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.

How Fast Sentiment Can Change – Tesla

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Throughout much of the last several years the Los Angeles Times has been enthusiastic about Tesla.  The paper enthused about the gigafactory, the Model 3, the powerwall and the solar shingles.  It was a surprise, therefore, to read the following headline on Saturday in the Times business section: “Tesla enters survial mode as layoffs loom, stock sinks.”  The fact is that not much has changed at Tesla from a fundamental standpoint.  It still faces the same issue of competing in the hotly competitive and capital intensive automotive market.  It still has problems trying to make money while honoring its promise of a $35,000 Model 3.  But now sentiment seems to be switching.  And sentiment can move much faster than fundamentals.  The stock was down over 12% on Friday.  It will be interesting to see what happens when trading reopens on Tuesday.

Apple, Inflation and Valuation

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In light of Mr. Cook’s revision of expected fourth quarter revenue for Apple, it is worth revisiting the question of whether the stock is overpriced.  To examine that question, I made the following assumptions.  To begin, the four quarters from Q4 2018 to Q3 2019 will show a year-over-year decline of 5% in revenue and EBIT from the same period a year before.  After that, Apple will have no real growth into perpetuity.  That is, revenue and EBIT will grow at the rate of inflation.  As an assumption for long-run inflation, I use 2% which matches the Fed’s long-run target and is consistent with current inflation rates.  For a cost of capital, I use 8.2% initially falling to 8% in the long run.  This discount rate is slightly greater than the discount rate used by my colleague, Aswath Damodaran, in his valuation of Apple.

It is worth stressing that assuming growth at the rate of inflation means that Apple will not grow in real terms, even as the real economy expands.  This is a very conservative assumption.  It means that in the years ahead Apple will become a progressively smaller part of the overall economy.  Prof. Damodaran uses what is arguably a more reasonable assumption that Apple will grow at 3%, about equal to the long-run growth rate in the overall economy.

The bottom line is that with the initial 5% drop and growth at inflation after that Apple has a fundamental value of $163.52.  If I retain the 5% drop and use Prof. Damodaran long-run growth rate of 3%, the value rises to $170.47.  If I used Prof. Damodaran’s cost of capital, the number would be even higher.  At $143, the stock looks like a buy, not a sell, even considering Mr. Cook’s revision.

Finally, Apple can help its own cause by stressing innovation.  The company did not upgrade its iMac line at all in 2018.  The standalone Mac Pro has not been upgraded since 2013.  It is time to get moving.  These are, of course, small steps compared to the iPhone, but they are a signal to customers and investors that Apple is pushing ahead on all fronts.

Efficient Markets?

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The efficient market hypothesis holds that the market prices of securities accurately reflect the fundamental value of those securities.  This implies that if no new fundamental arrives, prices should remain relatively constant.  It turns out this is not true, even in the case of the overall market, let alone for individual stocks.  Research by Summers and Poterba published in the Journal of Portfolio Managment in 1988 and a follow up article by Cornell (yes the Cornell of Cornell Capital) published in the same journal in 2012 looked at the 50 largest moves in the S&P 500 index of periods of 25 years.  Both papers found that the majority of the large moves were not associated with the release of any news related to valuation fundamentals.  That brings us to the current experience.  First, the S&P 500 dropped nearly 20% in close to record time only to be followed by one of the largest one day price increases (in points, not percent) in history.  And then the next day, the index dropped sharply erasing more than half of the previous day’s gain by midday before reversing again and finishing up on the day.  In all of this there has been basically no new fundamental news.  The only possible candidate is a 25 basis point increase in the Fed’s target interest rate, but that hardly qualifies as new news.  To begin, the action the Fed took was largely anticipated.  What’s more it is far from clear why changes in the Fed’s targets for very short-term interest, even if coming as a total surprise to the market, should have much impact on stock prices.  At best the relationship is complicated.  Among other things it depends on why the Fed is changing its target.  (For a detailed discussion of this issue see Damodaran.)

So why has the market been moving up and down so much?  The honest answer is we don’t know.  Markets can move dramatically on the basis of scant fundamental news leaving financial economists scratching their heads.  But in this regard, we financial economists have one step up on the financial media in that we know what we don’t know.  Whenever there is a sharp move in the market, the media feels the need to explain it somehow.  When there has not been the release of any fundamental news, those explanations are little more than speculation, often based on unverifiable guesss about market “psychology.”  It is best to pay them no mind.

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.

Advisors say “Get Defensive”

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From Charles Schwab to Goldman Sachs, analysts and investment advisors are warning investors to “get defensive.”  That may be good advice, but from a fundamental valuation standpoint it is a bit odd.  From a fundamental valuation perspective, the time to get defensive is when the ratio of market price to reasonable estimates of fundamental value is at peak levels.  As we noted in this blog on numerous occasions, that was the case at the end of the summer.  We argued that that was an ideal time to “get defensive.”  Today, even with the sharp pull back in stock prices, the ratio of price to value still remains on the high side in our opinion.   By definition, however, much less so than at the end of the summer.  The key point is that whether or not to “get defensive” should not be based on recent movements in stock prices because there is virtually no autocorrelation in stock returns.  That means that the fact that prices have fallen sharply in the past month has predictive power or whether they will fall next month.  Nonetheless, it after major pull backs that you see widespread warnings to get defensive.  The best advice is to ignore recent movements in the market and make decisions regarding whether to “get defensive” on the basis of a thoughtful comparison of price and value.

Why Fundamental Valuation Matters

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First, a little humility.  When we posted our list of ten bubble stocks we were not predicting an imminent collapse.  (Though, in fact, a collapse has occurred.  The ten bubble stocks are now down an average of almost 25%, 30% excluding Tesla.)  What we were saying is that prices appeared to be well above fundamental value.  Assuming that the two are going to converge at some point implies one of two things can happen.  One, future stock returns will be low relative to fair risk-adjusted returns on equity for an extended period.  Two, there will be a sudden collapse that quickly brings price down toward fundamental value.  The fact that the second has occured was not something we could predict, but neither was it a complete surprise.  In the long-run it is fundamental value that matters, it fact it is virtually all that matters.

Disappointment and Concern at the Los Angeles Auto Show

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As readers of this blog know, we have consistently opined that at prices exceeding $350 Tesla is significantly overvalued.  Therefore, Cornell Capital has pursued an investment strategy of writing call options with a strike price of 350 when Tesla stock reaches that level.  The strategy has worked well over the years and we continue to pursue it, but last weekend the Los Angeles auto show gave us pause.  We have marveled in previous posts at the lack of exciting, “sexy,” electric car offerings by major traditional manufacturers.  The L.A. show was jarring in that respect.  Teslas small exhibit was packed, as was that of Rivian, an exciting new electric startup.  However, the rest of the show was an electric desert.  Porsche did not even have a Taycan on display.  As we went from BMW, to Toyota, to Daimler, to GM, to Ford and so on the word for electric was 2020, if then.  The sole exception was Jaguar with their iPace.

As we have been driving Teslas for almost six years at Cornell Capital, it is aggravating to not have more real choice in electric cars by now.  But as writers of Tesla options, our concern is graver.  Why is the competition letting Tesla get such a large head start?  It makes sense that they may want to wade into the electric world slowly, given all the complicated political issues including the future of government subsidies.  However, the actual response has been more glacial than just slow.

There is also the issue of “learning by doing.”  Economic theory teaches that way you get better at making electric cars is by making them, not by talking about them, drawing mock-ups, or even producing demos.  There are innumerable little details that Teslas competitors will not get right until they are actually producing, selling and servicing electric cars. Those who wait too long may be unable to keep pace in the next decade.

In short, we fear that Tesla may have more market power than we have modeled.  If consumers begin to think of Tesla as synonymous with electric cars, then the company may be worth more than we have thought.  A price of $350 still appears to us to be rich, but less so than we thought before the show.