on Our Short Term, Gambling Culture
by Victor Sperandeo with the Curmudgeon
Background (by the Curmudgeon):
Larry Fink, Chairman and CEO of BlackRock was the focus of a NY Times story a few weeks ago about the letter he wrote to each of the S&P 500 company CEOs.
Mr. Fink complained that too many CEOs have been artificially boosting stock prices through "shareholder-friendly" steps like borrowing money at ultra-low rates to pay dividends and buy back stock (reducing the float boosts earnings per share, often when total earnings are declining!). Fink says these maneuvers, often done under pressure from activist "investors," are harming the long-term creation of value and may be doing companies and their investors a disservice, despite the large increases in stock prices that have often been the result.
From Fink's letter to the S&P 500 CEOs:
"It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies. Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks.
We certainly believe that returning cash to shareholders should be part of a balanced capital strategy; however, when done for the wrong reasons and at the expense of capital investment, it can jeopardize a company’s ability to generate sustainable long-term returns.
We do recognize the balance that must be achieved to drive near-term performance while simultaneously making those investments – in innovation and product enhancements, capital and plant equipment, employee development, and internal controls and technology – that will sustain growth."
Fink's follow up blog post is even more of an eye opener - a Mckinsey Insight publication titled: Our Gambling Culture.
The post highlights the long-term cost of today’s widespread cultural “short-termism” which is focused on fleeting capital gains, trades and gambling rather than long term investment and discipline that builds lasting value. Here's an excerpt:
"Instead, we’ve become mesmerized by the possibility of short-term, one-off gains. There’s a chicken-and-egg problem at work. In many cases, there is a serious misalignment of incentives. Instead of encouraging our institutions and our leaders to grapple effectively with complex, long-term challenges, we’re rewarding them to do the opposite. Often, there seems to be a great deal more upside to placing a simple bet for a quick win than for staying the course through difficult times to create sustainable gains that are more widely shared. Whether the wrong goals led to the wrong incentives or the reverse is hard to say."
"We see this myopia in Washington all the time. Congress has shown an astounding willingness over the past few years to focus on political theater such as debt-ceiling brinksmanship instead of solving long-term problems, fiscal and otherwise."
Victor: Why Do We Have a Gambling Culture in America?
I believe Mr. Fink's heart seems to be in the right place. However, the more important question is WHY is this gambling culture and short term thinking so prevalent today in the U.S.? Also, why are the banks and corporations hoarding cash? Why are so few people borrowing or spending capital to build businesses? Let's try to answer those important questions.
The focus on short term "investing" is driven primarily by government policy, which dictates investor demand. I strongly disagree with the reasons Fink cites in his post.
Curmudgeon Note 1.
I totally agree with this excerpt from Fink's McKinsey article:
"This wholesale return of cash to shareholders helps explain why equity markets are outpacing the economy. In the short run, we are rewarding shareholders, which causes the stock to spike. But to the extent that those cash expenditures starve corporate investment, the economy suffers. In particular, people who are riding the current wave will pay for it later when the ability to generate revenue in the long term dries up because of the lack of investment in the future."
Fink cites greed as one reason for short term mentality that's so prevalent today. To wit:
"There’s a host of reasons short-termism has taken hold in our culture, both in the United States and more broadly. Greed and the media’s reliance on daily bombardments of bad news certainly play a part, but more important, we’ve lost sight of our actual goals."
Greed is an "anti-concept" and could mean anything, so therefore it means nothing. The dictionary says it is an "excessive desire for more of something (as money) than is needed." Well what does that mean? Should Bill Gates, Warren Buffett etc. sell their companies and retire when they got to "more... than they needed"? What number is that.... $10, $50, or $100 million?
Under government policy, the three classic killers of long term planning with incentives for creating businesses and jobs are: Fed policy, taxes, and excess regulations.
We all have a feel of how Fed policy effects investing by distorting and causing the misallocation of capital, as the Curmudgeon has discussed and explained many times. Taxes are obvious as every other week the current administration talks about "the rich" not paying their "fair share," whatever that number actually is (99%)?
Lastly, the primary focus of the Democratic Party platform for 2016 is based on envy or "inequality." It's a progressive tax system aimed at populism and targeted at the "middle class."
The certainly of rising taxes drives investors to take what they can get NOW, as they'll get less later as taxes go up. For example, capital gains taxes went up 58.3% in 2013 or 15% to 23.75% with the Medicare tax. The 2+2 = 4 logic is taxes are going up so cash out now!
A tax law which is guaranteed to be stable would be a huge incentive for long term investing. Consider the effect of capital gains taxes which drop 2% per year to zero, the longer you hold the security. That would surely incentivize longer term investing.
Curmudgeon Note 2:
Mr. Fink told the NY Times he recommends that gains on investments held for less than three years be taxed as ordinary income, not at the usually lower long-term capital gains rate, which now applies after one year.
“We believe that U.S. tax policy, as it stands, incentivizes short-term behavior,” he said.
“Since when was one year considered a long-term investment? A more effective structure would be to grant long-term treatment only after three years, and then to decrease the tax rate for each year of ownership beyond that, potentially dropping to zero after 10 years.”
What is not often clear is how government regulation is influencing short-term investments rather than long-term investments. Kindly consider the following example of a leading insurance company's predicament due to regulation.
In the 3rd week of April each year, a BlackRock VP hosts the "Founders Dinner forum" in NYC. About 20-30 top well known experts from finance, investing, portfolio management, trading, economists, VC's, and hedge funds are invited - some from outside the U.S. I've been fortunate to have been invited to this event as "the Commodities expert" (?) for the last 10 years. Sometimes other commodity managers are also invited to share their views on the markets.
The forum is one in which about a third of the attendees present a synopsis of the ideas most important to them as they best see it. One person is honored, speaks first and gets a beautiful crystal "trophy-like" present. I was so honored once and was very grateful. I always get to speak my ideas, while anyone can ask questions, and offer short points of view.
This year the best education, in my opinion, came from the chief portfolio manager of Prudential (the insurance company). Not to mention names without permission let’s call him Bill.
The insurance business is now considered a SIFI or "Systemically Important Financial Institution" by the FED or the government regulator in this case. So as Bill tells the story of this Mary Shelley creation of the Frankenstein monster.
With all the divisions of "the Pru" in a conference room, the Regulator ("King") asks the head of each division: what is the "worst case" that can occur.
First, the question about "life insurance" is asked. After a few seconds, the head of the division says the worst thing that could happen is "everyone dies." OK, the Regulator says. Let's run the numbers and then give me a memo on the expected losses. Of course, the company would be bankrupt.
[Please note that the greatest pandemic in history was the "Bubonic Plague" (AKA the "Black Death") that killed 30-60% of the population in Europe from 1347-1351. That was about 75 million people of a "world population" estimated to be 450 million.]
OK, now for the Annuity division. The division head says: the worst case is "everyone lives." The Regulator asks how much you lose if everyone lives 10 years longer than the statistics indicate. Well, everyone can't live and die together at the same time! Yet the Regulator has been told by his boss to obtain the worst case numbers for each!
The implied point here is that the Chief Investment Officer has to invest in liquid assets for the worst case scenario which cannot ever occur.
The Dodd Frank Disincentive for Small Banks & Businesses:
In the spring of 2008, AIG had the money but it was "illiquid" when the credit default swaps on Bear Stearns came due. This is still the problem today. Since the Dodd Frank bill was signed into law on July 21, 2010, 346 banks have died - mostly from excess regulation.
In IBD April 25-27th weekend edition, there's a revealing editorial titled: "A Dodd Frank Disaster."
Here's a very on target quote from the editorial:
"Despite the promises, Dodd-Frank fixed nothing. As we predicted in 2010, it was simply "2,319 pages of unintended consequences for the economy." Of the many negative effects of Dodd-Frank, one is its disincentives for opening new banks."
The editorial goes on to discuss the first bank to open since the 2319 page "Godzilla-like" Dodd Frank bill. Interestingly, the bank was named "Bank of Bird in the Hand." The piece also quotes a Harvard study which states that "community banks share of assets has shrunk drastically -over 12% since Dodd Frank...It shows a 9.5% decline in small banks in just three years after the bill came into being."
It's crucial to note that small banks are the main lenders to small business. It's the latter which hires the bulk of new workers. Yet very little small business new hiring is occurring, partially because of Dodd Frank, whose regulations had zero to do with the 2008 financial crash.
"I lend my support to Victor’s position that the primary motivation to emphasize short-term gains is our byzantine government tax and regulation policies,” Brent Berarducci of Blacklion Capital Management wrote in an email to the Curmudgeon.
In closing, I assert that the U.S. is under siege by the progressive movement, which has no real interest in helping "Main Street." Its agenda is to control more power and thereby attract more political contributions to buy votes and attain even more power. This is not what the ancient Chinese philosopher and poet Lao Tzu said centuries ago:
"In dwelling, live close to the ground. In thinking, keep to the simple. In conflict be fair and generous. In governing, don't try to control. In work, do what you enjoy. In family life, be completely present."
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Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
Copyright © 2014 by the Curmudgeon and Marc Sexton. All rights reserved.
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