Wednesday Wisdom

Blank check

As the pandemic raged in 2020 and austere measures to battle the spread of Covid were enacted, the economy moved into severe negative growth resulting in travel and hospitality business coming to a standstill. Citing massive losses and layoffs, the airline industry went to congress seeking a relief package to survive the crisis. This begs the question of why did they need so much money, so quickly after a ten-year bull market and stable growing economy? Surely, they had plenty of capital in their treasury after so many good years to ride out the storm. Or why not go to the capital markets and raise new equity or debt?

50 years in the making

Post WWII and as the Cold War heated up, the democracy versus communism struggle was not just one of geopolitics but also of capitalism versus socialism and good versus evil. In 1962 famous economist Milton Friedman published a book "Capitalism and Freedom" which framed an argument for capitalism and how economic freedom leads to political freedom. In 1970 Friedman elaborated on these themes in his highly influential essay in the NY Times, "the Friedman Doctrine; The Social Responsibility of a Corporation is to increase it's Profits"* Friedman postulated the virtues of capitalism while arguing a corporations only moral obligation was to the stockholder. He argued that executives of a company that adheres to the doctrine of social responsibility is wasting company resources and engaging in the doctrine of collectivism. As MBAs infiltrated the boardroom in the late 70's and 80's with this economic philosophy in tow, corporations turned to financial engineering as a tool to raise the company's stock price by creating a new marginal buyer, the corporation itself. Financial engineering is (in context of corporate balance sheets) the mathematical practice of a company using the mix of equity and debt instruments to achieve a maximum stock price and thus fulfilling their obligation to the shareholder. The premise is by reducing the number of shares in the market, the stock looks attractive when compared to its earnings and thus a rise in the stock price. This is the capital principle called "maximum shareholder value".

Up, Up and Away

So why did the airlines need capital infusion and what happened to all the cash in the airline corporations? They initiated aggressive stock buybacks to produce short term stock appreciation. Since around 2010 airlines have been using their cash and debt to go out a purchase their own stock which is called a "stock buyback". According to Bloomberg news, the airlines have spent 96% of their free cash flow** this decade on stock buybacks and in 2019 this went up to 104%. The airlines also issued massive debt while burning through cash for these buybacks which increases the risk of solvency through this debt which is known as leverage. Illegal? certainly not, but it bites of ethical impropriety where shareholders profit on gains while socializing losses through taxpayer bailouts. If we look back at Friedman's influence, we might conclude that there is no coincidence that this type of financial engineering magically became legal in 1982. Stock buybacks were previously illegal because it was considered to be market manipulation and deemed risky to the financial system. What changed? the belief in unfettered capitalism and that free markets are fairer markets. We must also concede that there was aggressive lobbying from wall street and their army of MBAs, which knew financial engineering and buybacks would be a profitable to a business in the short run.

Lender of last resort - WHO? YOU

While maximizing shareholder value is an important construct of a corporation, it falls short as a mission statement for an entity to build a sustainable and profitable business. It encourages short-term thinking and financial engineering to support quarterly earnings. It also leads to a moral dilemma where a company takes on more risk knowing that taxpayer money will bail them out in a time of crisis. This concept arguably was institutionalized by the Greenspan Federal Reserve in 1987 and is known more commonly by the moniker "too big to fail". We have seen this scenario too many times between the airlines, the banks and the auto industry which were all deemed too important to the economy and to the labor market and thus “too big, to fail”. We have also seen the federal government recently deem the chips industry as critical to country and the passage of the “CHIPS Act” provided incentives, tax breaks, loans and grants to onshore chip manufacturing. More recently the federal government has taken a 10 percent ownership in chip manufacturer Intel in what can be only called “State Capitalism”.

Reforming Capitalism

Two factors may accelerate the discussion that is already under way in this country about re-thinking capitalism. Corporate bailouts certainly will bring greater scrutiny to companies that have been engaged in buying back stock without preserving a rainy-day fund. The second factor is wealth inequality, which is at its greatest margin since the depression of the 20's and has been magnified by hard assets appreciating for the wealthy over the last few decades while incomes remained stagnant. This inequality has brought rallying cries from activists and politicians which, too often leads to condemnation of capitalism as a whole. However, there are many in the business community and as well as academics that have recognized this issue as unsustainable and believe financial engineering as a means to an end must evolve. A proposal that has been discussed over the years is semiannual reporting versus quarterly to reduce some short-term thinking and number massaging has some merit. The crypto industry has also brought the concept of community and staking to the forefront as it continues to merge with traditional finance. In the crypto industry token buyers’ “stake” their tokens to help support and secure the blockchain network and participate in the revenues of the network.

Companies must look to better align the risks and rewards for investors and the managers while creating productive value as opposed to only purely financial value.

Goodbye Gordon?

In August of 2019 at Business Roundtable, the very issue of what a corporation's mission should be and who that corporation represents was discussed. Nearly 200 CEOs and executives agreed in principle for a new definition of a corporation in what is known as "stakeholder capitalism". In this mission or principle, the corporation recognizes the importance of stakeholder to the corporation. This means acknowledging that the customers, the employees, the suppliers and the local community alongside the shareholder all have an interest in the company’s success. The results have been mixed for the traditional finance and capital markets over the years since the pledge has been signed.  

In the 1980 movie Wall Street, Gordon Gekko played by Michael Douglas, delivered the famous line "greed is good" which epitomized not only the 80s but also the “shareholder principle”. Will "stakeholder capitalism" rebuke of Gekko lead to a reformation for a more inclusive and ethical form of capitalism? Will the tokenization of markets as traditional finance merges with crypto industry bring more transparency and a fairer market?

Trends worth watching and only time will tell....

*https://www.nytimes.com/1970/09/13/archives/a-friedman-doctrine-the-social-responsibility-of-business-is-to.html

** there are several ways to calculate free cash flow but in this example:

FCF = Cash Flow from Operations - Capital Expenditures (CAPEX)

And now you know...

Philosophy is the art of thinking, the building block of progress that shapes critical thinking across economics, ethics, religion, and science. 

METAPHYSICS: Literally, the term metaphysics means ‘beyond the physical.’ Typically, this is the branch that most people think of when they picture philosophy. In metaphysics, the goal is to answer the what and how questions in life. Who are we, and what are time and space?

LOGIC: The study of reasoning. Much like metaphysics, understanding logic helps to understand and appreciate how we perceive the rest of our world. More than that, it provides a foundation for which to build and interpret arguments and analyses. 

ETHICS: The study of morality, right and wrong, good and evil. Ethics tackles difficult conversations by adding weight to actions and decisions. Politics takes ethics to a larger scale, applying it to a group (or groups) of people. Political philosophers study political governments, laws, justice, authority, rights, liberty, ethics, and much more.

AESTHETICS: What is beautiful? Philosophers try to understand, qualify, and quantify what makes art what it is. Aesthetics also takes a deeper look at the artwork itself, trying to understand the meaning behind it, both art as a whole and art on an individual level. A question an aesthetics philosopher would seek to address is whether or not beauty truly is in the eye of the beholder.

EPISTEMOLOGY: This is the study and understanding of knowledge. The main question is how do we know? We can question the limitations of logic, how comprehension works, and the ability (or perception) to be certain.