Friday, February 20, 2009
Regulators Need To Fix Dividend & Share Buyback Schemes
Possibly my most important posting this year.... This is not the crux of the problem we are facing but is part and parcel of navigating the "compensation culture" of Wall Street and high-falutin' CEOs. Excessive risk taking has been the center of what brought the credit markets to its knees. The compensation culture is one where the base salary is only a fraction of these people's compensation packages, even though for many of them the base salary is already more than $1m. In Wall street, the culture is even more evident in that analysts and bankers get between $100,000-300,000 as their base salaries but there is a tacit understanding that their overall compensation will be in multiples of their base salary - and not in number of months like the rest of us. Hence many of them argue that the compensation cap by Obama will not work. Its like saying "don't throw us in prison as there are too many of us"...
An article by David Reilly, Bloomberg news columnist, wrote recently that there need to be a revamp of the way companies pay dividends and do share buybacks. I totally agree. Dividends that are steady, predictable and "high-ish" will always attract the longer term funds as solid shareholders, thus propping up share prices. As the CEO, your destiny is tied to the share price, thanks to the finance literature over the last 20 years which says that the CEO and senior management's goals, objectives and compensation must be tied to the share price performance - which indirectly implies that shareholders interest are served. BUT ARE SHAREHOLDERS INTERESTS BEING SERVED PROPERLY?
The compensation maniac rise over the last 10 years and the current crisis basically reinforced to us that shareholders interests are not best served under current system of tying in share prices to compensation.
The current system will make almost all CEOs to aggressively pay out strong dividends or have a strong dividend policy, and worse still, engage in frequent and at times excessive share buybacks. Share buybacks in the US are usually then canceled (unlike in Malaysia, which defeats the purpose) and that will improve the EPS by a corresponding amount, which will then move share prices higher if forward PER ratings and valuations stay the same. That is because the bulk of the CEOs and Wall Street compensation rides on share options.
The danger with Obama's pay cap is that much of the additional compensation will be paid via shares, although they will only vest after TARP money has been fully repaid. Thus, I can already predict what the CEOs will be doing once they get profits rolling again:
a) pay down TARP
b) improve dividends
c) buyback shares
The only difference is that they will pay down TARP as a new priority. It does not change the compensation culture. Especially in times like this any free cash flow should be used to shore up balance sheet and increase your capital standing and sufficiency, not paid back via dividends or doing useless share buybacks.
I can soften the blow for dividends, its good and essential to encourage long term shareholders to hold onto good stocks for a long time. I do agree that if a company can, they should pay good dividends, above the company's capital requirements for normal growth strategy. It would be prudent to have a proper dividend policy (e.g. percentage of profits that goes into dividend pool; or targeting a dividend yield year in year out). But do not do haphazard dividend payments one year from the next, it is unprofessional and unpredictable, and will cause valuations to be marked down.
Here is where we need more bite from the board of directors, especially the independent ones. New guidelines by the SEC should be furnished to the directors to ensure that dividends and share buybacks are backed by a solid grasp of business fundamentals and industry trends.
Share buybacks are only OK if shares are subsequently canceled, otherwise the CEOs have no fucking idea what share buybacks are supposed to do. Trashing share buybacks was my very first article for this blog, so its ranks very high on my list of piss-me-off-silly issues. However, owing to the compensation culture in Wall Street and among CEOs in the US, the share price is like their religion. Thus they will engage in excessive and frequent share buybacks, EVEN when they are not necessary - this will lead to a depletion of capital, and hello... what are really troubling the banks nowadays.... They have pushing a lot of free cash flow into share buybacks, depleting capital, pushing up EPS... and yet leveraged up even more on their remaining lesser capital.
Now, oops, they need more capital... We need a regulatory body to oversee the amount of shares each company is buying back and reassess them as normal capital requirements for the companies in those industry. For example, between 2003 and 2007, Citigroup paid out $44bn in dividends and spent $22bn buying back stocks. If they had slashed their dividends by half and not do any share buybacks, they would have an additional "capital" of $44bn. But noooo... the compensation culture is such that every time these buggers see some money flowing into the coffers, they will think of ways to use them immediately, always running on the edge, skirting between raindrops... maximising every dollar. Capital is there for a reason, ... to fund growth , AND TO HELP THE COMPANY RIDE OUT BUSINESS CYCLES & MAYBE CATACLYSMIC RECESSIONS.
Is there anybody out there???
p/s photos: JJ