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Buybacks, Executive Compensation and Trust

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In his blog, Musing on Markets, my colleague, Aswath Damodaran makes an important point about the buyback controversy that reflects an even more important issue.[1]  First, with regard to buybacks, Damodaran notes that the financial theory is simple.  Companies whose objective is to maximize value should undertake all projects for which their value exceeds the cost of investment.  Because value is a function of expected cash flows over the life of the investment, companies following this rule automatically have the appropriate long-term viewpoint.  If there is free cash flow left over after making value enhancing investments, finance theory teaches it should be returned to investors as dividends or buybacks.

Lurking behind this first issue is the second, more important, one: how do top executives really behave?  Are they really taking a long-term view and attempting to maximize shareholder value or are other incentives, such as personal gain, the driving force?  For instance, Heaton (2018) describes how repurchases can benefit shareholders, at the expense of bondholders and other debtors.  Even more negatively, some critics claim that companies try to do whatever they can to generate more cash for buybacks, including holding down worker wages, turning away good investments, and taking on unwise debt.  This suspicion of corporate behavior is a growing problem that has implications far beyond share buybacks.

Back in 1987, Alan Shapiro and I argued that what we called organizational capital, and what is now more generally referred to as social capital, was an important element of value creation at companies. [2]  As described by, Sapeinza and Zingales (2011) social capital is features of social life – networks, norms, trust, that enable participants of a given community to act together to pursue shared objectives. [3]  In the corporate world, those shared objectives are the effective and fair management of a company that leads to the maximization of its long-term value.

Berkshire Hathaway is a good example.  There is little doubt the Mr. Buffett and Mr. Munger, along with Berkshire’s board, do their best to create shareholder value at the company.  It helps, in that regard, that Mr. Buffett and Mr. Munger take salaries of only $100,000 – admittedly a ridiculously low number.  As a result, there was little hand wringing when Mr. Buffett announced the terms under which Berkshire would repurchase shares or when the company actually repurchased shares.  Members of the Berkshire community were confident that Mr. Buffett was acting in the best interest of the company.

Social capital, and the associated trust, are valuable corporate assets.  Like other corporate assets, if not properly maintained they depreciate.  It is here that executive compensation enters the picture.  Exhibit 1 presents data on the ratio of CEO compensation compared to that of private-sector, non-supervisory, workers.  Between 1965 and 2018, the ratio rose from 18 to over 300.  While some of that increase can be explained as the result of changing economic conditions, the movement is so large that it impinges on trust and thereby depreciates a company’s social capital.

The point here is that the debate about buybacks is not really about share repurchases, it is about social capital and trust.  It is a question of whether top executives and boards are acting in the interest of the company and its stakeholders or in their own interest.  As such, the buyback debate foreshadows future battles over issues such as corporate tax rates, special corporate subsidies, the composition of boards of directors, and, of course, executive compensation.  There is a significant risk that those battles will further erode social capital and trust.  To the extent that occurs, everybody loses.

CEO-to-worker compensation ratio: 1965 to 2018
Year Ratio Year Ratio
1965 18.4 2010 206
1973 20.5 2011 213
1978 27.4 2012 210
1989 53.7 2013 214
1995 136 2014 224
2000 411 2015 225
2007 240 2016 250
2009 184 2017 271
2018 312



[1] Aswath Damodaran,


[2] Bradford Cornell and Alan C. Shapiro, 1987, Corporate Stakeholders and Corporate Finance, Financial Management, 16, 5-14.


[3] Palo Sapeinza and Luigi Zingales, 2011, Trust and Finance, NBER Reporter, 16-19.


Upcoming Featured Publication – Energy and Investing :”The Great Transformation”

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Human civilization faces a daunting problem – how to provide reliable energy to a growing world economy and a rising population that will surpass 10 billion before the end of the century without doing undo environmental damage.  What makes the problem so daunting is not the technological hurdles, though to be sure there are many, but the sheer size and scope of the problem.  The amount of investment required globally may well exceed $100 trillion (about five times the GDP of the United States) world-wide before the transformation away from fossil fuels is complete.  To help appreciate the magnitude of the undertaking, the Cornell Capital report on Energy and Investing which will be posted this weekend brings together data from wide ranging sources on global energy usage to first assess the scope of the great transformation required to replace reliance on carbon fuels.  It then turns to the question of what financial innovations will be required to fund what will be the largest infrastructure projects in history.

Enough is Enough?

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For over a year now, we have been banging the drum saying that equities, particularly the equities of high-flying tech companies like Netflix were overpriced.  Today we say, enough is enough.  We are not ready to say that stocks, particularly tech stocks, are cheap across the board, but the extensive overpricing has disappeared, and some high-profile tech companies look downright attractive from a valuation perspective.

To start, the table below updates the results for the ten bubble stocks we called out on October 3.  The ten are down an average of 33.2% as of the close today.  They are down 36.9% if Tesla is excluded.  The ten are down 40.6% from their 2018 highs.  The table also shows the results for Apple and Goggle.  Apple is off 36.5% from its price on October 3 and 37.1% from its high.  Google has held up the best.  It is down 18.8% from its October 3 price and 23.4% from its high.

In our view, these large price drops were not accompanied by a corresponding decline in fundamental value.  Apple is a poster child in this respect.  Though iPhone growth may be slowing the company is the same cash generating machine it was on October 3.  On September 21, 2018, our colleague, Aswath Damodaran, posted what we believed was a conservative valuation of Apple taking account of the slowing iPhone growth.  Over the next ten years, Damodaran projected a rate of revenue growth below that of the overall economy and barely above the rate of inflation.  Using this low growth rate, he arrived at an estimated value of $201, below the then stock price of $220.  He also undertook a simulation analysis and concluded that $176 was the cutoff for the 10th percentile.  As the table shows, the price is now $146.83.  At that price, the company is trading below the average price at which Warren Buffett acquired his shares.  All of this points to a unique buying opportunity.

Apple is not the only example.  General Motors at less than $33 appears to be trading well below its fundamental value.  In our view, this is no longer the time to “get defensive,” but to start looking for opportunities.

Looking Back at Bitcoin

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Benjamin Graham once said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.”  That statement is a little hard to interpret.  The market is only open now, in the short run.  The way we interpret Graham is to say although investors may be swayed by emotion and folly in the short run, particularly if information is nebulous, as things become clear the market eventually gets it right.  The trick to being an intelligent investor, according to Graham, is to realize now what the market will only come to appreciate later.  That is to invest based on wise assessments of fundamental value.

That brings us to Bitcoin.  In our book, The Conceptual Foundations of Investing, we discussed bubbles.  We argued that bubble can arise when enough investors buy an asset because the price has risen in the past and, as a result, they believe the will be able to sell it for even more to someone else in the future.  If enough participants employ this strategy, it can become a self-fulfilling prophecy and prices can rise without a fundamental reason for the increase.

In our book, we offered Bitcoin as a modern-day example.  We warned that we could see little fundamental value for Bitcoin as either an investment or a medium of exchange.   We said, “The problem is that if the main source of demand is the general expectation of higher future prices, as soon as prices stop rising, demand evaporates.  With few, if any buyers willing to purchase on the basis of the security’s fundamental value, prices collapse. We suspect this will happen to Bitcoin” (page 123).

At the time of our writing, Bitcoin’s price had been skyrocketing and it was trading at over $15,000.  Not surprisingly, it was the focus of a vast amount of attention in the financial media.  Now Bitcoin is in the headlines again, but for the opposite reason.  As shown in the chart below, its price has fallen from nearly $20,000 to less than $4,000.  We suspect it will fall further still.  As Benjamin Graham stressed, in the long run the market will get it right and prices will converge to fundamental value.

An Alternative Hypothesis to Market Efficiency

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On repeated occasions, Eugene Fama has claimed that critics have failed to offer a complete alternative to the efficient market hypothesis (EMH). More specifically, in his Noble speech, Fama said, “Most important, the behavioral literature has not put forth a full blown model for prices and returns that can be tested and potentially rejected – the acid test for any model proposed as a replacement for another model.” Here I argue that Fama’s complaint is too strong.

By Brad Cornell