Archive for July, 2012

The Economics of Debt and Equity. with Football

July 13, 2012

It’s no secret I am a bad economist:  I don’t believe rent control is a bad thing, I consider most of the job-matching models to be ludicrous when someone tries to use them to claim unemployment compensation extends people’s period of unemployment, and I really, really, really don’t believe the equity premium is anything but a legacy of artificially-suppressed Government bond yields and fluke periods of excessive rents combined fortuitously with an absurdist survivor bias. Otherwise, Modigliani-Miller should be correct and when you start measuring corporate returns against Government bonds, the “premium” looks a lot like an overestimation of expected inflation (Πe)

But if I had to model why an equity premium might be possible, I would suggest that there might be a combination of undue pessimism (expectations of higher inflation and/or lower real growth) and clear indicators of companies that are more likely to be part of the survivor bias.* Such as, for instance, management buying its own stock instead of paying out more in buybacks and dividends than it makes in profits. (You know, the “miracle of compound interest” and all that.)

One of the things that would make me hesitate to think a company was going to come out on the right side of survivor bias is insiders selling their stock.  Or not buying it when they have a chance to do so.  Especially if they buy something else.

Don’t get me wrong; I think employees who buy company stock for their own 401(k) are pawns at best, idiots at worst.  Even Upper Middle Management—defined as people with the authority to say “yes” to some things without asking higher-ups—will rarely have a material positive effect on the company’s stock price. (My father retired with three or four patents to his name; their bottom line effect on Ford stock was indistinguishable from zero—maybe negative, if you count “made a better product for a while and so stayed in a market they eventually left” as misallocation of resources.)  But the guy’s running the company—especially when they also own the majority of the company—those are the people who should be buying equity, not taking it out of the company as they cash out their stock options.

What does this have to do with football?  Well, the Glazer family happens to own a football team.  (Yes, I’m talking about real football, not “putting on forty pounds of protective gear to play rugby.”)  It happens to be an English team—a member in good standing of the English Premier League—that is very good for an English team.  Which means that this year it was the second-best team in its City, it lost in the early rounds of the Champions League, and it qualified for what many expect will be another “Early Exit”—this phrase should be trademarked as the standard of English Football teams since at least 1950—in next year’s Champions League.

But the Red Devils have many fans who would like to own a piece of the team just to say they do.  Many of those fans are in England, but apparently there are enough of them in the United States—I know several; generally nice enough people even with that character flaw—that the team will be listed not on the LSE, but rater on the NYSE.  So I expect that—as with Visteon—I will be able one day soon to wander down to the area near the Federal Reserve and see a bunch of people wearing shirts advertising Aon Insurance (previous sponsor: AIG) celebrating and giving away some swag—say, imitation Wayne Rooney hair plugs (warning: site NSF Self-Respecting Humans) or Ryan Giggs’s used condoms—or something else that will be arguably more valuable than a few hundred shares of stock that amount to a small fraction of the listing that is only about 10% of the company anyway.

Why am I disparaging the stock? Well, after the FT and the WSJ did—and probably Deadspin, Gawker, and maybe even Noah Smith’s favorite site, Zero Hedge (oh, come on, I really don’t need to provide links those five sites, do I?)—it would almost feel like piling on.

But then we come back to the Equity Premium.

You see, there’s one good reason that there should be an Equity Premium.  Despite the best efforts of the Delaware Chancery Courts, Equity is still subordinate to debt.  If you run low on cash, you’re supposed to pay your debt holders and reduce—or even forego—dividend payments.**

So equities should have a premium—it’s a risk-adjusted premium for the likelihood of the firm not being so much of a “Going Concern” in the future as it is now.  We may have modeled Expected Free Cash Flow (FCF), but those expectations might be wrong, too.  And the risk is asymmetric.***

Which means the worst thing for any equity investor would be to see the owners of their company selling the company’s equity and buying its debt.

Which, as my ex-roommate noted in email, is precisely what “what some of the Glazers themselves are doing.”

ManU’s stock offering is for people who thought that the Facebook founders gave up too much control.  And if you throw in that the team is incorporating in Romneyville, a.k.a., The Cayman Islands, so that the new shareholders can be even more subordinate than they would have been otherwise, it’s clear that their fans would be far better off investing their money by going to Ladbroke’s and taking 7:1 on ManU to win the 2013 Champions League.  Or the 16:1 currently offered for the double of the EPL and the Champions League.

At least then, even when if they lose, the winner wouldn’t be someone who was betting against the house while holding the mortgage.

 

*By the end of writing this post, I had thought of a “real” reason for an Equity “Premium.” See the text accompanying the next two footnotes, and the third footnote itself.

**The end run of Stock Buybacks, not to mention the last twenty-five years of the court rulings, have rather eviscerated debt holders’s position in the queue, but we still at least pay lip service to the seniority.

***Short version: If you call the “equity premium” a “risk-adjusted return on capital,” it is much more likely that I will believe you might have a working model.  If you keep pointing to the U.S. from, say, 1937-1967 when the economy was growing and the coupon on Government debt was artificially low—looking at you, Prescott and Mehra—then I’m going to laugh at you.

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