I’ve heard more and more commentary/concern about the level of the overall market lately. With the market relentlessly marching to new all-time highs just about every day, I’ve even begun to hear the word “bubble” being used. While I certainly don’t think the market overall is cheap, and while I certainly believe it’s very possible that a bear market could occur at any time, we are definitely not in a bubble. Anyone who thinks that the current market is reaching levels that would correspond to previous manias should study previous manias. The late 1990’s saw unbridled enthusiasm among individual investors, reckless behavior by corporate managers, and significant complicity by lawmakers and regulators.
Even though the late 90’s bubble wasn’t that long ago, I think it’s easy to forget how crazy some of the valuations were and how egregious some of the behavior was among market participants and management teams.
I recently read the book Bull by Maggie Mahar, and I thought I’d highlight just one example that illustrates the speculative fervor that existed at the time.
One of the perks about being CEO of a publicly traded company of the 1990’s was that you could pay yourself with huge amounts of stock options, but yet not count those stock options as an expense on your company’s financial statements. It was creating money out of thin air. You, as public company CEO (along with other top executives) could mint multi-million dollar pay packages each year that seemingly had no strings attached (because it wasn’t an expense as far as the income statement was concerned). This was obviously a complete fallacy. The options were an expense—a significant one. Doling out millions of stock options to yourself and your friends might not have shown up in that year’s income statement, but it did show up in the shareholder’s equity statement in the form of increasing the overall amount of shares outstanding. Obviously, more shares outstanding means lower earnings per share for all other shareholders. Even without counting the options as an expense, the pie was the same size and each shareholder’s slice was now smaller.
Not counting this form of compensation as an expense was a ridiculous accounting practice, and one that was supported by ridiculous arguments by lobbyists and the lawmakers who wanted to protect their corporate constituents who were getting rich. These options were akin to lottery tickets that couldn’t lose, and, in the bull market of the late 1990’s, were sure to win.
But as it turned out, granting options wasn’t a free lunch. As mentioned, the obvious cost was that it increased the shares outstanding, thus lowering earnings per share. But this practice also led to a second derivative behavior, and one that is still practiced today (and is a pet peeve of mine)—companies began buying back their own stock to “offset dilution” that occurred from giving out options to management. Buying back shares—like any other capital allocation decision—only makes sense if the value you’re getting exceeds the price you’re paying. Overpaying for anything—including your own company’s shares—will lead to value destruction. What annoys me about this behavior, which is practiced very often today as well, is that for some reason corporate managers seem to act like these buybacks—when they are earmarked for the purpose of offsetting stock options—exist in a vacuum where the laws of economics are suspended. The act of buying back shares of stock is a separate capital allocation decision, regardless of the reason why you’re buying those shares. Doing so without any regard for value (simply to “offset” the dilution that you created with a previous decision) is completely illogical. Yet it occurs all the time. And in the late 1990’s, it was running rampant.
At least now these options are counted as compensation (although most companies try to avoid this by using magical terms like “adjusted EBITDA” which essentially does what GAAP accounting allowed in the 90’s—not counting this form of compensation expense as an expense). But regardless of the accounting treatment in the 90’s, these options became very expensive (and cost real cash) when companies began buying back their shares to offset the dilution that these options were causing. This practice has a bit of irony attached to it, because the corporate managers who fought tooth and nail to prevent these options from being called what they were (an expense) began paying for these options by draining the company’s cash to hide the true impact and cost that the options were creating in the first place.
One bad decision (granting excessive stock-based compensation and not expensing it) led to a second bad decision (using real cash to buy back extremely overvalued shares in the open market to keep overall shares outstanding from skyrocketing). Of course, shares of stock are fungible. As CEO, the shares you buy back in the open market are economically identical to the shares you created and gave yourself. In effect, by buying back shares to offset dilution, the irony is that the company was paying for the very shares that they were giving themselves, despite their unwillingness to call it an expense.
Dell—Superb Computer Maker, Financial Innovator
This post isn’t an attempt to pick on Dell, but that company was highlighted in the book as one of the firms that practiced this type of behavior. Other companies were doing the same thing, but Dell was one of the excessive practitioners. Michael Dell paid himself huge amounts of options (in 1998 he gave himself 12.8 million options to buy Dell’s stock, while at the same time unloading 8 million shares in the open market). To finance these generous option grants, Dell began ramping up his company’s buyback program. In 1998, Dell Computer spent a whopping $1.5 billion buying back its own stock—which by the end of the year was trading hands at 70 times earnings.
Although Dell (the founder) was personally selling his own shares, he clearly he wasn’t concerned about using Dell (the company) cash to buy back excessively overvalued shares. In fact, the company readily admitted that the shares repurchased weren’t done with any sort of benchmark to value, they were done simply to offset the dilutive effects of the huge number of options that the company executives gave themselves.
I went back and looked at the 2000 10-K, and here is why the company bought so many shares:
“During fiscal year 2000, the Company repurchased 56 million shares of common stock for an aggregate cost of $1.1 billion, primarily to manage dilution resulting from shares issued under the Company’s employee stock plans.”
Dell issued 82 million shares in 2000 for stock-based comp. It then bought back 56 million shares for $1.1 billion, to partially offset the dilution. This $1.1 billion was real cash that the company shelled out for something that wasn’t called an expense in 2000. $1.1 billion equaled about half of Dell’s pretax earnings for the year. Moreover, $1.1 billion for 56 million shares only equaled about 2/3rds of the shares that Dell issued for compensation (in other words, Dell didn’t completely offset the dilution). Dell earned $2.5 billion in pretax income in 2000. So the real cash cost ate up about half of Dell’s net income, and had the company offset the entire amount (in other words, called the compensation an actual expense), Dell’s income would have been 64% lower than actually what was reported.
To paraphrase what Buffett said about options:
If options aren’t a form of compensation, why did Dell spend $1.1 billion to “manage dilution”? And if $1.1 billion isn’t an expense, what is it? And, if $1.1 billion shouldn’t go into the calculation of earnings, where in the world should it go?
The answer, as Dell exemplified, is that stock options were an expense, often paid for with real cash dollars that showed up in the company’s cash flow statement (and should have showed up on the income statement).
When the Widget Maker Becomes a Hedge Fund
These rampant stock buybacks led to yet another behavior (now a third derivative of the decision to grant excessive options). This next level is what separates bad corporate behavior (which can be found in any environment) from bubble-behavior that typically only is found in manias. Companies not only began using cash to buy back common stock of their own company, they began using cash to buy call options of the common stock of their own company! To be clear, I’m not talking about the options that were given to managers as compensation, I’m talking about the options that traders use to make short-term bets on the price of the stock (puts and calls).
From the book Bull:
“Meanwhile, in order to try to offset the cost of buying back its shares, Dell Computer decided to gamble on its own stock. In an effort to make buybacks less expensive, the company began buying call options that gave it the right to purchase Dell shares at a preset price for a defined period of time…”
Amazingly, Dell not only bought calls on its own stock, it also sold puts to finance the cost:
“Dell’s foray into the options market did not stop there. To pay for the call options, the company began selling “put” options on its stock.”
Dell was using options as a way to be “long” its own stock without shelling out much cash (buying a call and selling a put at the same strike price is an “equivalent long position”, as option traders would say). But it was really just a bet that Dell’s stock price would go higher.
Dell casually explains the use of options in its 2000 10-K:
If the stock rose, Dell profited. If the stock fell, Dell would have to put up cash. (Hint: this program was ramped up in 1999 after Dell’s stock gained 216% in 1997 and another 248% in 1998. You can guess what happened shortly thereafter). But for a while, Dell the Hedge Fund did as good or better than Dell the Computer Maker—in one quarter it made more money trading options than it did selling computers!
Dell built up a truly massive position in options on its own stock. At the end of 1999, the company owned call options on 118 million shares and had sold put options on 69 million shares, and amount that equaled billions of dollars of notional value of Dell common stock—real cash that Dell would have to come up with if things went bad.
And things went bad. Dell lost billions of dollars over the next few years on the puts—they had to shell out over $1.2 billion in one year alone to buy back millions of shares of stock that had lost half their value in the previous year—this was more than they made selling computers that year.
By 2004, Dell seems to have learned their lesson, as I found some subtle changes in the paragraph titled Capital Commitments, which was where they previously tallied their bets on the puts and calls they traded:
Translation: We tried our hand at option trading, but we’ll stick to selling computers and using our cash to do buybacks the old-fashioned way.
To be clear, they are still buying back stock for illogical reasons. But at least they kicked the hedge fund experiment to the curb.
Manias Often Exhibit Extreme Behavior and Pervasive Aggressive Accounting
I didn’t highlight this example to disparage Michael Dell, whose business acumen I have a huge amount of respect for. I think Michael Dell is an incredible entrepreneur, and the business model he developed for Dell Computer allowed him to reap incredible rewards from an industry with commodity characteristics, mean-reverting profit margins, and low barriers to entry. Combined with rapid growth, these conditions led to extreme competition. But Dell succeeded, and built a business that—at least for a period of time—had some strong advantages.
But it’s interesting to observe the behavior from Dell and others (Dell was certainly not the only, nor the most egregious offender), who—as Mahar put it in the book—turned their companies into hedge funds.
The mania of the 1990’s was extreme, and while we will most likely see similar excesses at some point, we are nowhere close right now. There are almost always isolated areas of excess, fraud, or aggressive accounting, but it gets widespread during manias.
That said, this was not a post about the overall market valuation level. It was just a post to comment on a section of a book I found to be really interesting. I have no idea where the general market is going. Over time, it will go up. Over the next few years, I really don’t know. Nor do I really care much, as long as I’m able to find a few investment ideas that offer compelling value. In the short-term, the market’s tide will raise and lower all boats, but value investing works in the long-run, and unless you’re in a late 1990’s type mania, I think it probably is best to completely ignore the overall market and just focus on looking for undervalued stocks of individual companies that you think will be doing more business in five years than they are now.
But I love reading about market history, and Bull is a great book filled with interesting stories from the bull market that started in 1982 and culminated in early 2000. It’s a quick, fun read, and it has some good takeaways to think about regarding corporate management practices, market efficiency (or lack thereof), and individual investor behavior—all things that I think are useful to keep in mind as an investor in the stock market.
John Huber is the portfolio manager of Saber Capital Management, dressme.co.nz/ball-dresses.html”>LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.
To read more of John’s writings or to get on Saber Capital’s email distribution list, please visit the Letters and Commentary page on Saber’s website. John can be reached at [email protected].