William Lazonick: Profits Without Prosperity:
Five years after the official end of the Great Recession, corporate profits are high, and the stock market is booming. Yet most Americans are not sharing in the recovery. While the top 0.1% of income recipients—which include most of the highest-ranking corporate executives—reap almost all the income gains, good jobs keep disappearing, and new employment opportunities tend to be insecure and underpaid. Corporate profitability is not translating into widespread economic prosperity.
The allocation of corporate profits to stock buybacks deserves much of the blame. Consider the 449 companies in the S&P 500 index that were publicly listed from 2003 through 2012. During that period those companies used 54% of their earnings—a total of $2.4 trillion—to buy back their own stock, almost all through purchases on the open market. Dividends absorbed an additional 37% of their earnings. That left very little for investments in productive capabilities or higher incomes for employees…
…Stock-based instruments make up the majority of their pay, and in the short term buybacks drive up stock prices. In 2012 the 500 highest-paid executives named in proxy statements of U.S. public companies received, on average, $30.3 million each; 42% of their compensation came from stock options and 41% from stock awards. By increasing the demand for a company’s shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly earnings per share (EPS) targets.
As a result, the very people we rely on to make investments in the productive capabilities that will increase our shared prosperity are instead devoting most of their companies’ profits to uses that will increase their own prosperity—with unsurprising results. Even when adjusted for inflation, the compensation of top U.S. executives has doubled or tripled since the first half of the 1990s, when it was already widely viewed as excessive. Meanwhile, overall U.S. economic performance has faltered.
…until the late 1970s, a retain-and-reinvest approach to resource allocation prevailed…This pattern began to break down in the late 1970s, giving way to a downsize-and-distribute regime of reducing costs and then distributing the freed-up cash to financial interests, particularly shareholders…favoring value extraction over value creation…
…top executives turned to massive stock repurchases, which helped them “manage” stock prices. The result: Trillions of dollars that could have been spent on innovation and job creation in the U.S. economy over the past three decades have instead been used to buy back shares for what is effectively stock-price manipulation.
Not all buybacks undermine shared prosperity…Most…often come at the expense of investment in productive capabilities and, consequently, aren’t great for long-term shareholders.
Companies have been allowed to repurchase their shares on the open market with virtually no regulatory limits since 1982, when the SEC instituted Rule 10b-18 of the Securities Exchange Act…In essence, Rule 10b-18 legalized stock market manipulation through open-market repurchases. The rule was a major departure from the agency’s original mandate…
Executives give three main justifications for open-market repurchases. Let’s examine them one by one:
1. Buybacks are investments in our undervalued shares that signal our confidence in the company’s future.
But the reality is that over the past two decades major U.S. companies have tended to do buybacks in bull markets and cut back on them, often sharply, in bear markets…They buy high and, if they sell at all, sell low…[which] eventually reduces the value of the stock held by continuing shareholders.
2. Buybacks are necessary to offset the dilution of earnings per share when employees exercise stock options.
…Options are meant to motivate employees to work harder now to produce higher future returns for the company. Therefore, rather than using corporate cash to boost EPS immediately, executives should be willing to wait for the incentive to work…
3. Our company is mature and has run out of profitable investment opportunities; therefore, we should return its unneeded cash to shareholders.
…One of the chief functions of top executives is to discover new opportunities for… [the company’s productive] capabilities. When they opt to do large open-market repurchases instead, it raises the question of whether these executives are doing their jobs.
A related issue is the notion that the CEO’s main obligation is to shareholders…ut the MSV school ignores other participants in the economy who bear risk by investing without a guaranteed return. Taxpayers take on such risk through government agencies that invest in infrastructure and knowledge creation. And workers take it on by investing in the development of their capabilities at the firms that employ them. As risk bearers, taxpayers, whose dollars support business enterprises, and workers, whose efforts generate productivity improvements, have claims on profits that are at least as strong as the shareholders’.
The irony of MSV is that public-company shareholders typically never invest in the value-creating capabilities of the company at all. Rather, they invest in outstanding shares in the hope that the stock price will rise. And a prime way in which corporate executives fuel that hope is by doing buybacks to manipulate the market. The only money that Apple ever raised from public shareholders was $97 million at its IPO in 1980. Yet in recent years, hedge fund activists such as David Einhorn and Carl Icahn—who played absolutely no role in the company’s success over the decades—have purchased large amounts of Apple stock and then pressured the company to announce some of the largest buyback programs in history…
…if U.S. companies don’t start investing much more in research and manufacturing capabilities, they cannot expect to remain competitive in a range of advanced technology industries…
…MSV as commonly understood is a theory of value extraction, not value creation.
Executives Are Serving Their Own Interests
As I noted earlier, there is a simple, much more plausible explanation for the increase in open-market repurchases: the rise of stock-based pay. Combined with pressure from Wall Street, stock-based incentives make senior executives extremely motivated to do buybacks on a colossal and systemic scale…
Reforming the System
Buybacks have become an unhealthy corporate obsession. Shifting corporations back to a retain-and-reinvest regime that promotes stable and equitable growth will take bold action. Here are three proposals:
Put an end to open-market buybacks.
…A good first step toward that goal would be an extensive SEC study of the possible damage that open-market repurchases have done to capital formation, industrial corporations, and the U.S. economy over the past three decades. For example, during that period the amount of stock taken out of the market has exceeded the amount issued in almost every year; from 2004 through 2013 this net withdrawal averaged $316 billion a year…
Rein in stock-based pay.
In 1991 the SEC began allowing top executives to keep the gains from immediately selling stock acquired from options…At the very least, the SEC should stop allowing executives to sell stock immediately after options are exercised…overall the use of stock-based pay should be severely limited. Incentive compensation should be subject to performance criteria that reflect investment in innovative capabilities, not stock performance.
Transform the boards that determine executive compensation.
Boards are currently dominated by other CEOs, who have a strong bias toward ratifying higher pay packages for their peers. When approving enormous distributions to shareholders and stock-based pay for top executives, these directors believe they’re acting in the interests of shareholders. That’s a big part of the problem…Taxpayers and workers should have seats on boards.
Courage in Washington
Congress should fix a broken tax regime that frequently rewards value extractors as if they were value creators and ignores the critical role of government investment in the infrastructure and knowledge that are so crucial to the competitiveness of U.S. business…
…what we have now are corporations that lobby—often successfully—for federal subsidies for research, development, and exploration, while devoting far greater resources to stock buybacks. Here are three examples of such hypocrisy:
Alternative energy.
Exxon Mobil, while receiving about $600 million a year in U.S. government subsidies for oil exploration (according to the Center for American Progress), spends about $21 billion a year on buybacks. It spends virtually no money on alternative energy research.
Nanotechnology.
Intel executives have long lobbied the U.S. government to increase spending on nanotechnology research…Yet from 2001, when the U.S. government launched the National Nanotechnology Initiative (NNI), through 2013 Intel’s expenditures on buybacks were almost four times the total NNI budget.
Pharmaceutical drugs.
In response to complaints that U.S. drug prices are at least twice those in any other country, Pfizer and other U.S. pharmaceutical companies have argued that the profits from these high prices—enabled by a generous intellectual-property regime and lax price regulation—permit more R&D to be done in the United States than elsewhere. Yet from 2003 through 2012, Pfizer funneled an amount equal to 71% of its profits into buybacks, and an amount equal to 75% of its profits into dividends. In other words, it spent more on buybacks and dividends than it earned and tapped its capital reserves to help fund them. The reality is, Americans pay high drug prices so that major pharmaceutical companies can boost their stock prices and pad executive pay.
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