The Bear’s Lair: Financial engineering fuels U.S. weakness

The sale to a Chinese company in 2016 of one of the world’s largest cobalt sources, controlled by a U.S. company Freeport McMoran (NYSE:FCX), is emblematic of U.S. national weakness, “wokeness” and decline. However, one underlying cause of that sale was the blizzard of stock buybacks and unsound acquisitions made by FCX in the years preceding its hurried liquidity-seeking selloff. The ability of corporate management to play games with the balance sheet to maximize its own rewards is a major source of U.S. competitive weakness and should be eliminated.

FCX is not a uniquely incompetent company but was typical in its approach of the corporations seduced by the wisdom of General Electric’s (NYSE:GE) “Neutron Jack” Welch, who led that company from 1982 to 2000, leveraging it to the hilt, engaging in innumerable strategically fatuous acquisitions and paying himself Pharaonic remuneration via stock options and the rise in the stock price. It has taken 21 years under Welch’s successors Jeff Immelt and Larry Culp, for GE to collapse and be broken up, but that is a result of the ‘funny money” policies pursued throughout, which have allowed corporate weakness to perpetuate itself. For a company of GE’s size, death after Welch’s ministrations should probably have taken 5 years in a well-run economy; in our economy it has taken 21, with the zombie gulping up precious resources in the meantime.

FCX is historically a miner of gold and copper, with other projects in “strategic metals” such as its long-standing cobalt mine in Democratic Republic of Congo (DRC), one of the largest cobalt deposits in the world. Like many companies in its businesses, FCX engaged in massive stock buybacks in 2006-07 when its stock price was strong, to the tune of no less than $2.8 billion in the fourth quarter of 2007, when to discerning observers the writing was already on the wall for the world financial system and economy. Then it did an “emergency” stock issue of $740 million at the bottom of the market in the first quarter of 2009, thereby destroying substantial amounts of its’ shareholder value in less than two years.

In the next sharp cycle in the metals market, after 2011, FCX management got the bright idea of using the gigantic amounts of cheap debt available to diversify into the oil business. Regrettably, knowing nothing about the oil business’s own cycles, they did this in 2013, a year before the oil price fell out of bed. Consequently, by the end of 2015, FCX had over $20 billion of debt, not enough revenues to service it properly, and a share price in the low single digits. The solution was obvious: panic sales to pay off debt. FCX sold much of the oil operations it had bought only three years earlier (at a huge loss, naturally), it undertook yet another $1.1 billion share issue at an infinitesimal price and as outlined in the New York Times last week, it sold the DRC cobalt mine to a Chinese company.

It was known even in 2016 that cobalt is of immense strategic importance in a world that is battling climate change, being a key ingredient in electric-automobile batteries (the Paris Agreements had been signed the previous year) and it was already clear that Xi Jinping was leading China into more aggressive confrontation with the West. From a strategic viewpoint, therefore, FCX’s cobalt mine sale in 2016 was a disaster from the day it was signed. (From a financial viewpoint it was also a disaster, but that was a problem mostly for FCX’s shareholders.)

Overall, the general rule is clear: financial engineering in general and share buybacks in particular not only lose money for shareholders but impose an immense strategic cost on the U.S. economy, because of the likelihood of panic asset sales at the bottom of a business cycle. U.S. capitalism, which fifty years ago was the envy of the world because of its flexibility, has been turned against itself by excessive financialization.

This takes several forms, each of which can be addressed separately. First, large mergers and acquisitions have become too easy, even when the asset is strategic and the buyer is an agent of a potentially hostile foreign power. Building even a modest new mine or manufacturing facility can take a decade because of the harassment tools available to ill-wishing environmentalists and selfish NIMBY local residents. However, selling an existing facility to a strategically hostile buyer can be accomplished in weeks. Theoretically, sales of U.S. strategic assets are subject to review by the Committee on Foreign Investment in the United States (CFIUS), but that only applies to domestic assets. A foreign asset such as FCX’s DRC cobalt mine may have taken decades to create and involve all kinds of favor-swapping between the U.S. government and the local bunch of kleptocrats, but in that case CFIUS is not involved. The acquisition mania of U.S. companies, both for buying assets and for divesting them (often forced by previous foolish purchases) is economically completely counterproductive. Most acquisitions lose money for the buying company’s shareholders, but often such acquisitions involve bonanza payoffs for both sets of management. A “stickier” and less active market for corporate control would be wholly beneficial.

Management stock options have become a much more important part of top management’s pay packages since a tax “reform” of 1993 that effectively outlawed base salaries above $1 million. Since corporate management are as subject to greed as the rest of us, giving them a huge incentive to cook the books, report outsize profits and pursue short-term get-rich-quick strategies has been a disaster. Without such strategies, FCX would not have wasted the good profits of 2007, nor would it have leveraged itself up to the eyeballs in 2013, because its management would have valued long-term stability in a highly cyclical business above any short-term gains. Reversing the tax law revision of 1993 and incentivizing base salary above fly-by night bonus and option schemes (maybe penalizing the latter) would ensure that U.S, corporate management took fewer risks and focused more on the long-term. It might also work fewer hours and play more golf, but that too would probably be beneficial to the shareholders!

Stock buybacks, other than through a formal tender offer to all shareholders, were thought to be “insider trading” until an SEC ruling of 1982; we would be much better off if the SEC had kept its opinion to itself. As the FCX example shows, if a business has any kind of cyclicality in it, top management will engage in huge stock buybacks to boost the value of its stock options in good times, then be forced to undertake emergency stock issues or worse still panicked asset sell-offs in bad times. As a result of excessive stock buybacks, even such cyclical companies as Boeing (NYSE:BA) are now running with gigantic amounts of debt and no equity at all, having bought back stock at the peak of the market. Corporate managements become blinded by greed, hence incapable of determining when the stock is overvalued, thereby destroying huge amounts of value for outside shareholders, who are diluted or impoverished by the inevitable stock and asset sales in the next downturn. Given the perverse incentives involved, this is a financial engineering tool far too dangerous to be permitted; it should be outlawed altogether.

Finally, the worst buy-high, sell-low extremes are always the result of excessive leverage, which has increased enormously in the last 50 years, from three causes: “funny money” monetary policies, daft “efficient market” academic theories about stock valuation and the tax-deductibility of debt interest. Stopping “funny-money” policies is a decades-long campaign in which I hope eventually to prove successful, but probably not under the Biden Administration. Daft academic theories are a force of nature, that no power of God or Man can prevent. However, the tax-deductibility of corporate debt interest payments is an excessive incentive to borrow money and deprives the Treasury of much-needed revenue; it should be abolished.

I am a former banker and indeed financial engineer; in theory I welcome financial engineering, and the possibilities it provides to corporate managers. In practice, however it has produced a greedy short-termist corporate culture that destroys long-term investor value and benefits only America’s strategic rivals. It should be disabled, as far as is possible.

(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.)