In his 1922 autobiography My Life and Work, Henry Ford warned about businesses becoming addicted to debt:
I would not say that a man in business needs to know nothing at all about finance, but he is better off knowing too little than too much, for if he becomes too expert he will get into the way of thinking that he can borrow money instead of earning it and then he will borrow more money to pay back what he has borrowed, and instead of being a business man he will be a note juggler, trying to keep in the air a regular flock of bonds and notes…
…I think there is a tendency for too many business men to mix up in banking and for too many bankers to mix up in business.
Is that not a perfect description of what’s happening across the world’s largest businesses today?
Let’s look at an example. Disney reported their fiscal year 2016 results in November. Here are some important data points:
- Disney reported net income of $9.4 billion, against revenue of $55.6 billion (for a net income margin of 17%)
- Disney generated $13.2 billion in cash from operations, and invested $5.8 billion in cash back into the business, leaving a cushion of $7.5 billion
- Disney distributed an additional $9.8 billion in cash to shareholders ($2.3 billion in the form of dividends, $7.5 billion in the form of stock repurchases)
- To help plug the gap, Disney took on an additional $6.1 billion in new debt, in part to pay back $3.1 billion in already existing debt
Disney is literally “borrow[ing] more money to pay back what [it] has borrowed”. Is that wild or what?
Disney could avoid this fate by ratcheting down its payments to stockholders. But the company won’t do that. Executive compensation comes overwhelmingly in the form of stock awards. The thinking is that executives have the shame interest as shareholders: making the stock price go up. So they do.
How do you make the stock price go up?
The academic answer is…make the company more valuable. Generally that goal translates into making the company larger, or making it more profitable, or both.
Do you want to know a shortcut, for how to get the stock price to go up? Give cash to shareholders. They love that. Sure, it’s not changing anything about the company (other than its cash balance). But investors will pay a little more for a company if they know they’re getting cash kickbacks along the way.
The two avenues that large companies use to return cash to shareholders are (1) dividends and (2) stock repurchases (i.e. buybacks). Dividends are easy. They’re direct cash payments to shareholders. Stock repurchases are murkier. The company buys back stock from shareholders that are willing to sell. Those shares are then “retired”. The remaining shareholders (the ones who didn’t sell) now own a larger fraction of the company, which is worth more than the smaller fraction they owned before.
The takeaway is, the company is trading away cash, and getting a higher stock price in return. (That math doesn’t always work out in the real world. But that’s the guiding philosophy.)
There can be very good reasons to give cash to shareholders
You can make a sound economic argument for handing cash over to shareholders, even if you ignore the supposed bump in stock price. If the company cannot use its cash productively, it’s better to give that cash to its owners (i.e. shareholders). The assumption is that shareholders always have a way to productively invest their cash. The spectrum of investments a shareholder considers is almost always wider than what corporate managers would consider.
Here’s a quick example. Coca-Cola generates a lot of cash. But it’s so large that it can’t grow very quickly from here. It can target market niches. It can try to get in front of emerging trends. But it’s already operating at a very large scale.
Coca-Cola keeps some of its cash for these targeted investments, but it turns over the rest to shareholders. What might Coca-Cola shareholders do with that cash? Invest in another publicly-traded company. Or buy a home. Or start a business. Or any number of other options. The point is, the cash is going to waste sitting in Coca-Cola’s bank account. If Coca-Cola releases that cash to shareholders, it’s more likely that the cash goes to good use elsewhere in the economy.
In other words, there can be very good reasons to give cash to shareholders. You run into trouble, however, when you have to take on more debt to fuel these payments.
Cash transfers to shareholders come with a cost: an eroding safety net
A company’s (presumably good) credit rating is an asset. You won’t see it on a balance sheet. There’s no way to know exactly what it’s worth. But the company can still use this asset to benefit shareholders. How? Borrow more money, then give that cash to shareholders.
How much more valuable is a perfect credit rating than a very good one? You can try to figure it out by looking at the interest rates you’d get on loans under both scenarios. All else being equal, a better credit rating will get you a lower interest rate.
Shareholders, though, might not want you to have too good of a credit rating. Again, like the excess cash on hand…it’s wasteful. They’d rather you take your credit rating down a notch or two, if it means they can have more cash in their pockets. The idea is the same as above. Shareholders can put that cash to use elsewhere in the economy. The only price? The company might have a higher interest rate on future loans, which it shouldn’t need in the first place, if it’s running a healthy business.
You probably see where this is going. Loading up on debt to fund cash transfers to shareholders takes slack out of the system. The company has less of a safety net. Safety nets look wasteful, right up to the point that you need them. And no one…not a single person…know when any particular company is going to need a safety net. That’s why you must always have them.
Managing cash transfers to shareholders steals focus from managing the business
Managing cash transfers to shareholders adds a whole new dimension to the business. It’s something Henry Ford, for example, didn’t have to think about. He used his cash to invest in his business. Managers of today’s corporations have to balance investing in the business against paying out to shareholders.
This scenario reminds me of John Kay’s criticism of excessive financial ingenuity. Granted, giving cash to shareholders doesn’t require much ingenuity. But it’s one more financial machination. It’s one more decision the executive team has to make.
While cash distributions are a simple idea, they actually require some work to implement. On the dividend side, you have to decide if and when to raise your dividend payments. Some companies broadcast their record of consecutive years of dividend increases. On the buyback side, you have to decide when to implement the program, and how much money you’re going to spend. You have to decide if there’s a range of prices you’re willing to buy back at.
If cash transfers require taking on more debt, you have to seek out the most advantageous type of debt. Your financial organization will spend considerable effort designing and executing these programs. All so that shareholders can have some more cash in their pocket.
These kinds of program distract from corporate strategy. They might be necessary, but they’re not helping the company win. No company uses cash transfers to shareholders as their competitive advantage. You can’t. Anyone can make these payments.
I could pick any of a ton of quotes from Richard Rumelt’s book, Good Strategy Bad Strategy, about the importance of focus. Here’s one (p. 20):
Having conflicting goals, dedicated resources to unconnected targets, and accommodating incompatible interests are the luxuries of the rich and powerful, but they make for bad strategy…Strategy is at least as much about what an organization does not do as it is about what it does.
Okay, I can’t help myself. Here’s one more (p. 53):
Good strategy works by focusing energy and resources on one, or a very few, pivotal objectives whose accomplishment will lead to a cascade of favorable outcomes.
I don’t want to overplay my hand here. I’m not saying companies have bad strategy because they divert attention to making payments to shareholders. What I am saying, though, is that resources dedicated to making these payments, and taking on the necessary new debt, are necessarily not spent on the “pivotal objectives” that will make the company successful.
Good strategy dies a death of a thousand cuts. And managing the infrastructure around cash transfers to shareholders inflicts some of those cuts.
Companies are dying more quickly. Distractions like taking on debt to pay shareholders don’t help
Alright, I’ll wrap this up. The Boston Consulting Group published an interesting report in 2015 about the lifespan of corporations. In short, companies are dying more quickly than they used to.
There are tons of reasons that corporate lifespans are shrinking. Personally, I think dedicating resources to managing a delicate waltz between debt and cash transfers to shareholders doesn’t help. No business is built around these mechanics.
All businesses deliver value to customers. They have their own business models. They have relationships with suppliers and with customers. Giving kickbacks to shareholders is something they do to keep people on the periphery happy. And over time, these companies have become more consumed and distracted with these activities.
They’re falling perfectly into the trap that Henry Ford described. Executives think they “can borrow money instead of earning it and then [they] will borrow more money to pay back what [they have] borrowed”.
The whole idea of giving cash to shareholders is that companies have more cash than they know what to do with. In other words, they’re earning so much that they’re obligated to return some of it to their owners.
That’s not what’s happening in a lot of cases today, though. What’s happening is executives decide how much money they feel compelled to give shareholders. Then they use debt to make up any gap left by insufficient organic cash flow. It’s ludicrous.
Just because everyone is doing something doesn’t make it right. That’s an obvious statement. It’s still really interesting to see it in action, particularly when we’re talking about the richest, most respected people on the planet. Common sense can elude anyone. Don’t fall into that trap.