By Brendan Brown*
Demand for financial engineers rises and falls with asset inflation. So there is nothing odd about these professionals now enjoying a good market for their services. But why is Big Tech such a large recruiter?
The art (not science) of financial engineering – camouflaging a rise in leverage which boosts present and future earnings for the purpose of sustaining a bull equity run – is most sought after when irrationality in capital markets is at its strongest. That occurs in a monetary inflation featuring virulent asset inflation as its most obvious symptom. Hunger for yield or irrational exuberance means that sober rational cynicism which would help investors spot the engineers’ camouflage is abnormally weak.
Even so, one might have imagined that the Big Tech companies, given the fantastic nature of their profits (excluding Amazon which many analysts would not put in the Big Tech category), had a seductive enough narrative to spin without employing financial engineers. But with present equity values of the FAANMGs (Facebook, Apple, Amazon, Netflix, Microsoft, Google) reaching to the sky, it seems that engineers are needed to sustain the belief in persistent exponential earnings growth. And the financial engineers may also be helpful in dealing with those huge cash piles built by present monopoly power which could invite the scrutiny of regulators, anti-trust authorities and tax-hungry governments.
The force against which financial engineers fight is the rational perception that earnings due to a rise in leverage should not add to equity value. That is what we learn in Finance 101 under the lecture title of “The Modigliani-Miller Theorem.” According to this, if shareholders could have effected on their own personal account whatever leverage change the company makes, then they would not pay a price for any boost to reported earnings deriving from this.
Specifically, in those stages of asset inflation when interest rates are very low or even negative, companies can bolster their earnings per share and earnings return on book equity capital, as measured by the accountants, by adding to debt outstanding and retiring equity. But the rational shareholder would not pay any extra for that reported boost. He could have achieved the same result by adding to the leverage of his personal portfolio or reducing the amount of safe bonds – meaning less negative leverage.
Yet we know that in practice during asset inflations, rapid earnings per share growth bolstered by the financial engineers seems to work wonders. Indeed the implicit profits stemming from leverage (not disclosed) are multiplied by the same high price-earnings multiple to justify inflated equity value. Moreover, when the price of equity is climbing, leverage ratios calculated at market value (of equity and debt) may actually be falling despite the engineers.
In performing their skills inside Big Tech the financial engineers are not dealing with leverage in its usual positive sense. The task here is to camouflage a big decrease in negative leverage which results from a run-down of vast cash piles accumulated from years of mega monopoly profits. Equity buy-back programs are in effect an operation to distribute the piles to shareholders and correspondingly retire equity outstanding. By paying out this lowest return asset in the company’s portfolio there is much scope to raise earnings per share remaining and the rate of return to equity capital as shown in the accounts.
Along the way, the financial engineers may make the reasonable case that even in wholly rational efficient markets the cash depletion would raise equity value by reducing the cushions for inefficient corporate management (including badly justified take-overs). The engineers also doubtless hope to create a tail wind behind the given company’s equity price powered by much of the misleading chatter in markets about share buy-backs.
Much of the popular misconception derives from the fact that the company is in the market buying equity. Surely that tends to push up prices — especially if by the same operation earnings per share and earnings return are bolstered meaningfully. This would not be the case, however, in an efficient market bounded by strong rationality. Take the following arithmetic example.
Tech Titan A has 100m shares outstanding, each with market price of US$10,000. It has surplus cash of $100bn. So it decides to retire one in ten shares, giving the holder $10,000 in exchange for the share canceled. Many investors would be happy with just holding what remains (nine shares out of ten) in their portfolio and keeping the cash. Some might decide to build up their shareholdings to nearer the original amount before the equity cancellation (even though this would be a raised proportion of total business value now in Titan A); others might decide rather to hold a lower proportion. But the transaction price, with nothing else changing, should still be US$10,000. The equity retirement has not fundamentally changed the value of Titan A’s business investments; the total value of equity outstanding should fall just by the amount of cash paid out (maybe a little less if the engineers’ claims of increased efficiency as above are believed in the market-place).
In practice, businesses do not retire equity as in this example. Instead they buy back equity. But the collective outcome of the operation is in effect the same. When Titan A announces a share buy-back program, many of the existing shareholders would prepare their own sale program to match, not wanting to increase the intensity of their investment in the non-cash investment businesses of A and in some cases deciding to reduce the proportion. A few may take no action – whether out of irrational passivity or deliberate choice to increase their intensity of investment; others will decide to lighten up by selling more than what is needed to keep constant their share in the non-cash businesses of Titan A.
So why is there all the hype in the market about equity buy-back programs most of all Apple, followed by Google and Microsoft and joined recently by Facebook? One part of the explanation is surely the owner managers of those businesses having an interest in extending and increasing the present vast run-up in their equity value. To get eight fatter years rather than seven — that is worth calling in the financial engineers. Helpful to the prospects of engineering success are the large number of investors who for now believe fervently in FAANMG monopoly profits rising exponentially for decades and who are non-believers in divine-like prophesies of 7 lean years ahead.
About the author:
*Brendan Brown is the Head of Economic Research at Mitsubishi UFJ Securities International.
This article was published by the MISES Institute