The Capital Shell Game: Liquidity & Value
A principal tenet of shareholder wealth theory is that excess returns beyond those necessary to operate the business and fund capital expenditures should be returned to the shareholders who will most optimally reinvest. In a goods and ideas producing economy, this mechanism worked reasonably well. Shareholders would reinvest dividends and capital gains in companies that innovated and produced high quality products at competitive prices. This very much characterized the American economy from the end of WWII until late in the last century.
In the 80’s, a tectonic shift began to take place, however, as investment banks diversified from the traditional role of advising businesses and conventionally raising capital with securities and bank debt to create financial products and ultimately financial markets. These products grew ever more arcane as the banks competed for the best mathematicians and physicists MIT, Harvard, Princeton and Chicago had to offer.
Eventually, these instruments became Frankenstein algorithms whose creators could not divine or control unintended consequences. As many of the products were designed to trade outside the regulatory realm, investment banking enjoyed a shelter where the sheer velocity of trading produced billions of dollars of liquidity with no underlying value. Even something as basic as the Dow Jones Industrial Average grew from roughly eight million shares of daily trading in 1980 to four billion today.
As long ago as 1637 in Holland when a single tulip bulb could sell for ten times the annual salary of a skilled craftsman, financial investments detached from underlying value are not sustainable. In the global financial crisis, which began in 2007, the problem could be generalized as a lack of capital reserves to support the debt creating the illusion of liquidity. In the simplest rendition, homeowners borrowed more than their houses were ultimately worth when the real estate market crashed.
Investment banking functioned on the same flawed principle, only in far more complex ways. A credit default swap, for instance, is in fact insurance against the failure of a financial instrument or institution. However, because it is arbitrarily designated a swap and not insurance, it isn’t regulated under federal law and thus is exempt from having adequate capital reserves to back it. Without these reserves, the investment banks were unable to withstand what in commercial banking would effectively be “a run on the bank” and so, Bear Stearns and Lehman Brothers, after a century of business, fell in a matter of days. Others, “too big to fail”, were bailed out by the federal government.
The repeal of Glass-Steagall in 1999 was an accelerant as commercial banks became free to assume the trading and investment functions hitherto limited to merchant or investment banking. As a result, commercial banks began shifting deposits from lending to trading. Today, only 8% of bank deposits are lent to businesses.
Concurrently in the 80’s, a new investment entity was emerging in the form of private equity. Much in the news now because of Mitt Romney’s tenure at Bain & Co., private equity firms do invest in companies that produce goods and services, following the postwar model but tend to do so from a short-term financial play as the typical private equity investment lasts five years or less.
In 1980, there was about $5 billion in private equity investment. By 1995, that figure had climbed to $125 billion. Currently, according to Bain, private equity firms have nearly one trillion dollars of uninvested capital. In the same report, desirable private equity investments were characterized as having strong cash flow while requiring low capital expenditures and limited working capital. Indeed, it’s an attractive low-risk investment profile but one unlikely to create jobs or new products.
Private equity doesn’t tangibly invest in products, brands or people but rather, in financial statements. Products are inventory, brands are marketing expense and people are overhead. The goal is to minimize these costs to increase return on assets and return on equity. While a seemingly indisputable goal, when the investment horizon is short, the financial engineering may destroy the long-term competitive viability of the company after the investors have broken camp. Tangible capital is often destroyed rather than created, instead merely providing liquidity to start the cycle again.
The destruction of tangible capital is by no means limited to private equity. Publicly traded firms have similarly shifted from creating capital to creating liquidity. Since the beginning of the credit crisis, U.S. companies have accumulated nearly a trillion dollars in cash while capital expenditures have fallen 26%. Granted, there is little incentive to invest when there is excess capacity at hand yet these are not all smokestack firms that have competitively lost out overseas. Among them are Cisco with $40 billion in cash, Microsoft with just under that amount and Google with $35 billion. In 1980, total corporate net cash flow was around $200 billion; in 2011, it was just short of $2 trillion.
Far and away, the largest use of corporate cash is for takeovers. In 2011, global merger and acquisition activity exceeded three trillion dollars. In some cases, synergies are created that revitalize one or both entities but more often, the consolidation results in the elimination of jobs, plants and products. In 1980, there were 20 million manufacturing jobs in the U.S. Today, there are 15 million. When one considers that most of the high-tech industry has developed since 1980, our core manufacturing has probably fallen below 10 million. Some of this decline is attributable to greater productivity and the reliability and wearability of durable goods as well as a greater proportion of income being diverted to services such as medical care by an aging population. Nevertheless, one is more often surprised to see that a product is imprinted with ‘Made in the U.S.’
Without a change in incentives to invest in value producing capital, ten percent unemployment will be institutionalized and, correspondingly government will continue to grow to provide the income and services for the disenfranchised. This is not an apology for lack of initiative but simply stating a fact that an uneducated and unskilled work force cannot create jobs or services.
The American education system has become biased toward high value technicians—engineers, researchers, systems analysts—who comprise but a fraction of a complete work force. So, even where there are jobs, the jobs go unfilled for want of qualifications. Someone in a local high-tech firm recently lamented that he had fifty open jobs but couldn’t find qualified applicants.
Even if educational reforms were instituted, the stubborn fact remains that America doesn’t make things anymore, instead having first shipped jobs offshore, then capital, then knowledge. It remains to be seen if we can still create industries around technology to come. If instead, we continue on the present course, productive capital will continue to decline, unemployment will continue to grow and the gap between rich and poor will come to resemble the social fabric of 18th century Europe.