Peabody Energy (NYSE:BTU) share price fell 17% last Monday on news it had made $534 million in margin payments, hedging against the price of its main product: coal. Investors may justifiably feel aggrieved; they successfully called a revival of the coal market, only to be thwarted by an amateurish management that thwarted them. Not to dunk on Peabody in particular, but it raises the question: would today’s corporations be better off if they operated without any top management at all?
Ordinary retail shareholders are a pretty bright lot – the forces of economic Darwinism ensure a brisk natural selection, so that those retail shareholders who lack acuity tend to lose their shirts. This has been true for a very long time; I remember in my Investment Management class fifty years ago the professor telling me that the average stock market return since 1926 was 9.2% while the average institutional rate of return was 8.6%. “From which” I pointed out in a misguided attempt at class participation “it therefore follows by the laws of arithmetic averages that there are little old ladies out there who are stomping the institutions.”
This has been true ever since. Institutional investors have become an increasing part of the market, but they can be divided into two segments: the dozy drones who work for the large pension funds and investment funds and the greedy sharks who work for hedge funds. The dozy drones have consistently modestly underperformed the market from the 1970s to today; they are just a little bit slow on picking up new information and just a little bit sheep-like in analyzing it. The sharks analyze everything very quickly, but they have the investment timespan of about ten minutes, thundering into sectors that are just about to fall apart and losing their shirts. The best retail investors, thoughtful and neither drones nor sharks, outperform the lot of them.
Corporate management has never been noted for its respect for its retail shareholders (it pays vast attention to the larger institutions, and fears like the plague any hedge funds who acquire significant stakes). Once upon a time, there were correctives for this; shareholders’ meeting were held in person, and always likely to contain the ancient founder’s granddaughter who just happened to control 2% of the shares, and could blight the career prospects of any top managers who got uppity. Alas, with mergers and the passage of time, not to speak of the virtualization of the shareholders’ meeting, such useful figures have disappeared, knitting needles and all.
Not only does modern management have fewer restrictions from shareholders second-guessing their decisions, they also have new tools with which they can damage shareholders’ interests. The most dangerous of these are financial: the derivatives markets, stock options and stock repurchases. However, management has also shown a reckless disregard of shareholder interests in its adoption of ESG (environment, social and governance) strategies, and in its construction of rickety global supply chains that raise profits in the short-term but leave companies, their shareholders and their economies in huge peril whenever even the slightest headwind hits the world’s politics.
Derivatives are dangerous toys, that corporate management should not be allowed to play with – I speak as someone who ran derivatives platforms for half a decade. Using them, management can back its (inevitably inferior) judgement of the markets against the professional traders and market participants who dominate them, attempting to obscure their own failures in a blaze of derivatives profits.
Naturally, this doesn’t work; in general the derivatives profits arise only when the business itself is making catastrophic losses, and immediately get discounted by lenders and analysts alike. Conversely, and infuriatingly, investors who have seen a favorable outlook for the company’s products find their expectation of good profits blasted by a blizzard of derivatives losses as management has of course bet against favorable market trends for the company’s own products.
Most damagingly, since the accounting for the derivatives positions differs from the accounting for the underlying operations that they are supposed to hedge, the company’s profits become completely obscured, and it becomes impossible to work out how much money it is really making – of course, in many cases that is management’s objective in using derivatives in the first place.
There is little economic benefit to management’s use of derivatives; everybody’s life is made simpler by companies that swear off them and allow the world to see exactly how they are doing and, if necessary to provide emergency funding in times of crisis in an atmosphere of economic clarity about the position and prospects of the business.
Stock options and stock repurchases work together; the options allow management to reward itself for poor performance by awarding itself new more generous options when the stock price is low, while stock repurchases allow the company to leverage itself ad infinitum in good times to push up the stock price and reward option-incentivized management even more generously. As I have previously written, stock repurchases in a cyclical business very often produce the farce of large purchases in good times, when prices are high, followed by emergency stock issues at low prices when the over-leveraged wreck runs out of money.
Stock options and repurchases have an even more damaging underlying effect on the company’s health and its shareholders’ wealth: they encourage management to manage the company to produce quick short-term profits while neglecting the long-term investments that allow the company to flourish in the far future. Consultants worsen this tendency; they provide managements with all kinds of cost-cutting gimmicks, that goose near-term earnings while weakening long-term viability. These tools ensure that most managements do more harm than good, as far as their shareholders are concerned.
ESG strategies are specifically designed to damage the interests of shareholders, since the Business Roundtable and other groups that back them seek to put the interests of non-shareholder “stakeholders” ahead of economic returns. Even if ESG requirements were sensible (which in a few cases, notably governance, they are) they require the not-very-bright corporate management to focus on too many things at once. In practice, companies that take ESG most seriously have shown themselves the worst at running the actual business. This is unsurprising; managers are educated in business schools that inculcate a prescribed way for dealing with the complexities of life; if that way changes or is corrupted by ideological additions that damage shareholder interests, managers are generally unable to cope with the conflict and so fail at both sides of their objectives.
Finally, we are now seeing the cost of the 21st century fad for believing Thomas Friedman’s absurd assertion in 2005 that the world is flat and constructing impossibly baroque supply chains for straightforward products to save a few cents of manufacturing costs and boost quarterly earnings and stock options profits. Just because the Internet has enabled you to manufacture your supplies in Ulan Bator doesn’t mean you should do so. Each extra link in the supply chain adds inordinately to the complexity of shipping a product to the customer, even if plagues, wars and volcanoes do not interfere – and as the last few years have shown, they inevitably do. Supply chains should be kept short and simple; needless to say if this is done, they will then need far fewer top management to manage them.
Companies need middle managers; somebody has to manage the shop floor, sell the product and count the beans. But human resources departments add cost with no benefit, and it has become increasingly clear that the same is true of top management. Cut back the overpaid drones as far as possible and motivate the remainder mostly with a moderate salary and maybe a bonus of 10% or so for a good year. Not only will shareholders save costs directly, they will no longer be subjected to the innumerable intolerable burdens that a modern overpaid woke top management imposes.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)