
2009. So far this year, thirty-year rates have averaged 4.37%, down from
2018’s 4.54% average, showing economic self-correcting mechanisms at
work. Evidence of a slowing economy drove money into the perceived
safety of bonds, thereby lowering borrowing costs across the economy.
Eventually, this drop in borrowing costs will act to stimulate the
economy in general, and, in particular, housing construction (one of the
largest economic sectors) as the cheaper mortgages increase demand for
homes.
In contrast with the gloom prevailing toward
year-end 2018, stocks, too, enjoyed a remarkable rebound in the first
quarter of 2019. Following the worst December since the 1930s, stocks
had their best start to a year in three decades. January alone saw the
S&P 500 index jump 7.9%
—
the biggest rise for that month since 1987
—
making the first quarter of 2019 the best for that index in ten years. “As
goes January, so goes the year,” says the old Wall Street maxim
—
a
hopeful thought to many traders whipsawed by last year’s final
quarter
—
but just as 2018’s year-end market gloom did not provide an accurate
foretaste of things to come, we should take the predictive power of this
year’s initial euphoria with some skepticism.
1987 is best remembered for October’s “Black
Monday” crash. Few remember the strong run-up in prices during the first
nine months; January 1987 saw a gain of 13.2% in the S&P. Also, stocks
gained 6% in January of 2018, while they declined for the year. Such a
record certainly put paid to the reliability of old Wall Street wisdom,
at least the kind that promises to foretell market direction.
Not that any of these market foibles matter very
much over the long term, engrossing as they may be at the time. Stocks
soon rebounded from the Crash of 1987. The downturn of the early 2000s
proved fleeting as well, and the recovery in the markets after the much
more severe collapse of 2008-2009 has been rapid and long lasting. Stock
prices recouped their losses, and now stand near all-time highs. Profit
margins of U.S. businesses have been at record levels for several years,
and a few companies have reached market values in excess of $1 trillion.
Society’s wealth has expanded, its uneven distribution notwithstanding.
Through widespread holdings in pension and other retirement vehicles,
equities have played an important part in this wealth
accumulation
—
something that anyone can participate in if done properly.
The late John Bogle, Vanguard Group founder and long-time exponent of
low-cost index fund investing, once said “the stock market is a
distraction from investing.” As long as one remains true to investment,
as opposed to speculation or gambling in securities, one increases the
chances of benefitting to the furthest extent possible from our
society’s engine of wealth creation.
Financialization
We have long been interested in the impact that
an emphasis on financial factors has on business, investing, and our
society at large, because it seems to play a role out-of-proportion to
what is needed to make the wheels of commerce run efficiently. The
business of finance has always been an important part of U.S. industry;
for example, the proportion of total stock market capitalization
comprised of financial firms has not changed much over the past century
(about 20% in 1900 and 2018, with ups and downs). Financial shenanigans
of various kinds, and corporate structures set up with purely financial
aims in mind (pyramids in the 1920s, for example), have always been with
us, but finance and financial goals seem to demand an inordinate amount
of attention in modern business. Wall Street, once a relatively small
cottage industry, dominates business news. Many corporate executives
obsess over their own company’s share price and feature stock quotes on
their desktop computer screens
—
proving that the stock market can also be
a distraction from running a business.
An article by Anat Admati of the Stanford
business school (Journal of Economic Perspectives, Summer 2017)
provides an interesting review of the history of “financialized
corporate governance,” and its consequences. Admati points out that one
of the chief characteristics of financialization in the U.S. has been
the focus on “increasing shareholder value” as the overarching goal of
corporate activity, with executive incentives tied to its achievement.
This is actually a notable divergence from past practice. Prior to about
1970, only about 16% of U.S. CEOs of major corporations received
“performance-based” pay
—
with bonuses, stock awards and options being the typical instruments.
This figure grew to 47% in the 1990s, and nowadays most CEOs receive
stock market-linked incentive awards
—
all
with the stated intention of “aligning” the interests of
executives with those of shareholders. Through these arrangements, it
was claimed, the inherent conflict of interest between those with
intimate knowledge and control of corporate affairs (managements) and
those with limited knowledge and authority (shareholder-owners)
—
the so-called “agency problem”
—would be resolved to everyone’s benefit. What has happened in
practice, however, is that highly competitive and motivated individuals
have found common ground with speculators, focusing on efforts to
achieve short-term financial targets, including reported earnings, all
in an effort to boost stock prices and with them the value of their
compensation packages. As managements are fully aware, the investment
community responds well to a nice record of steadily expanding profits.
These practices can negatively impact the firm,
its various stakeholders (employees and customers, as well as
shareholders), and the larger society that it is supposed to serve as a
good corporate citizen. The manipulation of reported earnings (often
through perfectly-legal interpretations of accounting standards)
presents a misleading picture of the actual earning power of a business
(outright fraud, of course, has the same effect). “Cost
cutting,” a
common tool used to boost profitability, works well as long as the
business continues to invest in its future; however, the consequences of
underinvestment are usually only discovered years later (recent sharp
share price declines at a large consumer products company were
attributed to a lack of investment in its brands). Increasing debt loads
are often another symptom of short-term profit seeking (debt can
increase earnings until a weaker economy or poor investments make it
burdensome), as is increasing consumer prices to maintain profit
margins. At some old-line industrial companies, an emphasis on finance
and financial metrics has even come to dominate the original business
(in one case creating huge, continuing losses in the process).
The ultimate cost of this system is born by
individuals (hiding the harm from tobacco, for example) and society:
increasing inequality can at least be partially explained as the result
of those best positioned to manipulate the system deriving the most
benefit from it. And the caustic politics in numerous countries in
recent years can be tied at least to some extent to an increasing
perception that the management of business entities
—
the sources of
much of our society’s wealth
—
is rigged in favor of a small minority.
Businesses eventually suffer as well, through higher funding costs,
lower public trust, and, ironically, lower share prices.
As investors, we have had first-hand experience
with the effects of “financialization,” and one example stands out in
particular. Some years ago we purchased shares in a relatively small
industrial company in a cyclical business. We found it attractive
because it was well-established, and nicely profitable in good times. It
had an equally-nice balance sheet, with little debt and lots of cash to
get it through tougher times. It paid a dividend, which, at the price we
paid for the shares, represented a generous yield. We liquidated the
position a few years back for a good return.
Recently we looked again at the company when its
shares were trading at a fraction of the price at which we sold, only to
find its affairs to be completely altered. The balance sheet was larded
with debt; there was little cash; earnings were meager; and the dividend
had been cut in half. On an earnings conference call, a member of the
founding family, which still owns a significant position in the company,
complained that without a big upturn in business the debt would never be
paid off.
Yet here was a company that had done all of the
things typically found in the financial engineer’s toolkit. It had made
its balance sheet more “efficient,” adding debt (which should have
increased profitability) and buying back shares (to increase that
critically important earnings per share figure). It had made
acquisitions, including that of a company in Europe, in an effort to
boost its growth rate. But in the process it lost its way, forgetting
the lessons of its own history in a highly cyclical, competitive
industry that looks unkindly upon weak balance sheets and no cash
cushions. We are saddened by the fate of this company, but this example
is illustrative; it shows that investors should never be complacent
about companies they own. It also explains why despite all of the
incentives and interest alignment, so few businesses make it into the
ranks of old age.
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