June 10, 2014

Sunday Reflections, Now v. Then: Part 2) How Corporations Use Profits

Sunday was another unusually nice day, with low temperature and humidity. I spent a lot of time in my favorite spot, the rocking chair on the back porch. Just rocking and musing. 

I thought about Saturday's Gay Pride parade and wrote about it in yesterday's post. I also thought about an interesting conversation I'd had on Saturday with a young friend who was visiting the house. He asked me for advice with his investment plan. So we started talking about today's investment climate, a conversation that gave this old man a chance to discuss the differences between circumstances back in my day and now. 

He said his small start-up portfolio was doing OK, averaging a nine percent return in the brief time he'd had it. In light of that positive growth, he wondered why so many of his friends and other recent college grads were having job troubles. Either they couldn't find jobs at all, or they were working as bartenders, waiters or other jobs that didn't require a college degree. They weren't doing anything to enhance their long-term career prospects. "What's going on?" he asked.

The next day, from the comfort of my rocking chair, I worried that I'd dominated the conversation with a mini-lecture on how companies used their profits in "my day," and what they're doing now.

Not an expert, I had focused on two big differences: 1) executive vs. employee compensation, and 2) how corporations use their profits.

First, some background. I was hired in 1955 as a junior editor at BNA, a unique publishing company that was 100% employee owned until it became Bloomberg/BNA a few years ago. I stayed at BNA for 40 years, retiring at the end of 1994. I moved up the ladder from junior editor to managing editor to associate editor and ended up as VP for human resources.

Getting hired as a full-time employee, moving up the ladder, staying with the same company for 40 years, retiring with a defined benefit pension plan... that progression was fairly typical for those of us lucky enough to be hired during the century's third quarter, 1950-1975. Now, that kind of career trajectory is completely atypical.

My young visitor had been exceptionally fortunate to have attained employee status at his firm, but it took two years. Companies these days, seldom if ever immediately hire you as a regular full-time employee. Instead you're hired as an independent contractor and given a contract for three or four months, then if you're lucky maybe a five or six month contract. Some like my friend finally make it after a few years. Many others fall by the wayside.

OK, back to our chat. Here are the two then-and-now differences I highlighted:

CEO Pay vs. Average Worker Pay 
I broached this topic with general comments. After he left, I did some research and made a few stunning discoveries.

Let's start with a Bloomberg report based on a 2013 study of the top 250 of the Standard & Poor's 500 Index of companies. Bloomberg found that corporations don't make it easy to find out the average pay of their employees. It used industry-specific estimates for compensation to workers. Fortunately, corporations are required by law to disclose CEO pay.

Bloomberg found that the average CEO made 204 times the average employee's salary, a ratio up 20 percent since 2009. The slow economic recovery after the recession may have held everybody else back, but it didn't stop CEOs from widening the compensation gap.

How's this for appalling? Bloomberg reports that Ron Johnson was hired in 2011 as JCPenney's CEO at a salary 1,795 times more than the average wage and benefit package for employees. Johnson no longer is with Penneys. No doubt he left with a monster severance package.

The longer-term trends in the ratio of CEO and worker pay can be found in the Economic Policy Institute's report:
  • From 1978 to 2012, CEO compensation, measured with options realized,increased about 875 percent, a rise more than double stock market growth and substantially greater than the painfully slow 5.4 percent growth in a typical worker’s compensation over the same period. 
  • Using the same measure of options-realized CEO pay, the CEO-to-worker compensation ratio was 20.1-to-1 in 1965 and 29.0-to-1 in 1978, grew to 122.6-to-1 in 1995, peaked at 383.4-to-1 in 2000, and was 272.9-to-1 in 2012, far higher than it was in the 1960s, 1970s, 1980s, or 1990s. 
  • Measured with options granted, CEOs earned 18.3 times more than typical workers in 1965 and 26.5 times more in 1978; the ratio grew to 136.8-to-1 in 1995 and peaked at 411.3-to-1 in 2000. In 2012, CEO pay was 202.3 times more than typical worker pay, far higher than it was in the 1960s, 1970s, and 1990's. (The 201.2 ratio for 2012 accords with that found in the Bloomberg study.)
Putting Corporation Profits To Use
Bad as the executive pay story is, this next issue explains much more clearly why the recovery from the 2009 recession has been one of the slowest in history.

We made a profit at BNA every year except one. We lost money that year because we invested a pile of money in a new product that eventually became the company's biggest profit maker. That's what companies did. Some of profits were used to raise employee wages and benefits and to increase shareholder dividends. At the same time, as much as possible was reinvested into research and new product development. For years, that pattern drove the growth of the economy and work force.

That was then. In time, corporate boards and CEOs decided that -- rather than invest money in new product development -- they'd use it instead to play financial games that would drive up the stock prices and CEO salaries. Their actions had no impact on expanding the business.

In this financial game, corporations use profits not to build the business, but to buy the business. The extra cash is used to buy back huge amounts of company stock. Reducing the shares makes corporations' earnings per share look much better, and earnings per share is the metric investors consider when deciding whether to buy into a company. Corporation earnings for the year could be flat, but this trick makes the earnings per share look great.

And that trick drives up the stock price. The shareholders are richer. So are the CEOs, whose salaries increase as stock prices increase. But new employees aren’t hired, and new products aren’t developed. Since so many companies play this game today, it may explain in part why the economic recovery has been sluggish.

I retrieved a recent article in my files by my favorite business journalist, Steven Pearlstein. He wrote that 80 percent of companies on the S&P 500 bought back shares last year. They spent $477 billion (!!) playing this game. These companies spent 30 percent more on dividends and stock buybacks than they did on capital expenditures.

My apologies for going on so long about this issue, but few things make me angrier. These greedy bastards are robbing millions of young college graduates of the opportunities that gave me the terrific life I have today.

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