Friday, March 27, 2015

The GM Buyback: Beyond the Hysteria!

Here is a script for a movie about the evils of stock buybacks, with the following players. The victim is an well-managed company in a business with significant growth opportunities and profit potential. The company has delivered products that its customers love, while paying its workers top-notch wages & benefits and invested heavily and prudently in its future. The villain is an activist investor, and for added color, let's make him greedy, short term and a speculator. In the story, he forces the  company to redirect money it would have spent on more great investments to buy back stock. The white knight can be a regulator, the government or a noble investor (make him/her successful, wealthy and socially conscious, i.e., Buffett-like) who rides in and saves the hapless company from the villain and stops the buyback. The story ends happily, with the defeat and humiliation of the activist investor, and the moral  is that stock buybacks are evil (and need to be stopped). As you read some of the over-the-top responses to GM's buyback, such as this one, you would not be alone in thinking that you were reading about the mythical company in the movie. But given GM's history and current standing, do you really want to make it the basis for your case against buybacks? 

GM is not well managed now, and has not been so, for a long time
Is GM a well managed firm? The answer might have been yes in 1925, when GM was the auto industry's disruptor, challenging Ford, the established leader in the business at the time. It would have definitely been affirmative in 1945, when Alfred Sloan’s strategy of letting GM's many brands operate independently won the automobile market race for GM, and it was the largest and most profitable automobile company in the world. It may have still been positive in 1965, when GM was on top of the world, a key driver of the US economy and US equity markets. 

By 1985, the bloom was off the rose, as GM (and other US auto makers) were late to respond to the oil crisis and had let Japanese car makers not only take market share but also the mantle of reliability and innovation. In 2005, GM remained the largest car maker in the world, but it was in serious financial trouble, with an ageing customer base and huge legacy costs, from promises made to employees in good times. In 2008, the problems came to a head during the financial crisis, as GM had trouble  making its debt payments, attracted government attention and a bailout. As part of the bargain, equity investors in GM were wiped out and lenders had to accept significantly less than they had been promised. If the objective of the bailout was GM's survival, it worked, as the company was able to reverse a steep drop in revenues (in 2008) and start making profits again. That recovery came at a significant cost to taxpayers, who lost $11.2 billion in the bailout.

GM was able to go public again in 2010 and since it is the new version of the company that is buying back stock and it would be unfair to burden the incumbents with the mistakes of prior managers, I focus the bulk of my attention on how well the management of this new incarnation has done in its stewardship of the company. The picture below captures the new GM's evolution as a company over the last five years:
The New GM: Investment, Revenues and Profits from 2010-2014
GM has been reinvesting actively since it went public again in 2010, adding almost $25.5 billion in investments (in plant, equipment and working capital) to it base. The good news is that revenues have gone up, albeit at an anemic rate (3.56% a year between 2010 and 2014) but the bad news is that these increasing revenues have been accompanied by declining profitability. Even in 2011, the best of the five years in terms of profitability, GM's return on capital of 6.86% lagged its cost of capital.

Does this imply that the existing management of GM is not up to the task? Not necessarily, since they were dealt a bad hand to begin with. They were saddled with brand names that evoke nothing but nostalgia, a cost structure that put them at a disadvantage (still) relative to other automobile companies and a legacy of past mistakes. At the same time, there is little that this management has done that can be viewed as visionary or exciting in the years since the IPO (in 2010). In fact, the end game for the new GM seems to be the same one that doomed the older version of the company: a fixation on market share (and number of cars sold), a desire to be all things to all people and an inability to admit mistakes. In the last two years, GM’s fumbling response to its "ignition switch" problem seem to have pushed GM back into the  “troubled automobile company” category again. The bottom line is that the best case that you can make for GM's current management is that it is a "blah" management,  keeping the company alive and mildly profitable. The worst case is that this is still a management stuck in a time warp and in denial over how much the automobile business has changed in the last few decades and that it is only a matter of time before the government is faced again with the question of whether GM is too "big to fail".

The auto business a bad one, with disruption around the corner
My measure of the quality of a business is simple and perhaps even simplistic. In a good business, the companies collectively in that business should be able to generate a return on capital that exceeds the cost of capital (based on the risk in the business) and the “best” companies in the business should earn significantly more than their costs of capital. The auto business fails both tests. In my most recent data update in January 2015, I computed the aggregated return on capital at auto companies globally (about 125+) in the trailing 12 months leading into January and arrived at 6.47%, a little more than 1% below the collective cost of capital of 7.53% that I computed for auto companies. Lest this be viewed as an outlier, the table below summarizes the aggregated return on capital and cost of capital for companies in the global automobile business each year for the last ten years:

If you are wondering whether this collective miasma is caused by the laggards in the group, I isolated the twenty largest automobile companies in the world in 2015 and estimated profitability and leverage numbers for them in March 2015:

Note that, if anything, the return on capital (which is based on operating income and invested book capital) is biased towards making a company look better than it really is (largely because accountants are quick to write off mistakes), but even on this measure, only one of the ten largest companies (Audi) earned a return on capital that is higher than its cost of capital in 2014. In fact, mass-market auto companies like Volkswagen, Toyota and Ford have abysmal returns on capital, suggesting that the club that GM is trying to rejoin is not an attractive one. The typically large automobile company in 2015 is a highly levered behemoth, which struggles to earn enough to cover its cost of capital in a market with anemic revenue growth. 

Given that the business model for automobile companies seems to have broken down, it should come as no surprise that the business is being targeted for disruption. While I have argued against the pricing premiums that the market is paying for Tesla, it is undeniable that it's entry into the market has speeded up the investments that other auto makers are making in electric cars. Given their track record of poor profitability, I would not be surprised if the next big disruption of this market comes from companies in healthier businesses and that will bring more pressures on existing automobile companies. If there is a light at the end of this tunnel for incumbent automobile companies, I don't see it.

A GM Buyback: Value Effects?
In an earlier post on buybacks, I used a picture to illustrate how a buyback may affect value and I think that picture can help in assessing the GM buyback:

Looking at the picture, I can see why activist investors were pushing GM to return more cash. It is a middling company in a bad business, where even the very best companies struggle to earn their costs of capital. Since it is possible that I am blinded by my stockholder-focus, I considered what GM could have done with the $5 billion, instead of buying back stock.
  1. Invest the cash: GM could have invested the cash back into the auto business, but given the state of the business and the returns generated by players in it, this effectively throws good money after bad. In fact, looking at how little the $25.5 billion in reinvestment has done for GM in the last five years, I think a stronger argument can be made that they would perhaps have been better off not investing that money and returning it to stockholders as well. 
  2. Hold the cash or pay down debt: Auto companies are natural cash hoarders, arguing that as cyclical companies, they need the cash to survive the next recession or downturn. In fact, that argument seems to have added resonance at a company like GM, which has just come out of a near-death experience with default. At the risk of sounding heartless, I would counter that survival for the sake of survival makes little sense. A corporation is a legal entity and there is a corporate life cycle, a time to be born, a time to grow, a time to harvest and finally a time to shut down. If your response is that you cannot let that happen to an American icon like GM, there was a time when Xerox was so dominant in its business that it's corporate name  became synonymous with its product (copies) and Eastman Kodak was the 'camera' company, but pining for those days will not bring them back. The actions driven by the "too big to fail" ethos have cost the taxpayers $11 billion already. Do you really want to do this a second time around with GM?
  3. Return the cash to other stakeholders (labor, the government): You can argue that my view of buybacks fails to take into account the interests of other stakeholders in the firm, its workers, its suppliers and perhaps even the government. It is true that GM could use the $5 billion to give its workers raises and replenish their pensions. That will be good news for those workers, but doing so will only push down the measly return on capital that GM is currently earning, make future access to capital (debt or equity) even more difficult, and set the company on the pathway to financial devastation.
The Root of the Disagreement
There are "corporate finance" reasons for arguing against buybacks in some companies and they include concerns about damaging growth potential (where buybacks come at the expensive of good investments), about timing (when companies buy back shares when prices are high, rather than low) , or managerial self-interest (if buybacks are being used to push up stock prices ahead of option exercises). Since it is almost impossible to use any of these with GM, those arguing against a GM buyback are really against all stock buybacks, no matter who does them. While I don't agree with these critics, I think that there is a simple way to understand the vehemence of their opposition and it is rooted in ideology and philosophy, not finance.  If you believe, as I do, that as a publicly traded automobile company, GM's mission is to take capital from investors and generate higher returns for them that they could have made elsewhere, in investments of equivalent risk, with that money, you can justify the buyback and perhaps even argue that it should be more. If you believe that GM's mission as a car company is to build more auto plants and produce more cars, hire more workers and pay them premium wages and save the cities of Flint and Detroit from bankruptcy (as a side benefit), this or any buyback is a bad idea. In fact, it is not just buybacks that you should have a problem with but any cash returned (including dividends) to investors, since that cash could have been used more productively (with your definition of productivity) by the company. It is also extremely unlikely that you will find anything that I have to say about buybacks to be persuasive since we have a philosophical divide that cannot be bridged. So, its best that we agree to disagree!

Past posts on buybacks

  1. Stock Buybacks: What is happening and why (January 25, 2011)
  2. Buybacks and Stock Prices: Good news or bad news (January 25, 2011)
  3. The Shift to Buybacks: Implications for Investors (February 1, 2011)
  4. Stock Buybacks: They are big, they are back and they scare some people (September 22, 2014)

Friday, March 20, 2015

Illiquidity and Bubbles in Private Share Markets: Testing Mark Cuban's thesis!

It looks like Alibaba is investing $200 million in Snapchat, translating (at least according to deal watchers) into a value of $15 billion for Snapchat,  a mind-boggling number for a company that has been struggling to find ways to convert its popularity with some users (like my daughter) into revenues. While we can debate whether extrapolating from a small VC investment to a total value for a company make sense, there are two trends that are incontestable. The first is that estimated values have been climbing at exponential rates for companies like Uber, Airbnb and Snapchat. In venture capital lingo, the number of unicorns is climbing to the point where the name (which suggests unique or unusual) no longer fits. The second is that these companies seem to be in no hurry to go public, leaving the trading in the private sharemarket space. These rising valuations in private markets led Mark Cuban to declare last week that this "tech bubble" was worse (and will end much more badly) than the last one (with dot-com stocks). In the article, Cuban makes four assertions: (1) There is a tech bubble; (2) A large portion of the tech bubble is in the private share market which is less liquid than the public markets; (3) The bubble will be larger and burst more violently because of the absence of liquidity; and (4) This bubble is worse than the dot-com bubble, though it not clear on what dimension and from whose perspective. In his trademark fashion, Cuban ends his article with a provocative questions,  "If stock in a company is worth what somebody will pay for it, what is the stock of a company worth when there is no place to sell it ?" I like Mark Cuban but I think that he is wrong on all four counts.

This is not a tech bubble
In my last post, I took issue with the widespread view that the rise in stock prices from the depths of 2008 has been largely due to tech companies using a simple statistic: the proportion of overall equity market capitalization in the United States coming from tech stocks. Unlike the 1990s, when tech companies climbed from single digits in 1990 to almost 30% of the overall market capitalization by the end of 1999, tech stocks collectively have stayed at about 20% of the overall market.

Tech stocks in S&P 500
There are other indicators that also support the argument that this is not a tech bubble, since a bubble occurs when market prices disconnect from fundamentals. Unlike the 1990s, the market capitalization of technology companies in 2014 is backed up by operating numbers that are commensurate with value. In the figure below, I compare tech companies to non-tech companies on market values (enterprise and equity) as well as on operating statistics such as revenues, EBITDAR&D, EBITDA, operating income and net income, across the entire US market (not just the S&P 500):
Tech vs Non-tech companies in US market (Source: Cap IQ)
One measure of whether a sector is in a bubble is if it accounts for a much larger share of overall market value than it delivers in revenues, earnings and cash flows. In February 2015, tech companies account for about 13.84% of overall enterprise value and 19.94% of market capitalization and they hold their own on almost every operating metric. While tech companies generate only 11% of overall revenues, they account for 19.99% of EBITDA+R&D, 17.93% of operating income and 16.46% of EBITDA, all much higher than tech's 13.84% share of enterprise value, and 18.65% of net income, close to the 19.94% of overall market capitalization. On the cash flow measure, tech firms account for almost 29% of all cash flows (dividends and buybacks) returned to investors, much higher than their share of market capitalization. To provide a contrast, in 1999, at the peak of the dot-com bubble, tech firms accounted for 30% of overall market capitalization but delivered less than 10% of net income and dividends & buybacks. That was a bubble!

Note, though, that this is not an argument against a market bubble but one specifically against a collective tech bubble. If you believe that there is a bubble (and there are reasonable people who do), it is either a market-wide bubble or one in a specific segment of the tech sector, say baby tech or young tech. In my earlier post, I broke tech companies by age and noted that young tech companies are richly priced. If Cuban's assertion is that young tech companies are being over priced, relative to fundamentals and potential earnings/cash flows, it is a more defensible one, and if it is just about young tech companies in the private share market, it may even be a likely one. Even on that front, though, the question remains whether this over pricing is a tech phenomenon or a young company phenomenon.

Illiquidity is a continuum 
Cuban's second point is that this bubble, unlike the one in the nineties, is developing in private share markets, where venture capitalists, institutional investors and private wealth funds buy stakes of private businesses and that these private share markets are less liquid than publicly traded companies. While the notion that public markets are more liquid than private ones is widely held and generally true, illiquidity is a continuum and not all private markets are illiquid and not all publicly traded stocks are liquid. 

The private share market has made strides in the last decade in terms of liquidity. NASDAQ's private market allows wealthy investors to buy and sell positions in privately held businesses and there are other ventures like SecondMarket and Sharespost that allow for some liquidity in these markets. To those who would argue that this liquidity is skin deep and will disappear in the face of a market meltdown, you are probably right, but then again, what makes you believe that public markets are any different? While it is true that some of the big names in technology have high trading volume and deep liquidity, many of the smaller technology companies often have two strikes against them when it comes to liquidity:
  1. Low Float: The proportion of the shares in these companies that are traded is only a small proportion of the overall shares in the company. Just to illustrate, only 10.5% of the shares in Box, the latest technology listing, are traded in the market and small swings in mood in this market can translate into big price changes. Looking across all stocks in the market, the notion that young tech companies tend to have lower floats is backed up by the data:
    Source: S&P Capital IQ (February 2015 data)
  2. Here today, forgotten tomorrow: The young tech space is crowded, and holding investor attention is difficult. Consequently, while many young tech companies go public to high trading volume, that volume drops off in the weeks following as new entrants draw attention to themselves, as evidenced by the trading activity on Box:
    Box: Stock Price & Volume (Yahoo! Finance)
The bottom line is a simple one. The liquidity in tech companies in public markets is uneven and fragile, with heavy trading in high profile stocks, in good times, and around earnings reports masking lack of liquidity, especially when you need it the most.  While Mark Cuban worries about the illiquidity of the private share market, I am not sure that it is any more illiquid than the public markets in dot-com stocks were in the 2000, as the market collapsed.

Liquidity can feed bubbles
Let us, for purposes of argument, accept that Mark Cuban was talking about baby tech companies in the private share market and that he is right about the private share market being less liquid than public markets, is he right in his contention that bubbles get bigger and burst more violently in less liquid markets? Intuitively, his contention makes sense. With start-ups and very young companies, it is a pricing game, not a value game, and that price is set by mood and momentum, rather than fundamentals (cash flows, growth or risk). If you cannot easily trade an asset, it would seem logical to assume that any shift in mood or momentum in this market will be accentuated. If you bring them together in a private share market, you should have the ingredients for a bigger bubble, right?

My intuition leads me down the same path, but if there is a lesson that I have learned from behavioral finance, it is that your intuition is not always right. Some of the most interesting research on bubbles, on what allows them to form, and causes them to burst, comes from experimental economics. Vernon Smith, who won a Nobel Prize in Economics for his role in developing the field, has run a series of experiments where he illustrates that adding liquidity to a market makes bubbles bigger, not smaller. To illustrate, he (with two co-authors) ran a laboratory market, where participants traded a very simple asset (that paid out an expected cash flow of 24 cents every period for 15 periods, giving it a fair value of $3.60 at the start of the trading, dropping by 24 cents each period).  Not only did they find bubbles forming in this market, where the price increased to well above the fair value in the intermediate periods, but that these bubbles were bigger and lasted longer, when they gave traders more money (liquidity) to trade in the market:

In addition, they found that adding liquidity made the bubble bigger earlier in the game. (I strongly recommend this paper to anyone interested in bubbles, because they also explored the effects of adding price limits (like futures markets do), short sales restrictions and experience.) Extrapolating from one experimental study may be dangerous, but if this study holds true, the fact that the private share market is less liquid than a public market may be a check on the market's exuberance, and especially so for young start-ups. Put differently, if liquidity adds to bubbles, Uber, Airbnb and Snapchat would be trading at even higher prices in a public market than they are in the private share markets today.

If you are struggling with the question of why liquidity adds to market bubbles, let me offer one possible explanation. A market bubble needs a propagating mechanism, a process by which new investors are attracted into the market to keep the price momentum going (on the way up) and existing investors are induced to flee (on the way down). In a public market, the most effective propagating mechanism is an observable market price, as increases in the price draw investors in and price declines chase them out. If you add, to this phenomenon, the ease with which we can monitor market prices on our online devices (rather than wait until the next morning or call our brokers, as we had to, a few decades ago) and access to financial news channels (CNBC, Bloomberg and Fox Business News, to name just the US channels) which expound and analyze these price changes, it is no surprise to me that bubbles have steeper upsides and downsides today than they used to. In a private market, we hear about Uber, Airbnb and Snapchat's valuations only when venture capitalists invest in them and our inability to trade on these valuations may be a restraint on their rising. 

A big bubble is not necessarily a bad one
The final component of Mark Cuban's thesis (though I believe that the first three are flawed) is that this bubble is "worse" than prior bubbles. But what is it that makes one bubble worse than another? To me, the cost of a bubble is not whether those invested in the bubble lose money but whether others who are not invested in the bubble are forced to bear some costs when the bubble bursts. It is that spillover effect on other players that we loosely call systemic risk and it is the magnitude of these systemic costs which made the 2007-08 banking bubble so costly.

With this framework in mind, is this young (baby) tech bubble more dangerous than the one in the late nineties? I don't see why. If the bubble bursts, the immediate losers are the wealthy investors (VCs, private equity investors, and private banking clients) who partake in the private share market. Not only can they afford the losses, but perhaps they need a sobering reminder of why they should not let their greed get ahead of their common sense. In a public market collapse, there will be far more small investors who are hurt, and though they deserve the same wake-up call as wealthier investors, they may less equipped to deal with the losses. This could change if institutions that have no business playing in the private share market (like university endowments and public pension funds) decide to invest big amounts in it and screw it up big time.

It is true that there will be side costs, as there are in any bubble. First, when a bubble bursts, the lenders/banks that lent money to companies in the bubble will feel the pain (which does not bother me) and then pass it on to taxpayers (which does). Since young tech companies are lightly levered, these costs are likely to be small.  Second, the bursting of a bubble can have consequences for governments that collect tax revenues from these companies (corporate tax), their employees  (income tax) and investors (dividends & capital gains taxes). Again, since young tech companies are money losers, the vast majority of employees settle for deferred compensation and investors in private markets don't cash out quickly, the tax revenue loss will be contained. Third, every burst bubble carries consequences for the real estate in the region (of the bubble). So, yes, the Bay Area will see a drop in real estate value, and is that a bad thing? I don't think so, since anyone in that area, who is not part of the tech boom, has been reduced to living in cardboard boxes. Finally, I believe that the collapse in the private share market, if it happens, will follow a collapse of young tech companies in the public markets (Facebook, Twitter, Box, Linkedin et al.), which I will take as an indication that it is public markets that lead the bubble, not private markets. 

If this is a bubble, I don't see why its bursting is any more consequential or painful than the implosion of the dot-com bubble. There will undoubtedly be books written by people who claimed to see it coming (perhaps Mark Cuban is vying for a front spot), warnings from the Merchants of Doom (you know who they are) pointing out that this is what happens when greed runs its course and there will be government/market/regulatory action (almost all of it bad, and most of it ineffective) to stop something like this from happening again. So, don't be surprised to see curbs on private share markets or on institutions investing in these markets, as if those curbs will stop the next bubble from occurring. 

Bottom line
Mark Cuban's entry into the ranks of the very rich was greased by the 1990s dot-com boom where he built a business of little value, but sold at the right time . Since that is how you win at the pricing game, I tip my hat to him. For him to point fingers at other people who are playing exactly the same game and accuse them of greed and short-sightedness takes a lot of chutzpah. In fact, Cuban's assertion about this being a worse bubble than the dot-com bubble gives us some insight into one very self-serving way to classify bubbles into good and bad ones. A good bubble is one where you are making money of the excesses and a bad one is one where other people are making money (or more money than you are) from the over pricing. If Cuban is serious about staying out of bubbles, he should look at the largest investment in his portfolio, which is in a market where prices have soared, good sense has been abandoned and there is very little liquidity. In a market where the Los Angeles Clippers are priced at $2 billion and the Atlanta Hawks could fetch a billion, the Dallas Mavericks should go for more, right?