Monday, April 6, 2009

Chaos by Incentives – Part 1

Thesis: Corporations would be better managed, have higher and more stable growth, the jobs of employees would be more secure, and overall shareholder returns would be higher if corporate dividends were tax-free and capital gains were taxed at a flat rate of 20% regardless of income.

Double taxation of dividends encourages companies and shareholders to favor capital gains in the form of ever increasing share prices over dividend payments. As a result companies are under pressure to increase their earnings per share every quarter.

Companies that meet or exceed expectations are rewarded with rising share prices and high price/earnings (P/E) multiples. Those who fail to grow their earnings fast enough languish at low P/E’s and become takeover targets. Those that grow earnings quickly for a time and then slow down are punished with precipitous drops in their P/E and hence in their share price.

Consequently, management seeks to constantly increase their earnings per share. Conceptually this is a good thing. But the extreme is normal.

Many, if not most, mid-to-large size companies maintain “mergers & acquisitions” departments and have for decades. Every Spring business schools graduate thousands of aspiring “M&A” specialists. Supporting and financing corporate acquisitions is a huge part of the investment banking business.

Institutional and sophisticated individual investors believe that it is a productive use of a company’s resources to buy its own shares on the open market. They believe this because when a company buys its own shares the number of shares outstanding declines. This increases earnings per share even if the company’s overall earnings are flat.

The pressure for short term earnings per share growth drives boards of directors to create management incentives in alignment with this overarching objective. In turn, management is driven to outsource, acquire other companies, leverage earnings by taking on debt, creating unfathomable securities like credit default swaps, securitized bundled mortgages, and other “weapons of financial mass destruction” (quote from Warren Buffet).

The result is chaos. Well run stable companies are bought by unstable weak managements at companies whose share prices are inflated. The purchases are usually exchanges of stock or at best some combination of stock and cash. The acquiring companies frequently are not up to the task of running the acquired companies but they are quite capable of running them into the ground. Look at the history of Sanmina-SCI (SAMN) for one example amid hundreds.

Jobs are lost. Profitable businesses are bought and sold four or five times in a single decade; and each time resources are wasted realigning business systems and reorganizing departments.

Links to Other Posts in the Special Report: "Chaos By Incentives"

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