Sunday, November 02, 2008

Where the money goes

The LA Times continues to become thinner and sadder. The Sunday paper has about as much content as the old weekday editions. If the papers give up, who will do the heavy lifting of journalism?

Don't miss Elizabeth Douglass' Oil companies pour on charm before posting fat profits. I found the graphic at the top of this post especially telling. Why do these companies spend more money on stock buybacks than anything else? Why has the amount of money spent on stock buybacks grown so much in the past 15 years?

Several financial writers explained it a while back. I can't remember when or where, so I can't link to them. The stock buyback story is fairly universal in US companies for several reasons.

Companies are granting huge numbers of stock options to employees, especially the top 5 or so employees. In fact, they can more accurately be described as employee-owners. These employees are supposed to be paid for performance so they are rewarded when stock prices hit certain targets.

If they fail to bring the stock prices up, they don't get the options. Naturally, they will do everything they can to hit those targets. They can do that with "financial engineering" aka accounting lies. But there is a perfectly legal way to do it.

If they buy back shares so that there are fewer shares outstanding, then each share will be worth more! This almost always works and it is perfectly legal. If you are a shareholder, it doesn't ring alarm bells. After all, the shares you hold will become worth more, too. Moreover, the differential between tax rates on dividends (~25%) and capital gains (10%-20%) makes stock buybacks more attractive to current shareholders.

About 20 years ago, companies used to pay dividends on order of 4% (sometimes as much as 10%) to shareholders. Why has the dividend rate plunged to 1-2%, even in good times? This trend started even before the capital gains rate tax cuts, though it has accelerated in recent years.

The answer is stock dilution. Every time stock options are exercised by executives, the value of each share is diluted. The only way to reverse it is through revenue growth and stock buybacks. Stock buybacks work faster, and they have less risk and uncertainty. Hence companies have been investing less and less on research and their physical infrastructure (which can lead to business growth), and more on financial chicanery.

Each cycle of stock options and stock buybacks is really a stickup. Executives are systematically stripping the value of the companies they run from existing shareholders. Over time, they control a greater and greater proportion of the shares and power.

This is common practice across all industries and perfectly legal.

Did the politicians who voted to cut the capital gains rates so low relative to the income tax rates understand this? Did the tax cuts initiate this systematic strip-mining of American companies, or were they passed to provide a cover to convince Joe six-pack to support the tax cuts?

Look at the Federal Capital Gains Tax Rates, 1988-2011 and weep. Politicians love to cite that capital gains tax cuts lift all boats because "90% of all American families own stock".

But the vast majority of us hold them only in our retirement accounts. When we draw from them, we pay income tax rates, not capital gains tax rates. A very, very tiny percentage of Americans pay mostly capital gains taxes. (Don't get me started on payroll taxes.)

4 comments:

  1. Did you see the Fortune cover story on GE? Talk about financial chicanery coming back to bite you...

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  2. Interesting post about something that has bothered me for some time. Of course I do benefit from a low capital gains tax as not all my investments are protected in a retirement account. And I am in the minority, but alas I am not in the even smaller minority that profit from this kind of chicanery. I think I lose in the long run, and so does everyone else. But the system is set up for short term maximization of profits and the future is somehow overlooked.

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  3. The GE article can be found at: http://badmomgoodmom.blogspot.com/2008/11/where-money-goes.html

    It is very interesting.

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  4. Like Mardel, I pay capital gains taxes, too. But the vast majority of my investments are in tax-deferred retirement and college savings accounts.

    You really shouldn't take financial advice from a blogger with no finance credentials. However, we rebalance our portfolios by donated appreciated mutual fund shares in over-weighted sectors to charities rather than selling them. Then we buy shares in under-weighted sectors of our portfolio.

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