Juggling Dynamite

It is usual for individuals to be self-interested, but pragmatic people understand that durable, dynamic systems require strong counter-balancing forces.  History attests that neither capital nor labor can have it all their way indefinitely. Pendulums swing back and forth over time, because extreme conditions are inherently unstable.

The corporate compensation and financial incentives of the past two decades have been increasingly short-term focused, extractive and destructive for all stakeholders, in the end. New rules and policies will be born of the next global recession and financial crisis, when it becomes painfully clear how poorly resources have been allocated and managed during the latest credit-fueled boom period.

This is not about left versus right, it’s about striking some balance in order to reboot productive conditions for a sustainable economy. Ideas like Senator Warren’s new bill proposal, along with a reinstatement of a ban on share buybacks, as well as greater personal accountability of executives and fiduciaries in all areas, are all key steps that will precipitate the cathartic mean reversion coming.

Jim Cramer sits down with Sen. Elizabeth Warren to discuss her new bill, the Accountable Capitalism Act, introduced on Wednesday. The bill would require large corporations to consider the interests of all major stakeholders in company decisions. Warren also criticized U.S. trade policies that serve corporate interests over the interests of workers.  Here is a direct video link.

Sen. Warren tells Cramer about her plan to make companies and CEOs more accountable to employees from CNBC.

The truth about investment markets is plain, simple and timeless.  When you know what to look for and measure, financial analysis is the relatively easy part.  Maintaining the fortitude and patience to wait for markets and prices to acknowledge reality, is the harder part.  And it is in this aspect that most people fail over full market cycles.  Gary Shilling has invested through more market cycles than most people alive today.

According to a legendary economist — this is how you can beat the economy pic.twitter.com/RPZnpiDr9e

— Business Insider (@businessinsider) August 15, 2018

We have been working on this important topic for our upcoming month end client letter, and yesterday Senator Elizabeth Warren threw down the gauntlet in a Wall Street Journal op-ed proposing an Accountable Capitalism Act requiring corporations with $1 billion+ in annual revenue to operate under a federal charter where their directors must consider the interests of all major stakeholders—not only shareholders—in decisions. Shareholders could sue if they believed directors weren’t fulfilling those obligations, and employees would elect 40% of corporate board members, see Companies shouldn’t be accountable only to shareholders.

These measures seek to turn corporations back from the current myopic preoccupation with short-term financial gimmicks to a pre-1982 style focus on balance sheet strength and long term investment, while balancing the interests of multiple stakeholders including employees, lenders and public health.  Warren’s article offers a good factual summary of some key points:

• As recently as 1981, the Business Roundtable stated that corporations “have a responsibility, first of all, to make available to the public quality goods and services at fair prices, thereby earning a profit that attracts investment to continue and enhance the enterprise, provide jobs, and build the economy.”
• Late in the 20th century, the economist Milton Friedman posited a new theory that corporate directors had only one obligation: to maximize shareholder returns.
• By 1997 the Business Roundtable declared that the “principal objective of a business enterprise is to generate economic returns to its owners.”
• In the early 1980s, large American companies sent less than half their earnings to shareholders, spending the rest on their employees and other investments. Between 2007 and 2016, large American companies dedicated 93% of their earnings to shareholders. The wealthiest 10% of U.S. households own 84% of American-held shares.
• In the 40 years after World War II, shareholders on net contributed more than $250 billion to U.S. companies, since 1985 they have extracted almost $7 trillion.
• Before 1980, top CEOs were rarely compensated in equity. Today it accounts for 62% of their pay with incentives focusing on short-term share-price increases.
• The average CEO of a big company now makes a record 361x what the average worker makes, up from 42x in 1980.

It is clear that current policies are self-destructive–not only of social stability, our economy and natural resources, but also for the longevity and financial strength of corporations themselves. Change is inevitable, because the current approach is self-defeating.

All of this should be a warning for those holding corporate shares at record high valuations of heavily ‘financialized’ reported profits.  Price to earnings multiplies that are egregious now will look insane once share buybacks slow and organic growth rates move down toward historical norms–and they will.