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Alternative to Corporate Debt and Share Buybacks

As the above graph from Longtermtrends shows, during this financial cycle, corporations have been on a debt binge fueled by the Federal Reserve's quantitative easing and artificially low interest rates. Plus they got the gift of a massive reduction in taxes from Trump and the Republicans.

What have they used all this extra cash for? Certainly not for a rainy day like what we are experiencing with COVID-19. Definitely not used on employees and also not on dividends to investors since those are taxed. Instead, they used most of it on share buybacks.

You see, share buybacks are a way for a company to increase earnings per share which is the main metric that drives stock prices and how most executives are measured and incentivized. The lower the number of shares, the higher the earnings per share because the denominator in the equation is lower.

By meeting earnings per share ("EPS"), executives get awarded stock options. They can meet EPS buy either increasing profits of the company as a whole or decreasing the number of shares outstanding. The perverse feedback loop effect is the more shares that are bought back, the better chances are the executives will meet their incentive thresholds and the more money they will personally make. 

Here's an article by one of my favorite financial people to read and listen to, Ben Hunt from Epsilon Theory. In the piece, he used the company, Texas Instruments, as an example of how buybacks work and how companies are using them to the extreme in this cycle.

The problem with all this borrowing is that it is making the risk profile of the company increase dramatically. If the company experiences a set back (like most companies are currently with COVID-19), now the company is in jeopardy of not being able to pay the new debt service on the borrowings it used for share buybacks. As a result, it brings about the threat of bankruptcy and the possibility that all common shareholders lose their investment entirely.

There seems to be a better way than this. What if instead of having executives decide whether they should risk the future of the business for short term gain, how about that decision is left to shareholders? Companies should be able to use debt responsibly for real business needs (buying equipment, expanding operations, financing working capital, or for true emergency reserves). But going into debt to be able to buyback stock or pay dividends should not be allowed at the company level. 

Shareholders already have a way to borrow money to buy shares in stocks. It's called buying "on margin". Right now, online brokers like Schwab, Fidelity, or TD Ameritrade charge the same interest no matter what you buy. But the amount a shareholder can borrow has more to do with the balance and liquidity in their personal investment account as well as their own credit worthiness. What if instead, a shareholder could borrow money on a company's stock they already owned and be charged an interest rate based on the risk profile of the company?

Companies are already rated a bond rating (AAA, AA, A, BBB, BB, B, etc). And that rating is used to determine what the company can borrow money at. What if that same rating was used to determine what the equity shareholder can borrow money at if they owned stock in the company?

Say for instance someone owned $10,000 of stock in Microsoft. Microsoft carries a credit rating of AAA and can borrow funds at approx. 3%. What if instead of Microsoft borrowing the funds at 3% and using them to buyback stock, the individual investor is able to do that? That investor could maybe borrow half of their investment ($5,000) at 3% and do whatever they want with that money. They could buy more Microsoft stock (which is what Microsoft would do), or they can buy a different stock, or they could even use the funds for personal reasons outside of the stock market.

This would shift the risk from the company as a whole to the individual investor. If the company doesn't perform to expectations or hits a bump, it doesn't have nearly the same level of debt to jeopardize the entire company and all its shareholders. It just jeopardizes those that borrowed too much on their stock to service their own individual loan. Perhaps that investor in the example has a source outside of the company's dividends to service the 3% loan. Or he/she could say "you know what, it's not worth the continued 3% payment. I'll just give the shares to my broker." Then the broker takes the shares back and either sells them on the open market or perhaps holds onto them if they see them as a good investment. Meanwhile, Microsoft continues to be Microsoft without any change to the company or the other shareholders as a result of one shareholder borrowing too much.

In addition to shifting the risk, it also shifts the power. Right now, company executives have all the power. They decide how much to borrow and how those proceeds are used. Wouldn't it be better if the shareholders got to call the shots? After all, they are the owners in the business.

The best thing politicians can do is to allow this plumbing to happen through 3 ways. (1) Allow for shareholders to be the ones to borrow on their shares, not companies. (2) Stop allowing company executives to be incentivized on earnings per share and instead have them focus on earnings of the company as a whole. And (3) give companies the ability to distribute dividends tax free. This is why executives are so incentivized to do share buybacks, because they aren't taxed. If dividends were tax free, there would be no need for share buybacks except to boost and then disguise executive incentive compensation.

We are beginning to learn that the debt binge from this last financial cycle is having repercussions on the economy and the stability of the financial system. The Fed and Congress are already having to provide liquidity and bailout funds to over-indebted companies. If only they had the foresight to stop the corporate debt binge before it grew to extremes and infected nearly every public company. Hopefully, through this downturn, those in charge will learn the lesson that executives aren't the best at determining risk profiles for their companies and the thousands of shareholders they represent. Instead that power and risk needs to shift to the shareholder to make that determination for themselves. I bet most shareholders would prefer to be conservative with their own money and for the company to be conservatively financed as well. It's an investment after all and not a casino.

As Warren Buffet is quoted, "Rule #1, never lose money. Rule #2, never forget rule #1". Individual investors need for this rule to be their own decision and not the company executives'.