Thursday, February 28, 2013

Most people support slavery

A less sensationalist headline is that most people accept oppression at a level that is so close to slavery as to be functionally identical to slavery.  We might think that upon learning this, most people might turn against oppression, but instead most people will hate this article, and defend oppression.  This is an article in favour of basic income/social dividends as a tool for political reform, social happiness, and freedom.  To explain the headline, let's first understand oppression and freedom as a continuous line. Listed in order of most oppressive to most free:

Cattle: Your value is meat, body hair and body fluids
18th century slave: Your value is your work.  You receive privileges of food, shelter, rest.
Prisoner: You are a slave for a limited amount of time.  You may be a slave for a seemingly valid reason (if actually guilty of victimizing another living being).
Soldier: Though you may have vacation time, and may have joined voluntarily under inducements of education and peacetime, you are obligated to fulfill activities likely to get you killed.
Regulated slave:  Children and pets.  They must do what they are told, but they enjoy strong legal protections against abuse.
Released Felon: You are deprived of many survival tools available to freer persons such as social benefits and legitimate job opportunities, and face harsher penalties and suspicions for future crime.
Low wage worker: Limited choice of food and shelter, but a desperate obligation to work
Medium wage worker:  More choices on spending, but continued desperate reliance on employer and obligation to work.
The burden of funding retirement: Preparing for the eventuality of being unwanted or unable to work places an obligation to work harder today.
The burden of funding healthcare: Funding possible current or eventual illness and incapcity consumes a portion of your work.
The burden of repaying education costs:  Education is an investment that promises requiring less future work for the same benefits. Those without the privilege of being able to pay for that investment, may be burdened with irrevocable expensive loans and underperforming value of that education.
Self-imposed dependence: such as an expensive lifestyle or dependence on social services.  The first is a dependence on work.  The latter is dependence on poverty, and a restraint from work.
Financial independence:  The freedom from work.  It can reflect a wide range of wealth levels, and can be partial independence such as freedom from full time work, or work that mostly involves directing other's work and profiting from it.
The freedom to corrupt markets: Monopolies and abuse of trade.  Oppression of labour and oppression of investors.
The freedom to influence politicians: Pay the gatekeepers of government to channel society's and social funds towards one self.

Understanding freedom vs. oppression
The above models freedom within a society as a function of individual wealth, and individual work burdens.  The key point is that traditional conservative rhetoric for freedom and low taxes, advocates for freedom of the freest members of society.  Income taxes do not impede freedom.  They do not prevent financial independence.  Since taxes are always redistributed somehow, the wealthy and freest will collect the taxed funds back for themselves as a result of spending of the redistributed taxes, or directly from corporate government handouts.

Freedom of opportunity
The above model, by itself, tells us that most Cubans are Freer than the poorest Americans.  While that is true, its also true that there are many Americans who have more freedom of opportunity than most Cubans.  If we can fantasize the existence of "ethical capitalism", the key potential for opportunity exists when there is opportunity for profit.  Opportunity can still exist without oppression of labour, and without the "opportunity" of squeezing maximum profit out of society.  With opportunity for profit, it is possible, and a way can be found, to risk time, energy, and capital on something new and uncertain.

Within America, the freedom of opportunity is constrained for those at the oppressed end of the model.  Taking the risk of education or starting a business is repressed by an immediate requirement for work, and a dependence on employer provided healthcare.

The good and bad of government
Society has the right to make social decisions.  Decisions through majority is fair and practical.  Decisions that make the vast majority of society's lives more affordable and practical, such as social funding of healthcare, roads, and retirement are entirely valid and beneficial social programs. Funding social decisions through income taxes is fair.

The evil of government occurs when taxes are used to fund a war chest, when gatekeepers of that war chest use it not just for the literal evil of war, but use the authority of government to advance any private interest over the social interest.  More generally, it is a deep concern for abuse whenever a permission gatekeeper is allowed discretion to favour narrow interests over social interests.  Sometimes the deep concern for abuse and bias can be countered by net positive outcomes of the gatekeeper function, through a complex and difficult analysis, but whenever a gatekeeper function can be eliminated with equal or better results, it should be.

The rationale for anti slavery
The real wrong of slavery must be that slaves are forced to work, and not that they are merely mistreated.  We could instead develop a complicated regulatory framework that allowed slavery, but prevented physical abuse, mandated a (maximum) 40 hour work week, and regulated minimum quality standards for food, lodging, and healthcare.  The major problem with such an approach is that over time pro-slaver biases creep into the enforcement of the apparent concessions to slaves, until social anger builds enough to incite revolution.

While the modern near-slaves, those who are obligated to work for low pay, enjoy choices in allocating their budgets for food, shelter and healthcare, the dream of a better future for themselves and children is less plausible today than it was 70 years ago.  Increased government and education funding corruption, budgeting and population unsustainability, together with productivity increases means that workers/slaves will be less useful/valuable in the future, and thus there will be less opportunity to break free from near-slavery.

For businesses that can benefit from the control of slaves, the shift from negative reinforcement (punishment) to positive reinforcement (rewards) was a more effective means of control.  The slave owners are relieved of a large security cost by giving slaves the illusion of freedom, and they get better work output by having the slaves compete with each other for the privilege of working for them.

I started this section with the statement that the wrong of slavery is the obligation to work.  Most people don't think very long on the matter but might answer that slavery is wrong because Lincoln won, or because being owned feels icky.  But, the need to consent to a new master creates a power imbalance in the labour market.  There are many more sellers of labour than buyers.  Some of whon, are desperate for work/cash.  The employers can almost always dictate the terms of employment and duties within regulatory allowances.

basic income as a solution to slavery
Basic income is providing cash to all citizens.  If the amount is in the range of $7k to $10k, it can be paid out of existing tax levels by replacing other social services, and making the benefit taxable so that high income earning citizens pay back a larger portion than poorer citizens.  Basic income can also be paid in part or instead through money printing.

Basic income has many social, political and economic advantages, but the one pertinent to this article is that it balances power in the labour market.  It eliminates desperation as a reason to work, and everyone that wants a job will find a job.  It can replace much workplace regulations as well.  Minimum wage, maximum hours, rules for layoffs, and so on.  The level of $7k-$10k is designed specifically (though guesstimated) as a target that balances exactly the bargaining power (between employers and employees) in the low skill labour market.

The case for employers to prefer basic income over slavery
Even if employers lose bargaining power in the labour market as a result of basic income, putting a lot more cash into the hands of society, and giving them a significantly less risky life, will significantly increase citizens ability and willingness to spend, and so benefit successful businesses.

Since basic income of $10k/year is equivalent to a $5/hour raise to full time workers, and $10/hour raise to half time workers, there is no obvious reason for employees who are not oppressed to refuse to do work they did without basic income as a supplement, and to continue to do the work at the same employer-paid wage.  Its a good problem to have for businesses to need more employees to meet the demand of many new potential customers.

The case for employers to prefer slavery
A darker argument is that low wage workers all hate their work, and hate their employer, and would prefer to do nothing and earn basic income only, over earning more by continuing to work at the same wage as before.  The darker argument contines with low wage workers would all demand a very high wage to do their previous work, and then medium wage workers, who are assumed to all hate low wage slaves, would also either quit or demand significant wages to retain a social status gap over those who were "lesser slaves."

This darker argument essentially depends on low wages being the oppressive slavery that I accuse it of being.  It's mostly an argument against a commonly proposed and confused alternative to basic income called guaranteed/minimum income, which is a bad idea because as it typically guarantees a minimum of $20k/year, it provides no reward whatsoever to anyone that works for a wage lower than that total.

Even if I disagree with the expectation that most people would refuse to work if provided with basic income, its difficult to disprove.  The most important point, is that such a fear confirms the state of slavery, and implementing basic income not only would eliminate that slavery, but no matter the outcome would create a world we could get use to without inconveniences to most.

How the rest of us support slavery
Retired and near-retired citizens have no reason to care for the long term future of society, and no reason to care for employment conditions if they are no longer seeking work.  Oppressive slavery may (be expected to) lower the cost of consumer goods.

Oppressing anyone who is paid lower than you, or in a job you do not expect to ever do, may keep prices down, and provide you with someone to feel superior to.  These feelings may be racially motivated, may be motivated by hope of becoming an oppressor one day, or may be a product of brainwashing I cannot explain.  People will attack these ideas, even though they lack any obvious self-interest to do so.  Basic income would at least provide you with the same benefits as are given to any other class, and so eliminate any grievance you may have about imagined abuse of social services.

The rest of us support low wage slavery even when we support enhanced regulations designed to make the lives of the slaves more comfortable.  Very complex rules for identifying the oppressed, and then fixing cases individually, can help create empires for that purpose, but it layers empires over band-aids instead of abolishing slavery.  This motivation is almost always based in ideological support of unions

Just as some people support class/race based oppression of the poor, the opposite reaction of oppressing capital by being too "pro-slave class" is in fact being pro class warfare, instead of eliminating the war.

Technology advances are a good thing
Self driving cars would eliminate many jobs.  As would any automation-assisted self-service enabling for food-service, shopping, and even manufacturing.  Eliminating jobs through productivity increases is great for society if there is some income redistribution, because it cuts the cost of living, and creates more value per citizen.  If there is any concern that removing the obligation to work will increase wage and cost pressures, then that will facilitate labour replacing automation and technology.  If the opposite downward pressure on wages occurs as a result of basic income, then market forces will delay much automation.  The decision to allow or block self-driving cars should not be based on corrupt political protection or oppression of the labour market.

A key to future innovation and spreading the benefits of that innovation to an entire society or humanity, is eliminating the notion that work is mandatory and necessary.  The alternative of asking labour to unite and rise up is a losing proposition, because unionized labour strength occurred during periods of high labour demand.

The culture of work is irrational
The culture of work is the belief that work should be obligated on the poor.  It is irrational mainly because forcing someone to dig a hole and then refill it in order to collect welfare services helps you in no way whatsoever.  In fact, if that same person drank beer all day or watched television, it would help employ beer workers and advertising salesmen, and give them (or beer/advertising industry beneficiaries) the opportunity and time to purchase whatever products keep you employed.  Similarly, the entire bureaucracy that supervises social welfare recipients to prevent fraud and idleness, is useless and would best serve society by being idle instead.  Idleness at least carries the possibility of doing something useful/productive.  Forced uselessness actively prohibits using that time to be productive.  Basic income gives everyone the freedom to do anything, while welfare services incentivizes recipients to do nothing (because it takes away benefits when recipients work).

"but I don't want to work to support someone who chooses not to work"
To understand why this thinking is wrong, consider work as being one of two categories.  The first category being "work that must be done or arranged" such as house chores.  In this category, it is unfair if one household member does all the work, but it is not unfair if other household members agree to pay the only one willing to do the work.  Its also fair to allow 2 or more people to bid against each other for the right to be paid for the work.

The other classification of work can be simplified as "do whatever you are told in exchange for paycheck".  You are a privileged winner to receive the paycheck, and that privilege ultimately comes from customers that support your work.  You have no reason to care how customers receive their funding to support your work, other than possibly object if they are paid to do something useless or evil.

Basic income and social dividends should be seen as a giant make work program, which happens to be market driven, and so necessarily leads to useful work to collect the spending individuals want to make.  It furthermore eliminates poverty, and desperation-based slavery to work.

Freedom and income redistribution
Basic income funded through taxation, even at a minimum subsistence level, provides everyone with financial independence.  Even if the freest people are taxed more than the poorest, they remain freer with more consumption choices and influence.  Basic income also provides freedom of opportunity by allowing even the poorest people to fund their education or business startups.  Redistribution from winners to losers, through taxation and basic income, allows winners to spend the same and losers to spend more (compared to no redistribution), and so creates opportunity for both winners and losers to work to collect the available money from society.

Basic income as an entitlement provides a safety net for both rich and poor, allowing for more risk, and less savings.  A lower necessity to save necessarily creates more spending, and so more opportunity for work.

Natural Finance as a similar anti-oppression tool
Natural Finance Soft Loans are business loans without fixed repayment terms.  Instead, they are repaid when business cashflow materializes.  Soft loans are non-oppressive to borrowers because it allows them to borrow large amounts without giving up control of the business, or imposing fixed monthly repayment obligations that it might not meet in the short term.  Soft loans are non-oppressive to investors because it forces successful borrowers to repay investments instead of holding them in perpetuity, or colluding with initial investors to defraud future investors, and soft loans benefit investors by supporting higher interest-rate/repayment-obligations from borrowers because the borrower can afford more when terms are non oppressive.  Investors also benefit from the queue structure of soft loans, which ensures complete investor certainty, at the time of investment, as to the level of cashflow or revenue required to fully repay them.

Natural finance also creates non oppression among owners by encouraging communal partnerships as the ownership structure, and provides option instruments to help capital-less partners join, or potential large investors invest cautiously until success benchmarks are made.  A 3rd party comptrollership function ensures trust in the business, and together with the simplicity of contractual terms, creates partnership opportunities for the business by facilitating supplier, customer, employee, and other investor partnerships.

Finance is nearly as corrupt a market as Labour.  The key conceptual framework for eliminating oppression in markets are systems that replace regulatory whack-a-mole patchwork that react to oppressive transactions with simplified elimination of conflicts of interest that exist within those markets.

There is a relationship between basic income and natural finance.  The main/only concern with soft loans is the possibility that a borrower has no intention/ability of ever creating a successful business, and will use the money to benefit himself.  The main financial control within a natural financed company to prevent this abuse is low cash salaries for management  and complete discretion for future success-based compensation.  Basic income facilitates the early stage startup of a company by subsidizing its founder's salaries.  If there is no obligation for someone to work, there is no incentive for them to waste their time by pretending to run a company.

Wednesday, February 20, 2013

Linkedin valuation issues

I've posted a couple of articles this week about the dangers of investing in companies where management holds a controlling interest and no dividends are ever likely to be paid.

In one of the articles, I highlighted specific concerns about Linkedin (LNKD), and that perhaps financial analysts, stock promoters, and the company face liability for promoting the stock considering the fact that there is no possibility for a minority shareholder to get any return without selling their stock to a greater fool.

Linkedin, though has published (in its 10k regulatory form) really the same warnings that I have made for it.  So, it responsibly acknowledges the risks of investment in it.  I am copying the relevant portion below (with some additonal bolding+underlining).

Risks Related to Our Class A Common Stock
The dual class structure of our common stock as contained in our charter documents has the effect of concentrating voting control with those stockholders who held our stock prior to our initial public offering, including our founders and our executive officers, employees and directors and their affiliates, and limiting our other stockholders' ability to influence corporate matters.
Our Class B common stock has 10 votes per share, and our Class A common stock has one vote per share. Stockholders who hold shares of Class B common stock, including our founders, and our executive officers, employees and directors and their affiliates, together held approximately 69.1% of the voting power of our outstanding capital stock as of December 31, 2012. Our co-founder and Chair, Reid Hoffman, controlled approximately 16.3% of our outstanding shares of Class A and Class B common stock, representing approximately 61.5% of the voting power of our outstanding capital stock as of December 31, 2012. Therefore, Mr. Hoffman has significant influence over the management and affairs of the company and over all matters requiring stockholder approval, including election of directors and significant corporate transactions, such as a merger or other sale of our company or its assets. Mr. Hoffman will continue to have significant influence over these matters for the foreseeable future.

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In addition, the holders of Class B common stock collectively will continue to be able to control all matters submitted to our stockholders for approval even if their stock holdings represent less than 50% of the outstanding shares of our common stock. Because of the 10-to-1 voting ratio between our Class B and Class A common stock, the holders of our Class B common stock collectively will continue to control a majority of the combined voting power of our common stock even when the shares of Class B common stock represent as little as 10% of the combined voting power of all outstanding shares of our Class A and Class B common stock. This concentrated control will limit the ability of our Class A stockholders to influence corporate matters for the foreseeable future, and, as a result, the market price of our Class A common stock could be adversely affected.
Future transfers by holders of Class B common stock will generally result in those shares converting to Class A common stock, which will have the effect, over time, of increasing the relative voting power of those holders of Class B common stock who retain their shares in the long term. If, for example, Mr. Hoffman retains a significant portion of his holdings of Class B common stock for an extended period of time, he could, in the future, control a majority of the combined voting power of our Class A and Class B common stock. As a board member, Mr. Hoffman owes a fiduciary duty to our stockholders and must act in good faith in a manner he reasonably believes to be in the best interests of our stockholders. As a stockholder, even a controlling stockholder, Mr. Hoffman is entitled to vote his shares in his own interests, which may not always be in the interests of our stockholders generally.

Anti-takeover provisions in our charter documents and under Delaware law could make an acquisition of us more difficult, limit attempts by our stockholders to replace or remove our current management and limit the market price of our Class A common stock.
Provisions in our amended and restated certificate of incorporation and amended and restated bylaws, may have the effect of delaying or preventing a change of control or changes in our management. Our certificate of incorporation and bylaws include provisions that:
authorize our board of directors to issue, without further action by the stockholders, up to 100,000,000 shares of undesignated preferred stock;
require that any action to be taken by our stockholders be effected at a duly called annual or special meeting and not by written consent;
specify that special meetings of our stockholders can be called only by our board of directors, the Chair of our board of directors, or our Chief Executive Officer;
establish an advance notice procedure for stockholder proposals to be brought before an annual meeting, including proposed nominations of persons for election to our board of directors;
establish that our board of directors is divided into three classes, Class I, Class II and Class III, with each class serving three-year staggered terms;

prohibit cumulative voting in the election of directors;
provide that our directors may be removed only for cause;

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provide that vacancies on our board of directors may be filled only by a majority of directors then in office, even though less than a quorum;
require the approval of our board of directors or the holders of a supermajority of our outstanding shares of capital stock to amend our bylaws and certain provisions of our certificate of incorporation; and

reflect two classes of common stock, as discussed above.
These provisions may frustrate or prevent any attempts by our stockholders to replace or remove our current management by making it more difficult for stockholders to replace members of our board of directors, which is responsible for appointing the members of our management. In addition, institutional shareholder representative groups, shareholder activists and others may disagree with our corporate governance provisions or other practices, including our dual class structure and the other anti-takeover provisions, such as those listed above. We generally will consider recommendations of institutional shareholder representative groups, but we will make decisions based on what our board and management believe to be in the best long term interests of our company and stockholders. Our dual class structure concentrates the voting power of our stock in a small group of stockholders who would have the ability to control the outcome of a stockholder vote. Additionally, these groups could make recommendations to our stockholders against our practices or our board members if they disagree with our positions. Finally, because we are incorporated in Delaware, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which generally prohibits a Delaware corporation from engaging in any of a broad range of business combinations with any “interested” stockholder for a period of three years following the date on which the stockholder became an “interested” stockholder.

We do not intend to pay dividends for the foreseeable future.
We have never declared or paid any cash dividends on our common stock and do not intend to pay any cash dividends in the foreseeable future. We anticipate that we will retain all of our future earnings for use in the development of our business and for general corporate purposes. Any determination to pay dividends in the future will be at the discretion of our board of directors. Accordingly, investors must rely on sales of their Class A common stock after price appreciation, which may never occur, as the only way to realize any future gains on their investments.

The other issue I brought up in my analysis of Linkedin is a limit to the total recruiting market.  This is a similar concern to the analysis of OPENtable I provided 2 years ago (which dropped in value dramatically since that time).  The online job recruitment market has been estimated at $3B annually as recently as 2 years ago.  There is an irresponsible report out today that suggests it will grow to $369B in 2014, but it is necessarily irresponsible because it is not measuring recruitment fees, and likely estimating total salaries hired.  At a $500 fee rate, to earn $4B, LNKD would need to place 8M jobs per year.  At a $200/job fee rate, it would need to place 20M jobs per year.  Simple competition for LNKD is from which offers (including free) job search listings and postings.  The other reason I mention is that they list the current total US online job listings as 2.2M.  Assuming the world is 3 times the size of the US, and extremely optimistically assuming that the rest of the world pays as much in recruiting fees as the US, then if Linkedin were to get nearly the entire online jobs market and place 6M jobs per year at $500 fee per job, that would cap its recruitment revenues at $3B.  This is well below any possibility of justifying a current valuation near $18B.

Friday, February 15, 2013

Proof that minority share positions are worth less than majority interests

So many people refuse to believe this basic truth of finance, I will make this article devoted only to proving it as simply as possible, then towards the end show how lies against this truth are abused:  A minority share in a corporation is worth much less than a majority share.

Definition of a corporation and shareholder
A corporation is like a box that holds assets (like cash and equipment) and may owe liabilities (debts).

Shareholders "own" a portion of the net assets (assets - liabilities) based on the proportion of total shares that they own.  If a shareholder owns 1 share, and there are 100 total shares, then that shareholder has 1% of the 3 core shareholder rights ("own" is in scare quotes because you will see that it doesn't conform to its common meaning)

The 3 core shareholder rights
For each % of shares the shareholder owns, he can:

  1. Vote on corporate decisions.  Each share is entitled to one vote, and so a majority shareholder is effectively a dictator.
  2. If an offer to buy the company is accepted (through above vote), then the proceeds must be shared among all shareholders, according to their respective percentage ownership
  3. If a decision to disburse funds from the box as dividends is made (through vote) then the dividend amount must be equal for each share.
The lie that the financial industry would have you believe is that these rules are fair to all shareholders.  The main proof that it is a lie is that dividends and buyouts are not the only way that a controlling member of the corporation can extract proceeds from it, and so shareholder rights are meaningless if a shareholder has no decision power.

Let's you and I make a corporation to hold $10k
The box will hold $10k at the start.  You will put in $4k and own 40% of shares.  I will put in $6k and own 60% of shares.  The minute after our corporation is formed we will have a series of votes, the results of which will be that I manage/hold the box, and I am to receive a management/security fee for holding the box.

I know that all of the boxes contents will eventually be transferred to me through management fees.  I would never vote in favour of a dividend because that would mean some of the funds in the box would go to you.  In order for me to accept a buyout offer for the box, it must be $16700 or higher, because only an offer that high nets me (my 60% share) more than the $10k I will eventually get from the box if I don't accept a buyout.  There is no rational reason for any buyer to offer more than $10k for the box, so there is no expectation the box will ever be bought.

Your 40% share in the box is worthless because you will never receive any proceeds from the box, because the decision to do so is entirely within my controlling interest.

Let's buy a car to use for taxi/shipping services with the $10k
I have Good news.  If we buy a car with the money in the box, then with the proceeds of taxi/shipping services more money could go into the box, and so your 40% might be worth more, according to this finance textbook.  Let's vote on it.  Yay! I win again.  After more votes, it is decided that the car will be kept in my drive way, and I will receive a reasonable salary for driving the car and looking for business.  Hopefully, I will actually look for business and actually put all the revenue in the box.  Repairs and gas money comes out of the box of course.

Wow the taxi service has put $20k in the box
You are as surprised as anyone else, and suggest that we should both take dividends out of the box.  I have a better idea.  We vote to get a nicer car for my driveway, and deservedly increase my driving salary.  The finance textbooks say I deserve more money for my successful management of the company.  This is much better for me because I get a nice car, and if the business does not enjoy continued success, I will still be able to drain the full $20K for myself.

Taxi service a big success.  Time to go public
My entire extended family now has a car in their driveways, and the business appears to be successful enough that stock market investors could be convinced to buy shares into the company.  Although, you have learned the hard way that a minority interest in my (I mean our) corporation is worthless because I have no intention of ever letting you be paid anything from the company, you have a definite interest in pretending that the company is successful, and will remain successful, and pretending that your shares are worth something.  If the general public believes that shares in our corporation have value, then you will be able to dump your shares to those idiots at a nice price.  It's in your clear interest to go along with the lie.  Your grandma and her friends end up with 40% of the company due to your skillful sales efforts.

Dual class shares
I have run out of family members to give cars to, and I am pushing the limits of what a reasonable salary is, but I would still like to get more of the money out of our corporation for myself.  The answer, is that we will vote to make a new share class in our corporation:  Non-voting shares have the 2nd and 3rd shareholder right to dividends and buyout proceeds, but no voting right.  The non voting share class will be the one traded publicly on the stock markets.  I will choose an executive compensation committee, and a new employee stock program will be implemented, where most employees receive a few non voting shares, the members of the compensation committee a few extra, and I will be showered in bonus shares.

Extra non voting shares is fantastic for the employees and me.  We get to turn the shares into cash without taking that cash out of the/my box.  We get the cash from stock market idiots.  By keeping the cash in the box, the stock market idiots will think that the non voting shares are worth something, and so pay more for them, and keeping money in the box means that I can find additional ways of diverting it to myself later.

Borrowing against shares
Another way for me to get cash without paying dividends or letting anyone else in the company make money is to borrow against the shares.  Although there is an interest cost, it is tax deductible, and if shares go up in perceived value by more than the after tax cost of the borrowing, then it has no cost.

Corporate share buybacks
Corporations may buy shares from the stock market.  The finance industry and textbooks tell us that this is a great sign for the stock, as the company must believe that its shares are undervalued, and the extra demand for the shares will push up its price, and reducing the shares outstanding means that future earnings and dividends per share will be increased.  The finance industry also tells us that corporate share buybacks count as giving back to shareholders, because there is flow out of the box.  But technically, that money is only going to shareholders who are unhappy and selling out.  No one that continues holding their shares is paid.

For me (as controlling owner of the corporation), corporate share buybacks are a useful use of the funds in the box if it is effective in convincing stock market idiots that the shares are worth more.  That belief allows me to sell voting and non voting shares at a higher price while continuing to maintain a controlling interest.  Even if the funds in the box don't directly flow to me, different stock market idiot buyers will pay me a higher amount, than if I didn't compete with them with the money from the box.

In fact, the more fearful I am about the worthlessness of the stock, or the deterioration of the value of the box, the more useful it is to me to use corporate share buybacks to help me cash out at a reasonable level.  I necessarily have better information on the future of the company than anyone else.

Maintaining controlling interest without a majority of shares
Even without a total majority of shares, buyouts can still be prevented by management.  Poison pills and golden parachutes are corporate bylaws that can be created for the sole purpose of making buyouts more expensive, and thus less likely, and protecting management's compensation.  Laws that prevent institutional investors from voting for board members, and manipulation of democratic process and voter apathy, can allow management to appoint loyal board members with industry experience, while returning the favour and serving as board members on their companies.

Loyalty to management by the financial industry that promotes their shares, and industry leaders that share a desire to maintain the corporate gravy train for management conspire against paying dividends or sufficiently high dividends.  The core lie that justifies this behaviour is that management deserves to keep your money because they will invest it wisely.  This misleads society by denying investors the choice to give back their dividend earnings to the company only when the investors agree that management deserves to reinvest it.

The harm that is created
The stock market price a stock trades for reflects the value of the minority shareholder stake.  Trades occur  a small number of shares at a time.  When a company trades its controlling interests those trades happen behind closed boardroom doors.  Controlling stakes in the company are worth the value of the box.  Minority stakes are worth less.

When a company is difficult or impossible to take over, and when it refuses to pay dividends, then the shares that minority stake holders are trading on the stock market are worth far less than the value of the company, and cannot justify their trading price.  The increasing corruption of shareholder value is partially responsible for poor stock market returns in the last decade, but it ensures future dismal investment performance.  Society also loses significantly when businesses hoard cash because businesses will only invest when consumer markets have the cash needed to buy their products, and keeping the cash to themselves necessarily reduces the cash available to consumers.

Dividends also significantly reduce risk of investment.  There is no possible way of knowing what will happen to a company in 20 years.  A 5% per year dividend for 20 years ensures that no matter what happens after that time, the investor cannot lose money.

Calling this a pyramid or ponzi scheme
When a share in stock will never receive sufficient compensation in the form of dividends or a buyout, then it is necessarily a scam.  That you have the power to sell that share to a greater fool is simply the power to make a different victim of the scam.  While its easy to argue that ponzi and pyramid schemes are a different scam than worthless stock shares, there is a core commonality:  Trading financial instruments that are determined mathematically to be worth less than their traded value.

Who is to blame for the lie
While I've implicated finance academia in the lies that permit corporations' abuse of minority shareholders, they would defend themselves by claiming that finance academics only speak of the value of the box.  They are still culpable through their silence on the issue and cosy loyalty to the financial industry, and the propaganda and brainwashing force that comes with rewarding 20 year olds with good test scores when they  internalize the lies.  For most people, it seems, lies that were created for them by their first year college teachers are some of the most passionately defended and internalized.

The financial industry and their client stock issuing firms are the most responsible for misleading the investing public that some company shares have value.  There is no excuse for valuing shares based only on the value of the box, when that box has no direct relevance to a share's returns.

Investors that go along with the lie, just because it is more believed than the truth, and hope the belief will stay common long enough for them to flip the stock have some responsibility as well.  They should be staying away from companies that can not compensate their shares rather than hope the truth stays hidden.

The biggest single issue that assures shareholder abuse is dual class shares.  That is what makes dividends impossible.  What makes buyouts impossible.  The tech and social media companies that went public with dual share structures did so because they could.  They did not need extra capital, and so did not need to go public.  The tech companies were great vehicles for the financial industry to sell an investment story, and that is why their stocks turned into a scam.  The financial industry was confident in being able to sell that scam.

My original essay on the topic contains solutions at the end.  I still believe they are all needed.  An additional solution would be to threaten supporters of worthless stock with legal consequences.  The same common sense basis for Bernie Maddoff being liable for selling worthless investments should apply to others who lie about the value of shares.

Monday, February 11, 2013

Institutions that invest in stock market - extreme liability

Institutions that invest client and members funds in the stock market are very likely investing in pyramid schemes and thus very likely to be defrauding those clients/members by investing in instruments that are known to have no intrinsic value.  The intrinsic/inherent value of a share of stock is the future value of dividends and the future company buyout price.

Most large public companies trade at a value far higher than a reasonable estimate of their stock's inherent value to minority shareholders.  Any institutional fund or analyst that recommends or invests client funds at inflated market prices has a conflict of interest of participating in a pyramid scheme even if they have a genuine speculative belief that for the next few months collective market exhuberance/hysteria/mispricing will maintains a stock's price.

A valuable company with a worthless stock
A company that cannot be taken over either because it is too big, or because it is controlled by insiders who can block any takeover attempt, necessarily has a stock that is relatively worthless (to outside minority shareholders) compared to the value of the company.  For such a stock to have value as a piece of paper, it must be paid dividends or have the reasonable prospect of high future dividends. (Proof of this statement)  For a stock to be worth what it was bought for the company must either be bought out at a higher price or the sum of all dividends to be paid must be high enough.

A reasonable hoped minimum stock return of 7.2%
The concept of a reasonable hoped return is relevant as a threshold for establishing liability when influencing other people's money.  A 7.2% return per year on a company that cannot be bought out, and doesn't pay a dividend, means an expectation that its price will double in 10 years, or quadruple in 20 years.  After those 10 or 20 years, there should be an expectation of a continued healthy company, and an expectation of say a 3.6% dividend yield instituted in that future, and expected dividend growth that accompanies the company's continued health and prosperity.

The key part in the above analysis is the continued healthy future prospects.  If you believe the company's health will be deteriorated in 20 or 50 years, then its stock must pay significant dividends prior to its deterioration in order to compensate for its purchase price.  While I've said that all companies pay too little in dividends today, the big dividing line between reasonable disagreement on dividend policy is the division between sustainably hopefully permanent companies and those destined to eventual deterioration.  It is excusable to tolerate low dividend payout ratios from companies with sustainable growth, because there is a theoretical possibility of proper shareholder compensation in the future.

My previous article delves into the math behind this in more detail

The problem with social media companies
The core problem with investing in social media stocks is that the companies have no unique technology.  Its unlikely that the generation 10 or 20 years from now will want to use the same social networks as their parents, teachers and grandparents.  Its hard to maintain a sustainable value of 10s of billions, when competition can be created easily/cheaply, and necessarily provide better value to members by monetizing them less.

The core misunderstanding of social media company valuation is that their member/subscribers are equivalent to 1990s cable company subscribers with the assumption that they can be infinitely milked as a captive audience.  Social media members are in fact more sensitive to excessive monetization efforts, and likely to move to a new platform that buys growth.

The problem with high sales growth and no profit
Any company should be able to increase sales by $100M by increasing sales expenses by the same amount. Marketing rebates, bribes or "hookers and blow" can create the sales increase.  Financial reporting and auditing is not designed to inform investors whether the spending is legitimate or not, but even if legitimate, it is never an effective marketing program if its costs match the increased sales revenues.  There's no reason for investors to be impressed by unprofitable high sales growth, because it never includes evidence of sustainability.

Facebook (FB)
The majority of Facebook's shares are owned by its main founder.  Because facebook has a dual class share system, its founder can compensate himself by awarding and selling non voting shares without the possibility of diluting his ownership.  For that reason, and because of current dividend tax treatment rules, there is no possibility that FB will ever declare a dividend until the founder retires.  Because FB is currently worth $60B it is too large to be bought out.  It is also impossible for it to be bought out because the owner/founder doesn't want it to be.  The owner enjoys the surplus privilege to his shares of being able to control the FB empire.  Only significant deterioration in the company could change the outlook on a takeover.

So, even if FB as a company can be optimistically valued at $60B or even $100B, hoping that it has sustainable longevity, its shares cannot be worth more than $10B because minority shareholders rely on deterioration in the company to ever see compensation on those shares.

Linkedin (LNKD)
Linkedin shares FB's dual class share structure.  That means that its difficult for outsiders to buy out the company, and insiders that control the company strongly prefer issuing themselves additional shares over the prospect of ever paying out a dividend.  The other issue that makes a takeover impossible is that LNKD shares are grossly overvalued, and not something that informed investors using their own money would buy hoping to replicate current management's performance.  Its more sensible to launch a new job recruitment platform instead.

Linkedin's main problem as a company is that it pays its management and employees too well, has no real profitability this past year, forecasts no growth in the next quarter, and forecasts no real profitability for all of 2013 either.  The addressable market for its core recruitment services is saturating, as it has approximately the same recruitment revenue as Monster worldwide, and it has spent so much to gain that revenue.  I don't believe that users will ever value the social aspects of Linkedin, and may be turned off by constant sales communications.  For all of its sales growth, it has stagnated in page views even though it is buying high profile blog content, and investing heavily in redesigns.

With a current value over $16B, and the criteria outlined before, we could ask if it is reasonable that LNKD could be worth $32B in 10 years.  However, because LNKD pays its management and employess with a large amount of stock compensation, its shares oustanding grow about 5% per year.  We should be evaluating, as a criteria to justify a $16B valuation today, whether LNKD will be worth $50B+ in 10 years, if we take into account expected future issued shares.  I don't think it is possible or reasonable to expect LNKD to make more than $1B or so in annual profit in 10 or 20 years, and so would not understand a company future value of beyond $10B (and so max $5B in today's value).

There is substantial competitive risk to the company, because while it does the heavy lifting to penetrate international markets, it is simple to duplicate the useful aspects of the platform, and offer it with a cheaper self-serve model for recruitment.  It would seem impossible for LNKD to maintain a sustainable $10B+ value as a company, if easily formed competition is content with sustainable valuation under $1B.

Bigger issues than the value of LNKD as a company, is the value to external shareholders.  Will LNKD ever repay shareholders $50B before it deteriorates?  Will it ever even repay $16B or $5B?

Liability of ratings firms
When analysts announce a target value of $175/share ($19B) for LNKD, I have to wonder about their crack addiction based on Linkedin's own projections of sales and profitability growth.  It becomes blatantly irresponsible when you factor in the company's limited addressable market, dual class share structure, and its impossibility of being bought out or offering dividends, as well as its nearly assured eventual deterioration.

If it is indeed irresponsible for analysts to confirm a stock's current high valuation, or for institutions to invest client/member money in such stocks, then there is liability for investor losses both for short sellers that might suffer from a short term price hike, and buyers/members who suffer eventual losses from long term deterioration of that stock price.

The defense that investors have a short term horizon, and hope to flip out of the stock prior to any collapse, is invalid.  If it is irresponsible to view the piece of paper that is a stock as having any real long term value (possibility of receiving sufficient compensation through buyouts or dividends), then it is irresponsible to participate in the short term hype and greed manipulation surrounding that stock.