Trickle up economics?

There’s been a lot of talk lately about the “Trump Bump” and why the market has chugged to record highs. Investors are certainly optimistic about the future and where the market is going, pushing stocks up in their wake.

It’s all about tax reform, regulatory reform, and stimulus spending, all of which will improve the bottom lines of companies. Investors are cheering and stock prices are rising as a result.

Last week it was the turn of the airline industry, and after a meeting with Trump to discuss those exact policy proposals, airline stocks jumped, with JetBlue ($JBLU), American Airlines ($AAL) and Delta ($DAL) each rising more than 2%.

Whether these policies come to fruition is still up for debate, but the motivation is there and investors are optimistic. There is little debate about whether this administration is pro business or not. It’s all about HOW pro business it is…

So good news for corporate America is good news for everybody, right? The argument is that companies will take their extra profits and reinvest them back into their businesses, innovating, expanding, developing new products and hiring new workers.

So is this true? Will this happen?

Let’s start by saying that US corporations are already immensely profitable. They pulled in almost $1.6 trillion in after-tax profits in the third quarter of 2016. That’s just under the record of $1.7 billion. That’s a huge amount of money.

But the overall US economy is not growing. Real GDP growth is a weak 1.9%, well below the historic average of 3.22%. And Wages for average Americans have also not kept up, having been stagnant for years. So on the surface, companies are not spending their record profits to boost growth or to raise pay.

The hope is that companies will reinvest their profits into their business. Maybe they will spend it on research and development, or to expand their business, hire new people and create new products. And the hope is that this investment will trickle down to the general US population through higher employment and higher wages. So maybe this administration’s policies are the shot in the arm that the middle class has been waiting for.

Unfortunately, early indications are not positive.

A telling sign came from Cisco Systems CEO, Chuck Robbins, on CNBC’s Squawkbox. When asked what he would do if the US government gave him a tax break to repatriate company cash that sits overseas (which for Cisco is $60 billion), he said “a combination of dividends, share buybacks and M&A activity.”

Ummm… How about R&D, opening US plants, hiring US workers? Nope… Not on his list.

Just so you know, share buybacks, dividends and mergers really only benefit the shareholders of companies. Company money goes to shareholders as cash (with a dividend) or as a boosted stock price (share buybacks and mergers). For Cisco at least, there is no talk about putting that money back to the overall economy through higher wages, spending on innovation or increased employment. So in this case people, in general, get very little of the benefit from those policies.

The underlying theory that backs these strategies is called “Shareholder Value Theory” and it holds that company polices should be guided towards maximizing value for shareholders. It makes some sense that companies should be focused on building value for shareholders. If a company is doing well, then why shouldn’t shareholders be rewarded?

But the idea of making this the “goal” of a company has its detractors. Jack Welsh, the ex CEO of GE calls it “the dumbest idea in the world”, Harvard Business Harvard Business Review has called it “stock price manipulation” and Reuters calls it “corporate self-cannibalization”. The best quote comes from the Economist magazine, which calls this behavior “corporate cocaine”- it makes you feel great in the sort term, but is addictive and ultimately destructive.

Dividends, buybacks and mergers may be loved by shareholders, but they do little to build the long term value of a company. It is not investing in the future. There are no new ideas or products that are built off of these policies. They are just short-term policies that boost stock prices.

How pervasive is this focus on shareholder returns? Well, it’s everywhere. This WSJ article showed that spending on share buybacks and dividends S&P 500 companies increased from 18% of operating cash flow to 36% between 2003 and 2013. In the same period, those companies decreased spending on plant and equipment from 33% of operating cash flow to 29%.

More evidence comes from the behavior of private companies. This study by economists from the Stern School of Business and Harvard Business School showed private U.S. companies reinvest cash into their companies nearly twice as much as those listed on the stock market: 6.8% of total assets versus just 3.7 %.

And the short-sighted vision of these policies can be glaring. Between 2006 and 2008, US financial firms spent $207 billion on share repurchases. By the very next year, taxpayers had injected $250 billion back into the banks to keep them from collapsing. “You’re welcome banks” (say all the US taxpayers).

Just Exxon-Mobil, on its own, spent over $200 billion on stock repurchases between 2003 and 2014. That’s enough money to buy their biggest competitor BP outright.

Oh, and check out this strange coincidence. As stocks rise, so too do CEO paychecks… With CEO pay being more tied to stock price and earnings per share, CEOs have seen their wallets get fat. Between 1978 and 2013, CEO pay increased by 937%. Too bad worker pay didn’t follow suit.

And that’s the rub of this Trump Bump. As a shareholder, YOU will most likely benefit from all of this talk about deregulation, stimulus and tax cuts. Dividends and share buybacks can inflate the value of your portfolios. But be careful. Stock bumps that based on benefits that only go to shareholders are short-term policies.

And if you’re interested in the bigger picture of things that benefit the economy and employment, these polices may do little to help those further down the economic ladder. So will the profits generated by the Trump Bump trickle down to middle class workers? You shouldn’t be too optimistic.

At GoldBean we want people to become investors because it is the best way to get a share of the economic benefits that come from things like a Trump Bump. But keep your eye on what companies do with that extra cash. If companies use it to innovate and stimulate, then that’s a good sign. And everybody benefits. If they give it back to you, the shareholder, enjoy the bump. But understand that the party may end one day.

 

 

 

 

 

 

 

 

 

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