When CEOs’ Equity Is About to Vest, They Cut Investment to Boost the Stock Price
hbr.org
hbr.org
Further research reached the surprising conclusion that CEOs are people too, and game the system just like any other person.
[Edit: adding color, as my comment lacked substance to abide by HN's guidelines]
Snark aside, this is a great example on how we need to design robust incentive systems that minimize the chance of gaming them. People are amazing optimizers, and will find any loopholes or gaps that allow them to use any system to their advantage.
CEOs delaying investments, CFOs colluding with industry analysts, rushing product launches, technical debt, etc. are all examples of the same symptom.
"Detecting Earnings Management", by Richard Sloan (a former professor of mine) is a great article that shows the same behavior as this article: managers will anticipate or delay earnings and investments in a way that maximises whatever metric they are evaluated on.
This is further exacerbated by the non-linearity of the market response to earnings surprises. Unsurprisingly, the distribution of earnings surprises over time are not symmetrical to the average market return.
Please don't post shallow dismissals, especially of other people's work. A good critical comment teaches us something.
It also breaks this guideline, since you've ignored the substantive core of the article:
Please respond to the strongest plausible interpretation of what someone says, not a weaker one that's easier to criticize.
We all know how easy and satisfying it can be to fire off a bit of snark into the internet, but it makes for poor discussion, and actually causes harder systemic problems than outright personal attacks and the like. So please don't post like this to Hacker News.
Sorry, couldn't resist.
I will show myself out now.
This isn't really about whether markets are or can be efficient. This is about corporate governance. Boards of directors should not permit CEOs to play these games, and compensation of CEOs should be structured to not create such destructive incentives.
You can have efficient-enough markets, like ±0.001% efficient, without requiring P=NP.
Wall Street I and II aren't the most accurate pictures, but they certainly aren't fiction. If you aren't the shark, you're getting sharked. But because of 21st century prosperity, you still might be happy with your returns, even while paying the tax of giving money to those with better information.
[1] https://en.wikipedia.org/wiki/Efficient-market_hypothesis
People say this a lot, but I think it's misleading to most who hear it. This is certainly true in a trading context (i.e. where the buy/sell time horizon is short enough where the underlying asset's economic value doesn't change, though the market price might), but not in an investment context (where it's expected that the inflow of capital will create economic value and the stock price will reflect that).
The takeaway is that you should leave daytrading to the pros, and instead bet on humanity improving the means of production over long time horizons. Unless you're actually a pro and have good reason to believe you can beat the market.
The only "proof" of this I've seen asserts that there are 2^n boolean-valued functions on n-bit vectors.
The remaining problem is how to uniquely describe in polynomial space an element of a set with doubly exponentially many elements, but the authors don't bring that up because they're working under the assumption that there are 2^n functions rather than 2^(2^n).
The assertion that the efficient market hypothesis is equivalent to P=NP also comes with no proof that future performance of a trading strategy will match its past performance or that anyone will actually deploy a perfect strategy if one exists.
Given that the powers that be clearly have no consensus on the existence of the problem (nevermind that they may have a vested interest in not identifying the problem), and that identifying a problem, while non-trivial, is typically orders of magnitude easier than identifying a solution, it's a little disingenuous to dismiss the point by asking for a solution. Just because the solution is unknown doesn't mean we can't discuss the existence of the problem.
[edit]
The sibling comment that asks if the markets are failing more than in the past is more productive because if they are that means that something is different; I personally am disturbed by the degree to which "a rising tide lifts all boats" is no longer true.
I wonder if it's because the wealthy and powerful have gotten better at cornering the market on gains (which would beg for some check on their power), but I also worry that it's actually because material growth has actually stalled, and the market gains are mostly illusion (which would require some other correction).
All this wealth is being generated, but it's going disproportionately (historically speaking) to the wealthy. Well, the problem with that is that the wealthy have an extremely low marginal propensity to consume, so, all they do is invest. That means that both more wealth is available to build businesses and less wealth is available to purchase the resulting products. So, it's easier than ever to create a business because investment dollars are cheaper than ever, but it's harder than ever to make it profitable because nobody's buying. That should depress costs, but the race against inflation has got to catch up eventually. You can keep making it cheaper and cheaper to run a business, but if wages don't increase and cost of living continues to increase just due to inflation, then it doesn't matter how cheap your goods are. There's no middle class left with the money to purchase luxury goods. Then what?
Edit:
> Austrian economics doesn't claim that short-term inefficiencies do not exist in markets, but rather that they are less harmful than attempts to fix them.
This seems -- at least partially -- bogus on it's face. Sure, you can definitely regulate a market into collapse (see the Soviet Union) but deregulation can just as easily create supermonopolies which are equally unjust and ineffective. The point of the market isn't to generate wealth, it's to distribute resources efficiently so that the nation as a whole (or state, or world, or whatever collective noun you want to use for human civilization) gets their required products. Generating wealth is a complete side effect of the market as far as the benefits to society are concerned.
This makes a lot of sense, but it doesn't automatically imply unilaterally implementing a wealth tax will solve the problem. It's not like there aren't a lot of people who want to tax wealth rather than income, but it is much harder to hide income than wealth (and yet we still have people who do so to a large degree).
They seem to assume this a priori.
Do you really think ignoring the issue or remaining silent will fix the issue? Do you know what happened historically when wealth distribution and societal demands got wildly out of balance? Crime, famine, revolution, war, and death.
If CEOs are managing to manipulate the stock price for personal gain having nothing to do with how efficiently that company manages actually delivering products and services then that's a failure of the market as an economic allocation tool. Choose winners and loser stocks all you want - you can engineer a profit, but all that work might not do anything as a signal for companies to manage their fundamentals better. Now - you can argue about if this is just a short term influence and it doesn't matter because maybe it all still balances out in longer terms. But I lean towards thinking it's a systemic long term disconnect problem.
Consider: you are an investment manager considering allocating capital. You know that company A is engaged in short term manipulation tactics to the detriment of their long term business prospects, and company B doesn't care at all about short term market movements and focuses entirely on growing and sustaining their business. You also know that there was this McKinsey study recently that showed that companies like company B earn higher market returns long term. Where are you going to allocate your capital?
Now, I grant you, some investment managers are under pressure from their clients for short term performance. And that can skew the results here. But in aggregate, over time, the machine is efficient, and it will eventually price these things correctly. And in so far as i'm aware, there is no better known mechanism for allocating capital.
Now that this problem is published, to the extent that it's true, you, I, and anyone else who wants to can make it go away by allocating our own capital accordingly. And the nice thing is that we get compensated for doing so in the form of superior returns.
It's the same thing with cops and firefighters. Their pensions are calculated based on the earnings of the last few years of employment. So that save vacation days the last few years to inflate their earnings the last few years.
If there is one thing you can count on, it's human greed. And I'm not pretending I'm above it myself.
The problem is that the system is set up to be exploited by the CEOs/etc.
Hoo boy, but if a CEO has self-interests that involve steering the company in a socially responsible direction (or maybe just being less extractive), cries of fiduciary duty to shareholders ring out.
One of these is an ongoing source of considerable societal damage. The other is illegal.
I'm not very equipped to judge legally what is or is not a crime, but it does seem like there's a lot of leeway for people in control of public companies to effectively take money from their investors.
Most laws are just enforcing social norms
Cutting costs and investments can easily dress up short-term financial performance at the cost of long-term productivity. But it will look good for investors who don't understand the underlying matter and rely on simplistic metrics to make investment decisions.
If a company retires 10% of its shares from a buyback, each investor now owns ~11% more of the company than they did before.
Of course markets are not perfect, and nobody knows for sure if the market value of the company is fair or not. When a company engages in stock buybacks, it’s essentially saying that it believes its stock to be undervalued, which is why stock buybacks sometimes have the surprising effect of elevating the stock price, at least in the short run. After all, who has better information about the company and its prospects than itself?
But as they say, the market is a voting machine in the short run, but a weighing machine in the long run. If it turns out that the market value of the company is higher than its intrinsic value, then stock buybacks are actually destroying shareholder value. The cash would have been better spent buying shares in an index fund.
That's not right. You have a larger piece of a smaller pie, but you have the same amount of pie.
Edit: the confusion is you are talking about total market cap while the parent is talking about share price. Total market cap is irrelevant to stockholders. Share price is all that's relevant.
Yes, this was my point. Stock buybacks are value neutral if the market value of the company is correct. Ie. the share price stays the same.
All large stock purchases have the short-run effect of elevating the stock price. It would be shocking if this didn't happen; it is not surprising in the slightest that it does.
Edit: Sorry, I got myself confused and mixed up the total market cap (which should go down) with the share price (which should stay the same, because there are now fewer of them).
Consider a company worth $100 with ten shares of stock with $10 of cash on their balance sheet. Each share is worth $10. They company uses the $10 to buy back one share of stock. The company is now worth $90 and has 9 shares outstanding. Each share is still worth $10.
Another interesting thing is that this form of buyback return channel would seem to exclude passive index funds unless they were actively shrinking (i.e. selling).
(1) Example from this morning talking how GE bought $30B of shares and later tanked. That's a pretty significant although unequally distributed return of value to those shareholders who sold vs. those still owning GE. https://finance.yahoo.com/news/general-electric-company-stoc...
> They call it “returning money to shareholders.” I call it “wasting shareholder money,” because they almost always buy at prices that are too high
It's the easiest lever a CEO can push on to look good.
The numbers don't lie, right?
When there are fewer shares, my individual stake in the company is actually performing better.
Also, and most importantly, the CEO is now in the money and can sell, so his compensation increased just by increasing the share price.
The part you're ignoring is future earnings. Assuming a company maintains its earnings, you have a bigger slice of the pie next quarter. If the company trades at the same EPS multiple, your stake definitely has gained value. You're totally ignoring enterprise value.
In a vacuum, nothing has changed about a company's future earnings when they repurchase shares.
The kind of bizarre roundabout way to consider it is if Apple bought 25% of itself with its money mountain (they can't, beside the point), your stake in the company goes up because you own shares in Apple, which in turn owns 25% of itself.
You effectively have more equity in Apple when it buys its own shares.
What the previous poster is trying to get at is that a big-ticket buyback signals an inability to invest that sum in a way that will improve growth or profitability. The best move to increase EPS is invest in capital improvements to increase earnings. If you can deploy money effectively, that means you're also growing in the long-term. Reducing the number of shares via a buyback also increases EPS, but it doesn't improve the top line.
In other words, a buyback is a way to increase your (and the CEO's) earnings per share even in the midst of stalling growth. So what I'm getting out of the previous comment is: don't confuse a buyback with continued growth; it's actually a "cashing out" moment.
Whichever combination of those items provides the best risk-adjusted return is the one (or several) that they should choose. The risk of share buybacks is quite low. You more or less know what the outcome will be, so even if the reward of a successful M&A or an organic expansion project is higher, it may still be smarter to buyback shares once you discount the former possibilities for the uncertainty. This is even more true if you believe the stock market is undervaluing your firm's shares, which of course then becomes a very common storyline when buyback programs are announced or expanded.
If you invested because you believe in the long-term growth prospects of the company, then you expect them to plow their cash into increasing the top line, and a buyback can be a disappointing signal. If you invested because you believe it's a good income stock, a buyback is exactly what you want.
No it's not because it can be sold in the market for more money. Value is what the market will pay for your shares.
If a company has lots of projects that can exceed the cost of capital, then they reinvest profits and ingest more capital. When this is no longer the case, the responsible thing to do is return money to shareholders via dividends or (more tax efficiently) via buybacks. Then investors can use the money elsewhere.
The issue here is it seems like on the margin CEOs get more risk averse on long term projects as they vest, and can grab the bird in the hand.
This is also a favorite hedge fund raid. Hedge funds open up large positions on companies. Demand board seats. Get board seats and then get the execs to sell assets, layoff employees and take out loans to buyback shares. Get out with a nice profit. And the company is left with a huge debt loan that'll crush them once interest rates rise.
Yes. That was my point.
> That’s only a tax advantage if you get options in a worthless company that later becomes valuable.
What? Since 2010, most large companies had their stock prices double, triple or even more.
> For public companies, you can reap this advantage yourself by buying and holding their stock using your cash compensation.
Except you don't get all your salary upfront.
Paper is pretty thorough, including looking at changes in actual measures of firm efficiency, forecasts by friendly analysts vs actual earnings growth and an attempt to defeat the reasonable alternate hypothesis that boards time vesting decisions according to when they think massive investment is no longer needed and earnings growth will kick in.
It does however focus on [estimated per quarter based on annual info] vesting schedules and not actual share sale decisions. Actual share sales are found not to be statistically significantly related to investment drops (likely due to a variety of other reasons for offloading and reluctance to offload if the investment drop is due to short term dips)
I think URL shorteners are frowned on here.
It's a rewrite of https://hbr.org/2018/01/the-fastest-path-to-the-ceo-job-acco...
I imagine looking for ways to increase sales growth and cut costs is something a good CEO does on a regular basis, so maybe there's not much low hanging fruit in that respect. I honestly don't see an issue with the explanation that CEOs are simply more motivated to cut wasteful investment prior to their equity vesting.
CEO's have a great deal of exposure to the upside of their company doing well, they want protection from the downside of it doing poorly.
They are talking about changing vesting from 3 years to 5. Instead, how about take that pile of options and split it into 5 piles. Pile 1 vests in 3 years. Pile 2 vests in 4 years and so on.
The point is to spread it out over time--they'll do better with a long term approach.
https://www.bloomberg.com/graphics/2018-blackstone-schwarzma...
> he had made a "mistake" in believing that banks in operating in their self-interest would be sufficient to protect their shareholders and the equity in their institutions. Greenspan said that he had found "a flaw in the model that I perceived is the critical functioning structure that defines how the world works."
It's not a stretch to apply it to all C-levels at all public companies: they will absolutely manipulate the company to benefit themselves at the expense of the shareholder.
https://www.cbsnews.com/news/greenspan-my-faith-in-banks-a-m...
She got sick of it all after 20 years, and now runs a chocolate shop in semi-retirement.
And often the failing company would even pay for the outplacement consultants.
Crappy system, IMO.
"You found that your view of the world, your ideology, was not right, it was not working?" Greenspan agreed: "That's precisely the reason I was shocked because I'd been going for 40 years or so with considerable evidence that it was working exceptionally well."
No, that actually is a stretch, essentially by definition.
The reason that companies are not going public as quickly is because they aren’t making money, not because they are making too much money.
You: Notes a small amount of manipulation by CEOs and says public ownership is doomed.
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