Tag: debt

How LBOs, Share Buybacks & Private Equity Revolutionized Corporate America: Don Chew’s Case for Transformation – EP270

Donald Chew discusses the evolution of corporate finance, emphasizing the shift from old-fashioned corporate finance, which focused on steady earnings growth, to modern corporate finance, which aims for high returns on capital. He highlights the decline of conglomerates in the 1970s and the rise of private equity. Despite criticism, Chew argues that modern corporate finance has been a success story, citing the doubling of U.S. public company market capitalization in the 1980s and the significant correlation of R&D and selling, general and administrative expenses (SG&A) expenses with corporate value. He also addresses the financial crisis, arguing it was due to mispriced mortgages and government policies, not market inefficiencies. Donald Chew is the founding editor of the Journal of Applied Corporate Finance, and joins show host Gene Tunny to discuss his latest book, The Making of Modern Corporate Finance, published by Columbia University Press.

If you have any questions, comments, or suggestions for Gene, please email him at contact@economicsexplored.com.

You can listen to the episode via the embedded player below or via podcasting apps including Apple Podcast and Spotify.

About this episode’s guest: Donald Chew

Don Chew is the founding editor and Editor-in-Chief of the Journal of Applied Corporate Finance (JACF), a publication he started almost 30 years ago. He has published over ten books on corporate finance, including The New Corporate Finance: Where Theory Meets Practice and The Revolution in Corporate Finance (with Joel Stern), which are both widely used in business schools throughout the United States and Europe. Don has both a Ph.D. in English and an MBA in finance from the University of Rochester.

Timestamps for EP270

Introduction (0:00)
The Decline of Conglomerates and the Rise of Modern Corporate Finance (5:58)
The Role of Private Equity and Corporate Governance (14:25)
The Impact of Modern Corporate Finance on Corporate Value (15:03)
The Future of Corporate Finance and Productivity Measurement (16:37)
The Role of Corporate Finance in Economic Growth (19:27)
The Critique of Modern Corporate Finance and Corporate Social Responsibility (27:26)
The Financial Crisis and the Role of Government Policy (35:40)
The Future of Corporate Finance and the Role of Private Equity (43:21)

Takeaways

Modern Corporate Finance Principles: The shift from prioritizing steady earnings growth to maximizing long-term firm value has reshaped corporate strategies globally.
The Importance of R&D: Increases in R&D and SG&A spending are now critical indicators of corporate value and long-term success, according to Don Chew.
Private Equity’s Role: Private equity has transformed underperforming companies, streamlining operations and reallocating capital for growth.
The Evolution of Corporate Governance: Shareholder activism has replaced hostile takeovers as the primary tool for enforcing corporate accountability.
ESG and Value Creation: Enlightened value maximization is the idea that corporations can address societal concerns while enhancing long-term profitability.

Links relevant to the conversation

Don Chew’s new book The Making of Modern Corporate Finance:

https://www.amazon.com.au/Making-Modern-Corporate-Finance-History/dp/0231211104

Econometric study of benefits to consumers of Wal-Mart:

https://onlinelibrary.wiley.com/doi/abs/10.1002/jae.994

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Transcript: How LBOs, Share Buybacks & Private Equity Revolutionized Corporate America: Don Chew’s Case for Transformation – EP270

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Donald Chew 00:03

If you see large increases in R and D and S, G and A, that is kind of the best indicator of increases in corporate value. And it suggests that, you know, corporations, the investors, are recognized the values of these companies, even though it’s not reflected in earnings, and the companies keep pouring more money into it. So you see these PE multiples going through the roof, and you also see lots of companies with negative earnings. You know, in the old days, in the 70s, only 10% of US companies would have negative operating cash flow. Today it’s over 30% of publicly traded companies are losing money every year.

Gene Tunny 00:52

Donald Chew 02:35

to be here. Thanks for the invitation.

Gene Tunny 02:38

Of course, we’re talking about your new book, The Making of Modern corporate finance, published by Columbia University Press. And the subtitle of it is a history of the ideas and how they help build the Wealth of Nations. Now, as you point out in in the introduction to your book. I mean, this is, this is not necessarily a take that many people will. You know, people might find this controversial. They because finance, the financial industry has been much maligned in recent years, particularly after financial crisis. I’d like to ask you about that a bit later. To start with Dom, could you tell me what do you mean by modern corporate finance? Please.

Donald Chew 03:26

Modern corporate finance is a it’s a different approach to financial management that it’s it’s probably got its roots from academic work in the it started in the late 60s, and then proceeded through the 70s, and has been going on since then. But the basic idea is that, well, let me start with what old core, old fashioned corporate finances that that is the notion that a company’s obligations to its shareholders really consist of just, you know, basically satisfying their needs for steadily rising earnings per share. The job of the corporation, in a financial sense, is just to keep earnings per share rising with the understanding that the price stock prices will sort of rise proportionally in tandem. So the corporate mission is just to produce enough cash flow to be able to report steadily rising earnings per share, probably with minimal use of debt, and you probably want some diversification too, so that you can ensure this steady increase in earnings by by having a diversified, you know, set of industries and businesses. Modern Corporate Finance says no, the aim of the corporation is not to produce steadily rising earnings per share, but to produce high rates of return on capital, higher than the cost of capital, and do as much of that as possible, and and your mission is basically to maximize the long run value of the firm. And in defense of that proposition, you Well, I’m getting ahead of myself. No,

Gene Tunny 04:58

no, that’s okay. Yeah, go. Ahead, yeah, that was the old corporate finance, yeah. And what are some of the names associated with that historically, Jack

Donald Chew 05:08

Welch is the preeminent practitioner of old fashioned corporate finance. He, he viewed his mission as as again, he know he, he never missed an earnings target in his 20 years of managing, being the CEO and and to be fair to Welch, he created the firm with the largest market capitalization of its of it of its era. But it was a diversified conglomerate. It had, it was 50% financial firms in a variety of industries, power, health care, and you name it, but, but, but again, his goal was to keep reporting steady increases in earnings per share, and then when Welch stepped down in 2000 there was no no future CEO was basically able to manage that unwieldy conglomerate that he had produced, Jeff immolt ended up failing, and the conglomerate ended up being pulled apart over time, as were conglomerates throughout the United States. I should say that the failure of old fashioned corporate finance became clear in the 1970s when all these bloated conglomerates were unable to restore their profitability, and they did the S, p5, 100, lost half it’s valued during that point, and then that basically triggered the reaction of active investors who began in the 1980s to start pulling apart these conglomerates.

Gene Tunny 06:38

Right. Okay, so you Jack wells. You were talking about General Electric GE, yeah, what was some of the blighted conglomerates of the 70s? What are the prominent ones? And you said they were pulled apart?

Donald Chew 06:51

Well, General Mills was became. It called itself the All Weather growth company. It was really its core business was cereals, and then it was taken over by a retired former general who decided he wanted to make small submarines. They bought Play Doh and they but the goal, again, was, was to provide businesses that would offset whose fortunes would offset one another and create this corporate diversification. Again, it’s you know, we you you wanted to protect your employees and communities from the business cycle, and the way you did that, in theory, was to buy lots of different kinds of businesses. But the outcome of that was that the businesses ended up all being they didn’t perform well. Some businesses were starved of capital. Others were over invested in, and they all urged virtually to a company ended up being dismantled over the next 20 or 30 years. Other companies were it and T beat Beatriz foods, RJR Nabisco, ended up diversifying into different areas, if we could talk about the RJR, Nabisco, LBO, I’d

Gene Tunny 08:04

like to cover it, because that was one of the fascinating examples. Wasn’t there a famous book about it, the barbarians at the gate? Is that barbarians at the gate? Yeah, that’s right, yeah, yeah. The

Donald Chew 08:15

wonder of all this was that RJR, in the late 80s, was widely viewed as a very profitable company and well run and had a market cap of $12 billion so at that point, a number of private equity firms, one of them was Colberg, Travis and Roberts, began to look inside the operations, and there was a There was a competition to buy the firm, which actually included an offer from the CEO itself, but they ended up paying twice the amount of the firm to take it private, 25 billion for a $12 billion company, and the amount of waste inside the firm led Michael Jensen to basically declare that the barbarians were inside the gate, that Johnson was wasting through cash flow, just to conceal the profit potential the business from his competitors. And, you know, and the rates of return on new investment were from two two to 5% you know, for a new cookie manufacturing company. And so you basically double the value of the company, even if the buyers didn’t make a cent, you know, you know, just by virtue of the, you know, the amount of mismanagement that was going on behind the scenes. Again, colossal waves. You

Gene Tunny 09:33

mentioned Michael Jensen. I mean, that he’s one of the big names in modern corporate finance, isn’t he? Could you tell us a bit about Jensen and his contribution. Please, Don

Donald Chew 09:45

Michael Jensen, with his colleague Bill mechling at the University of Rochester, wrote what became the most cited article in the corporate finance literature in 1976 called theory, the firm, agency, costs and I. Forgotten the rest. But the basic argument is that there is a a conflict of interest between management and shareholders at the very heart of the organization. That means it’s going to be very you can’t expect managers to maximize firm value. They have their they’re torn in two different many ways. And the biggest conflict between management and shareholders is not, you know, corporate jets and perks. You know, that’s that’s one source of conflict, but the big one is over the optimal size and diversity of firm. If you’re a corporate manager with minimal stock ownership and you’re a resourceful person, what you want to do is build an empire. You want to buy as many different companies as you can. Again, which makes you more famous and actually raises your pay given the way CEO pay evolved in corporate America, which was to say that the larger the company you ran, the higher your pay would be. And and again, this is all premised on the idea that CEOs didn’t own much stock in their own companies, which was true in the 70s. But Jensen and meckling set themselves the task of, how do we explain the dominance of the corporation, given this basic conflict at the heart of it, you know, Adam Smith that we go back 250 years, said the public corporation could not work. You know, managers could not people could not manage other people’s money in any kind of operation requiring lots of managerial discretion and control. So what you saw in Smith’s day was, were these joint stock companies that were like canals and turnkeys and regulated banks, but that, but nowhere else. Everything else was closely held partnerships because outsiders could not trust other people with their money. There were no mechanisms that would allow the joint stock company to end up managing large scale operations. Well, well, Jensen found a solution to that problem, in the sense that that there are all these mechanisms, governance mechanisms that evolved over time to give outside shareholders a measure of control. You know, there were audit financial statements, there were boards of directors that were in CEO incentive pay plans, and then and then, there were competitive product markets. You had to sell a product and make money, and then you had labor markets. If you were a CEO and you wanted a good job, you had to do a, you know, you had to have shown the market that you were in the labor market, that you were doing a good job. And then if all else failed, there were supposed to be some outside forces. That is, you know, maybe eventually there were hostile takeovers, but there really was not, not much sign of it, of a hostile market for corporate control. When Jensen was writing his paper, so he and Bill meckling said to themselves, you know, we really don’t understand how these companies work, where CEOs earn just minute. You know, I have minimal stock ownership, they Jensen and Murphy concluded that the average CEO, for every $1,000 increase in the value of the stock, they earn $3 so it was, which was a bit people are being paid like your occurrence. So this, this is that there’s got to be a problem. And then, and then, at the very end of the article, they said, Well, what if managers went out and bought back 99% of the shares using debt finance and then became basically the sole owners of the firm? We are going to propose here that this would lead to wonderful efficiency gains in these corporations if they could transform their structure. And this is basically what happened. This was the LBO that they forecast. They showed us the template and and all of the 80s can be seen as a vindication of this forecast by Jensen and meckling back in 1976 and as I said it is far and away the most cited article in the corporate finance literature, with like 150,000

Gene Tunny 14:06

sites. Yeah, yeah. So this provided the theoretical support for the leveraged buyout, which has been controversial at times. Yes. Can I ask, like, because as an economist, to what extent has the is it economic logic that has led to this transformation in corporate finance? Is it the applicant like fully understanding the economic value and how to maximize the economic value of the corporation, looking at it in a you know, over the future, looking at the discounted cash flow is, is that? Is that fair to say

Donald Chew 14:44

yes and no. I mean, it’s, it’s certainly, it’s part of the answer. But it’s not enough. So you had to, you know, by law and custom, hostile takeovers were frowned on you. Just if you were a Morgan Stanley, you. Not fund the hostile takeover because you were violating, you know, the rule about, how do you how do companies deal with you know, they have their beholden to their investors, and they’re beholden to their corporate clients, and it was a rule, Thou shalt not do hostile takeovers. Everything has to be done with the agreement of management. Well, anyway, that that consensus shifted over time, and active investors became, you know, they they, what they saw was the huge difference in the values of these companies, if they were dismantled, the sum of the parts was vastly greater than the market values of these companies. And as the as that gap became larger and larger, the pressure to actually break them up grew great enough that people like Michael Milken and all the people he funded saw this opportunity. And then when the Reagan administration came in, there were, there were relaxations of some kinds of financial constraints, anti trust, and this, this collocation and and the discounted cash flow met, you know, method and modern finance, all these forces work together to lead to this eruption of the market for corporate control. In carrying out the market for corporate control basically ensured that the principles and methods of modern corporate finance would would go into action, would be implemented. This provided the basis, but, but again, you had to allow active investors to assert their control, their voice, which just didn’t happen in this in the 70s or the six or the fifth, yeah.

Gene Tunny 16:37

Okay, and is it right that there’s a trend towards companies staying private or going private, so going off the the you know, not being listed on the stock the stock market, is that a trend? Is that driven by this new approach to corporate finance?

Donald Chew 16:55

Yeah, absolutely. There’s a bunch of factors here. You know that the number of publicly traded companies in the United States has fallen in half over the last 30 years. The ones that remain are actually much more valuable than the ones in the past. I think the average company, publicly traded company today is is four times what it once was, even so, so the the market value us publicly traded companies, is twice what it once was, say, 50 years ago, but with half as many companies and at whereas the number of private companies is now something like 8000 There are 8000 PE controlled companies, you know, double the amount of public but they are. They’re much smaller. In fact, if you add up all the private companies, they amount to maybe 10% of the market cap of public companies. So what you see here is that the companies with extraordinary growth potential, most of them end up going public, because that’s the beauty of the public corporation for growth is that is the dumb investors like you and me will provide them with cheap equity capital, because we know they have growth opportunities. It’s just clear as crystal you know that these companies will succeed so so for companies with growth opportunities, public equity markets are a great deal, but once you start losing your your luster as a growth company, then eventually your PE multiples fall and they become within reach of private equity investors. And I think it’s now, you know, Jensen has shown us that companies without growth opportunities are generally run better as private companies for all variety of reasons. For if you’re doing a dirty business that the newspapers don’t like, if you’re an oil and gas you want to be out of the public eye, so you’ll end up getting higher multiples from private investors. And you can do stuff in private that just doesn’t look good in the newspapers. You know, you’ll notice that lots of public oil companies are shedding their oil exposure to meet their carbon commitments by selling their operations to private companies. And this all makes perfect sense, and we benefit from it, in fact, because, you know, again, these companies get opera, and I’m not meaning to suggest they’re shady, but, people don’t like one of private equity’s poor competencies is is cutting unprofitable growth. You know, that’s what it’s famous for cutting, and it’s an essential economic function. It’s almost as important as growth itself. The capital for growth us comes from cutting unprofitable operations. And nobody talks about this. You never talk, you know, you never hear about the heroic efforts of PE to streamline and cut limb by limb so that this money can get recycled back into the growth sector. Which is what happens? Yeah,

Gene Tunny 19:54

well, well, I think economists are sympathetic to that, that perspective, if you. Think about Schumpeter with the gales of creative destruction. And yes, also, I think Friedman had one of he wrote an article about how one way of seeing the market outcome, or the mark market efficiency, is the result of competition being an evolutionary process, or a competitive process that weeds out the inefficient Darwinian. That’s it. Yeah, yeah. So, yeah, very, very sympathetic to that. Now don’t Can I ask, I got a question about, like, the contention you make, and this is, I mean, this is fascinating. And this American style corporate finance, a phrase that combines two, if not three, of the most vilified words in today’s English Language Media. It’s brilliant. Yes, it’s very true, social and otherwise, okay, you agree? Okay, yes, I agree. Has for the past 40 years been one of the world’s remarkable success stories. The principles and methods of Finance to continue to be taught in business schools around the world have played a critical role in the productivity of the US private sector. Now that is a I agree, I largely agree, but I want to know what empirical support is there for that proposition.

Donald Chew 21:19

Well, again, I have to, I have to go back to the 70s, when the dot the Dow Jones market lost half its value and the economy was struggling. It was a millez and and Jimmy Carter didn’t know what to do. His politicians didn’t know what to do. Inflation was out of control, and unemployment kept going higher and higher and and, but nobody, few macro economists, looked at what the companies were like, and that’s what my book does. It says these companies, back in the 70s, had been allowed to grow into these bloated conglomerates. There were no outside forces checking this managerial desire to build empires. And so in order to create a productive, prosperous society, you had to cut back these conglomerates and break them up. And this, although painful at first, this ends up creating the basis for more growth. And it starts as shareholder value, and it looks, it looks bad for a while, but ultimately it creates lots of growth opportunities. And I believe the last 45 years have borne this out. Jensen, when he tried to make his case, he looked at he said, well, the market capitalization of US public companies doubled during the 80s. So that’s that’s one data point. Labor productivity a total factor. Productivity statistics went up dramatically in the 80s. Some versions of labor productivity statistics went up. But, you know, these are the best market and operating data we have for that period of time. But then, you know, again, you have to point, I would point to the last 45 years and say, look, it’s been this. Us, equity returns have been 12% a year on average, you know, which is far and way higher than anyone else and and it is just in the process. It’s really a process of continuous restructuring. In other words, companies have to keep putting pressure on themselves, always squeezing out excess capital, always reevaluating every investment. Is it time to get rid of this, give it to somebody else, or is it time to grow it? And conglomerates were terrible at this. Conglomerates always, they starve their best opportunities, and they fed a lot of their and so they were horrible allocators of assets because they didn’t understand the businesses they were in, and and so and I just believe, you just look at the like, what has happened to America in almost every economic dimension is, is proof, you know, is proof of this process. And now we don’t, we don’t see hostile takeovers anymore. We see shareholder activists so and it’s a fundamentally different device, but it operates in much the same way. And in a hostile takeover, you go out and buy control of the company, and that a lot of people didn’t like. Peter Drucker hated that process. He said, This is a violation everything we know about good management, but today’s activists like Paul Singer of Elliot management, he will buy five to 10% of the stock, and he will say, Hey folks, we think there’s a problem out here, like south southwest airlines. So let maybe, let’s have a shareholder meeting and and so it’s all you large investors. I’m going to put the proposition out there. You get the vote on my idea. My idea is that, hey, maybe we should get a new CEO, or maybe you should follow a bunch of steps. But it’s sort of shareholder democracy in action. So and if the majority. Shareholders don’t like what Elliot management is doing. They can say, No, we’re voting against you and what? But what happened in the southwest cases, I think he won four out of 12 board seats. The CEO was not ousted, but he was put on notice, and they now have a the stock price is probably up 25% since they went in there, and the company is sort of getting right, you know, righted back to the way it should be going again. It’s putting the company on notice, suggesting alternatives, and then allowing the large institutional investors, the Black Rocks of the world, to vote on your proposal. And to me, I find that just a wonderful system. And I don’t know if you saw this last week, but the FT did a piece on Japanese shareholder activism. There was a statement by the the the leader of the association, who was welcoming a new era of shareholder of activism to end the 30 years of Japanese stagnation, I said that the Japanese slumbering for 30 years. We think this is the solution to our, you know, our economic melees, which includes a 7% drop in the population for last five years. I actually go so far in my book is to suggest those two things are directly related. You know, they’re just not wrong. Yeah, opportunities for in their quest for full employment, they basically have ensured that there are no employment opportunities for the next generation of workers and Germans heading for the same thing. If you saw what happened in Volkswagen, yeah? Which, to me, is a corporate governance failure.

Gene Tunny 26:44

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Gene Tunny 27:19

now. Back to the show, can I ask about what’s your take on ESG or corporate social responsibility? Ask that because there’s so much bad press about what we’re calling modern corporate finance, about private equity. I mean that there’s the, you know, concerns about job job losses. You look in the popular culture, wall the films, Wall Street, pretty woman, the private equity sort of people, the, you know, the financial markets. Person, Gecko, yeah. Richard gears character, and pretty woman, who’s, I think he’s in private equities, breaking up companies. And Julia Roberts’s character is sort of wondering, what on earth you’re doing, and pull apart companies to make them more valuable, and their concerns about job losses associated with that. And you’ve got issues, you know, various social issues, various social ills in the US. I mean, it’s quite clear what’s your take on do corporations have a responsibility for that. How to what’s the role? What’s the corporate social responsibility there? I think the

Donald Chew 28:27

mission of the corporation, as Milton Friedman said, is to maximize their own but they missed quoted. He is quoted as saying it’s to maximize its own profit. That’s not what they do. They maximize their long run value. And to do that, as you really you have to invest and take care of everybody you know. To maximize value, you have to decide how much, what kind of commitments are, am I going to make to each of my constituencies? How much and but with the idea that if you pay another that Michael Jensen’s rule was, pay another dollar to every stakeholder who matters, as long as you expect $1 in return. Measured. And you know, it’s, you know, the old rule. But Jensen, Jensen has this concept of enlightened value maximization, which is the perception that I hold out in this book. And it is, again, it’s about committing to every stakeholder who matters, making very clear what it is, what we’re going to do for you and what we expect in return, and just getting people on board and again, but all with the idea that this is going to increase the long run value of the whole franchise, and it means you can’t you want to pay, you don’t want to pay too much or too little. You want to get just the right amount. And to me, one of the best illustrations of a really good ESG program is Walmart. Yes, well before the pandemic, Walmart basically increased across the board, their employee pay and then they’ve also they they hire and promote from within. Their store managers make an average of $175,000 a year. They invest in their suppliers. They monitor their suppliers. They brought a lot of them back to America, and though they squeeze their suppliers, they also make sure that they’re working and take care of them. And they have the largest plastic waste facility in the world, plastic waste recovery through repackaging and Doug McMillan, the CEO who is a Walmart lifer, is now the chairman of the US Business Roundtable. In other words, that is the group of the largest, most prestigious US corporations. McMillan, this southern guy who was raised as a Walmart, you know, employee, is now the the head of this large lobbying organization. I you know what? To me, it’s a huge ESG success story, but there’s a lot of ESG failures. There’s a lot of bad ESG that basically doesn’t pay attention to corporate value. To me, anything that any investment has to have its focus on maximizing long run value, but there are lots of ways that you can address social problems through your investments, and it’s that magical, you know, Confluence that ends up, it ends up putting higher price earnings multiples on companies. Investors like to feel good about the things they invest in, and when they do that, your company, you know, Walmart, probably increased its value by 50% last year, and I would wager that 10% of that is just people feeling good about what the company does, yeah,

Gene Tunny 32:02

yeah. I like your comments on, yeah, on enlightened value maximization. I like that because, you know, this is these sort of concerns about corporations, and they’re in the news. They’re in the, you know, lot of commentators are coming quite, you know, very critical of corporate power. There was the extraordinary reaction to the killing of the United Healthcare CEO in New York City, gunned down in in Manhattan. And a lot of people were was almost celebrating, in a way. I mean, no, we don’t condone, obviously, we’re not going to support murder, but people were saying, Oh, you can understand this, because they’ve been ripping off people for years, like it had such a high rejection rate of claims. So yeah, just you don’t need to comment on that. It’s just putting that out there. As

Donald Chew 32:54

my daughter is sending love letters to Luigi man Jones, right,

Gene Tunny 32:59

yeah, yeah, yeah. He’s, he’s a become a folk hero, in a way, hero,

Donald Chew 33:04

right? Yeah, because the corporate pursuit of profit is inherently evil. It’s inherently anti social. And that you could go, take that back to Roman Catholicism, you know, the first time you go into church. But that is what you learn. You know, one man’s problem is evil because it’s it somehow comes out of the pocket of somebody else, and changing that point of view is one of the great contributions of modern capitalism. In other words, when you create, yeah, you’re not hurting somebody. In fact, in most cases, you’re helping somebody. It’s like they asked Jeff Bezos, Jeff, are do you really deserve to have a $200 billion fortune? Can you justify that? And he said, Yes, I’ve created $2 trillion of value for my investors, not to mention all the jobs, all the taxes paid. That just begins. My success is it’s just created enormous wealth for other people. And this is, this is not cheap, so I

Gene Tunny 34:09

Oh no, it’s certainly, certainly not widely appreciated, because now we’ve got people like Bernie Sanders and commentators on the progressive side saying, Well, every billionaire is a policy failure that’s becoming a widespread, you know, contention. The other Yeah. So it’s all very, you know, contentious and up for the up for debate. So, yeah. So, I mean, I think I agree with you. I mean, a lot of the value, like they do create a lot of value. There’s a lot of value from entrepreneurialism. And I remember Robert Barrow, The Economist at forget where he is now is he’s been at Harvard or Chicago, has been all over the place. He has an Institute in Washington. Now, does he right? Very good. I’ll have to, have to look it up. But he once said there are we wrote a column just to the effect that Bill Gates has created more value, or did more good for the world through Microsoft than he has done through his foundation. It was something along those lines. I mean, yeah, yeah. If you look at the

Donald Chew 35:13

I would say the Jeff Bezos is the world have done more for poverty than Mother Teresa than the Mother Teresa’s put it that way,

Gene Tunny 35:22

right? Yeah, through, through, yeah. Lower price goods through, yeah, so, yeah, yeah, yeah, very good. Okay, estimate

Donald Chew 35:33

that Walmart saves the average family $5,000 a year, just just by selling low cost products. You know, that’s consumer surplus and so and look at Walmart might be the only US operation that’s growing in China. China loves Walmart because it understands that its people are being helped by the operation of Walmart in getting these low cost products to them. So, you know, GM is leaving China because they don’t make enough money and because China basically they’re just being squeezed out by state owned enterprises by but government policy in China has chosen to allow Walmart to succeed, and to me, that’s incredibly telling, because they understand the social benefits. That’s my hip hop

Gene Tunny 36:28

question, yeah, yeah, yeah. I’m gonna have to track down that study that’s fascinating about the the 5000 saving from, okay, yeah,

Donald Chew 36:34

yeah. I believe that I’m shooting from that, but I think it’s great.

Gene Tunny 36:39

That’s okay. I know that it’ll be, it’ll be something of that, of that magnitude. I’ve got no doubt. I’ll just, I’ll just, I’m just interested, because that’s a useful that would be a useful empirical study, or to point to, yeah, but that is very good

Donald Chew 36:51

corporate mission. Their corporate mission is to save other people money so they can live good lives. You know that so that they’re saving their consumers money. That’s that’s their, well, that’s their mission statement. And I’ve never it’s

Gene Tunny 37:08

a rather, rather extraordinary story. Was it Sam Walton? Am I getting the name right? Well,

Donald Chew 37:15

that was when rod, yeah, awarded the Presidential, Congressional Medal of Honor, and that’s where he made that statement. He said, we’re going to make our job save other people money, you know, so they can live good lives. So help them

Gene Tunny 37:29

live good luck. Gotcha Okay, right. So now, and as a sort of final part of the the interview, I’d like to talk about the financial crisis, because, look, I largely agree about the theories or the hypothesis, the what you’re what you’re saying in the book. One, one area where I may have some hesitation is it’s an interesting perspective. You argue that the financial crisis isn’t something that violates or is in or contradicts the efficient market hypothesis. So this is Gene farmer’s idea that the market prices of financial products represent all of the available information and the market’s efficient. Can you explain? Please, Don What’s your view on the financial crisis and why you think that doesn’t violate the efficiency efficient markets hypothesis, please. Well,

Donald Chew 38:27

let me start with what I think the efficient market theory says, and then, because that’s generally misunderstood, the caricature of efficient market theory is that the price is always right. And that’s not the theory says that it’s it’s an unbiased estimate of that is it’s either too high or too low on on average. But Fisher black wrote a paper call on the noise theory that said, you know, the average price is within 100% of the correct value, 100% plus or minus. So yeah, and that’s not which just tells you there is a hell of a lot of uncertainty out there about things. Well, it turns out that, the way I read the global financial crisis there, there were something like $6 trillion of toxic mortgages sitting on bank balance sheets throughout the world that people just didn’t realize were out there. They didn’t understand how bad these mortgages were. And I’ve written about this, and I say a mortgage when it’s first issued is expected to lose 1% of its value, and the Basel risk requirements say, Okay, we need 1% backing for 1% expected loss. A corporate loan is supposed to lose 4% of its value, so we need 4% to back that. Well, what happened? What ended up happening is that these mortgages lost 10% of their value. They were, they ended up being and we don’t. We still. Don’t know, even to this day, how much they lost, because these numbers have just, you know, there has been no federal attempt to determine, as far as I know, to determine how much money these mortgages ended up losing, and and the problem, and, and I, I don’t want to I can’t blame the private sector entirely, because these mortgages were were pretty much demand, is too strong a word, but they were certainly blessed by the Federal Reserve that the government with government policy starting in 1992 was to make low down payment mortgages to underprivileged areas. And then that that became, that became expanded to not only underprivileged and low income people, but high income people were also given low down payment mortgages. And the the ability of Fannie and Freddie may to get their congressional their right to operate was premised on their making low down payment mortgages called all a and it meant that if you were I had a friend who was a commercial airline pilot Who bought a house in Hawaii for $750,000 put down 15,000 the down payment, and when down value fell by 40% he just walked away from the mortgage. And this was done everywhere and and as again the mortgage, the loss rate on these mortgages has turned out to be in excess of 10% and then, when you, when you understand that banks themselves were allowed to operate with three to 5% capital before the crisis, you’re just you’re losing money on every dollar. And in fact, if you you, if you compute the amount of if you take that 90% hole in bank balance sheets, it was almost equal to the 600 billion that the government poured into the banks as bailout money, and it, you know, I’m, I’m not doing a good job of explaining this now, but the the money that they put into the banks allowed the banks To continue to operate and if you’re on when you’re a bankruptcy judge, your first job is to say, okay, is this a viable entity? Does it deserve to be rescued, or should it be shut down? Well, what we now know every bank paid back every dollar the bailout money with 10% interest it within a year. But there was one company that never paid the money back, that was General Motors. General Motors has never paid back the $11 billion that company was really made probably should have been shut down. It was. It still owes us taxpayers $11 billion and it was and Obama rescued it. He became the self appointed bankruptcy judge, and, you know, and to this day,

Gene Tunny 43:11

yeah, I’ll have to look into, I didn’t realize that about GM,

Donald Chew 43:15

yeah, they don’t talk about that. That was one of the worst, run. That was one of the worst run companies in America. You know that that cup GM was immune to take over. It was too big, taken over by anybody, and the result was that in 2008 it had one and a half times the number of employees to service a normal market. There were employees that were being paid to stay home. It’s like the New York City school system, you there were people, there were rubber rooms where they said, Look, we have access. We don’t have any work for you. We’re just going to pay you to stay home. And this went on for years, you know, you know. And so this was a company that had somehow was immune to any kind of outside influence, and that’s what you get when you when you have and that’s really the story. The 70s, you know, lots of companies had grown to that kind of Elven time proportion, and that’s why, you know, one of the big predictions in my book was very few macro economists foresaw the ability of US companies to withstand the COVID pandemic, then the interest rate hikes that followed it, but you know, and I felt like I was the only person on Wall Street saying our companies are going to do fine because they’re lean and mean now they they’re not companies in the 70s, but every macro economist model is premised on the 70s, because they all go back and say, Well, that’s what happened in the 70s, but the companies are assumed to be the same ones, because macro just doesn’t look at corporate finance. They’re two as chapter 12 of my book is about what macro gets wrong.

Gene Tunny 44:55

Yeah, and yeah. I mean, I think there’s some some good points there. It’s. The problem of, you know, the data, they’re highly aggregated, and, like, how much detail do you get to get in there? I mean, that’s, that’s certainly an issue. Another issue is, you know, macro hasn’t really, they don’t really have a their financial model or sector model. They don’t really have the banking sector in there very well, if at all, in some of their macro models. So, yeah, I think there’s, that’s a really, really good point you make there. Okay, John, this has been, this has been great. Yeah, I’ve learned a lot about about what, you know, what’s been happening since, you know, 70s, 80s, so compared with the past. So you contrasted the modern cop corporate finance with the previous approach, where you had the big conglomerates, there was an aversion to debt. And I mean, by doing that, you’re reducing your return, aren’t you, because I mean, debt is a way of getting debts. Debts cheaper than equity. Is that the argument? And all the debt lets you leverage up and that enhances the the equity return. Well, it

Donald Chew 46:04

does both. So you, yeah, I mean, debt is really a control device. It basically, if you don’t have, this is the Michael Jensen argument that debt forces you to pay out excess capital. So you, if you So, the rule of thumb is, if you are a mature cash cow, you want as much debt as you can put on it, because you want to squeeze that capital out. If you’re a growth company, you want to avoid debt like the plague, because debt will cause you to pass up valuable investment opportunities. So it’s a very simple proposition, and that, and it it, you know, and it can be seen, private equity tends to go for the mature they squeeze out excess capital from companies without growth opportunities. But although private equity has started to move over into the growth spectrum, to a certain extent, they now operate with, in some cases, more than 50% equity. So the whole movement private equity has been to reduce the amount of debt and take on more growth. And now we see the largest companies, these unicorns, which is a company with more than a billion dollar market. They’re staying private because the costs of raising outside equity are just very high. You know, the I call it the cost of having dumb investors once. If you bring dumb investors into the party, you’re gonna, you’re just gonna have to say more you’re gonna provide more information. And you’re, they’re just not in a position to pay up for risk. So these unicorns are now. They look like public companies. They have the same collection of fidelities and black rocks, but there’s no retail investor. It’s just the smart money all sitting around the table, still very large market caps, growth opportunities, but they can have a private conversation about the value of the company. That ends up it just, it means the company’s worth much more, because you don’t have to spend money educating your investor base. You know, that’s it. There are huge public company, and that’s why there’s only, opposed to 8000 Yeah, and it’s not just Yeah,

Gene Tunny 48:19

absolutely no, I agree. And I agree. And I was just thinking, with all the additional regulation that, yeah, I mean, public companies tend to have more the regulatory requirements are much greater reporting requirements. So, yeah, that’s a good point, but it’s not,

Donald Chew 48:34

it’s not just the regulation and those costs. It’s the if you’re a small company that’s not attracting, not not much growth, you’re gonna, you’re gonna have a very depressed value. They’re all these tiny little companies that went public and they’re now orphans. Nobody wants them. Nobody covers them. So they trade at two or three times earnings. And that that’s a cost. With hindsight, they should not have gone public. They’re going to end up going back into private ownership. But you can’t. Is this? Public investors just can’t. They’re not smart enough to go in and rescue the values of these companies. So it just ends up leaving, you know, leaving them in a no man’s land and and I chopped that up to the the information costs of being a a public company. Gotcha,

Gene Tunny 49:26

are there some notable examples, or prominent examples of those smaller companies that have gone public and it’s not worked out for them? I can’t,

Donald Chew 49:33

I don’t know. I, you know, I wasn’t prepped for that, but, but I’ve heard people talk, no, I Yeah, it’s become a the liquidity is dried up. You know, lots of people will say that. And yeah, you would think, then they would sort the GO, GO private again. You would that would be the natural first step. But, but, but, no, okay, sorry,

Gene Tunny 49:55

no, that’s all right. I was just just wondering, because it was an interesting, interesting point. I. Right. Oh, well, Don just to finish up any final points, anything, any points in the book. You think it’d be worth bringing out in this conversation that we haven’t covered

Donald Chew 50:09

yet? Oh, yeah, let me. Let me take it one more shot. During the last 50 years, earnings relevance has dropped from something like 50% to zero. There’s a book called The End of accounting by Baruch Lev so the statistical correlation between five year changes in earnings and five year movements in stock prices, that’s how accountants track the relevance of earnings. That that statistical correlation has dropped from 50% to zero, and this is consistent with my, my view of modern corporate finance, which is not, it’s not about earnings, but there is one variable that actually has explained an incredible amount, an increasing amount of corporate stock prices. Would you care to take a wager? What it is? Well,

Gene Tunny 50:57

I’ve read the book. I’m trying to remember that this is your it’s the it’s the category. It’s one of the cost categories, isn’t it? Yes. Is that right? Yes. It’s,

Donald Chew 51:06

yeah, it’s, it’s R D, increase in R D, increase in S G and A and S G selling general and administrative expense. Well, during the last 50 years, that number has jumped from 25% of total assets to 55% which is amazing. And so yeah, the question, what is in SG and a that wasn’t in there before? And it’s all kinds of stuff like marketing and promotion, employee training expenses, all kinds of intangible expenses. And this stuff gets, you know, it gets expensed. It’s not capitalized, but it’s really, it’s kind of a modern day form of r, d, you know, Amazon has a ton of that stuff. And what we’ve discovered is that the the this, the correlation with those two variables and market prices, is is really remarkably high. So the one variable that you want to see, if you see large increases in R and D and S, GNA, that is kind of a the best indicator of increases in corporate value. And it suggests that, you know corporations are, you know they’re the investors are recognized the values of these companies, even though it’s not reflected in earnings, and the companies keep pouring more money into it, so you see these PE multiples going through the roof, and you also see lots of companies with negative earnings. You know, in the old days, in the 70s, only 10% of US companies would have negative operating cash flow. Today, it’s over 30% of publicly traded companies are losing money every year, and then every couple of years, they go back and raise private equity. They raise they raise public they raise equity from private sources because the public markets can’t invest in it. They don’t want to buy a company that’s losing money every year, but they go back to the Chase Manhattan Bank and get private equity so and the popular press thinks that these companies are zombies, but they’re not zombies. They’re actually quite valuable companies, but you won’t see it on their P and L’s. And I find this a really remarkable phenomena. I just, you know, I haven’t seen, there’s two or three academics that are talking about it, but it’s just, so, yeah,

Gene Tunny 53:27

but so what’s justifying the valuation? I mean, you, you show there’s this correlation between that, that those expenses and R and D and their value. So, but what are people who who are buying these, these companies, are investing in these companies. What are they seeing? Are they seeing that they’re building eventually, they’ll, they’ll earn a ridiculous amount of money, or that, or they building up an asset, intangible assets, knowledge, software, or whatever, that will be bought out by a Google or by, well, yeah,

Donald Chew 54:02

okay, it could be either those two. Okay, yeah. I mean, it’s probably more likely to be bought out by somebody else, but, but it’s the Amazon story. I mean, Amazon really didn’t show earnings a long time and but to their investors, the idea that these were investments and that they had phenomenally high margins, you know, once they turn cash flow positive, that you can see the amount of dollars they would earn on each you know, because the the requirements for future capital were so limited that they were bound and they were going to become money machines. But it’s hard to again, it’s hard to communicate that to a public market. But if you get a small people and group of people in the room, they share their your vision, and then, you know, for now, it’s private equity, but eventually, when the growth opportunities start to materialize and the cash flows, then it becomes public but the wonder of Amazon is that Jeff Bezos had the confidence to do this. You know, this is. When he did, I mean, because he had no earnings. I remember my firm, stern Stewart was once hired by an investor to determine if Amazon was going to go belly up. They were so concerned because he had no earnings, and so they had to hire us to then, you know, to verify that this was actually a solvent operation. And then that’s, you know, it’s really about, you know, smart investors versus dumb investors. You it’s hard to communicate with dumb investors, so you need to find and but Bezos had the confidence to say, I can keep doing this. He had his credo in 1997 and he got a following, and then he became, he basically conditioned these investors into following and rewarding him. You know, the larger his losses, the larger the stock price game for a period of time, which, which is the way a smart market should work. So anyway, more than

Gene Tunny 55:54

you want to know. No, not at all. I mean, I find it, I find it extraordinary that the end of accounting. So I’ll have to read that book. I haven’t read it, and it sounds, had you heard of it? No, I hadn’t, actually, not until I read your book. That’s, yeah, that’s fascinating. I mean, there are all sorts. I mean, as an economist, I’m often, you know, like economists often think, sort of try and look through the what accountants produce. Or, you know, because accountants don’t always represent things the way that economists would. So sometimes things the way accountants show things are not helpful. So yeah, it’s interesting about the end of the end of accounting. Yeah, yeah, I have to look into

Donald Chew 56:40

that. Very good. Are you trained in accounting or finance or

Gene Tunny 56:45

Well, I mean, I I’m an economist. So I’ve done, I’ve studied accounting, and I’ve studied some finance. I used to work in the treasury here in Canberra, and I work as an economist now. So do cost benefit analysis studies and business cases and things

Donald Chew 57:01

I really look forward to hearing what you have to say about my macro chapter, the chapter 12, yes,

Gene Tunny 57:08

well, I like the point you made about economists not not properly, considering that change in the corporate the composition of corporations, I’m gonna have To go back and read that more closely, but I think that’s a that’s a very compelling point, and I’ve got to think about what that means for how economists might model that. So yeah, I can’t. I probably haven’t got much to say on it at the moment that’s as profound, but yeah, leave it with me, and I might shoot you a note about it. Big debate

Donald Chew 57:42

is about productivity. Yes, you know, how do we measure it? And, you know, I just think, and people, a lot of people, think that GDP just doesn’t provide any grounds for measuring productivity. So the you know, but with the measures we’re getting from the national income accounts, just don’t. They don’t do a good job of reflecting inflation, but they’re even worse. Yeah, they’re even worse than reflecting productivity. And we can just kind of go after Robert Gordon and suggest that he was, you know, way too pessimistic about productivity growth in the latter part. So that’s the argument, yeah. And one, one last, are you a Robert Gordon, yeah, I like,

Gene Tunny 58:25

I think that’s a very good book. The I mean, his argument is that, that we’ve already, we’ve had major general purpose technologies, and we haven’t. We had that in the industrial revolution, then the second industrial revolution, yeah. And then the third industrial revolution with ICT, or the internet mate was actually, but, yeah, there was, or maybe back in the 80s with ICT. But what we’re seeing now isn’t quite of that same magnitude, and he’s pessimistic about productivity growth, but that’s before the modern I mean, AI is giving me cause to reflect on Gordon’s thesis. I think, yes, yes.

Donald Chew 59:06

Okay, well, anyway, I take issue it with it in my chapter 12 and and this is based on the work of an economist named James Sweeney at First Boston. But he says, when he my favorite line is, when, when I, he says, when I go in to talk to a CEO about Gordon’s book and productivity decline, I get laughed out of the room. You know, they they just don’t rot because the productivity doesn’t show it. Just can’t show up in GDP, the numbers they’re using just can’t reflect the quality. You know, you can’t make these quality product adjustments that are required to make something comparable and so. And my argument is, yeah, look at stock price. You want to see productivity gains, at least projected forward stock prices is the place to look, not, not at GDP. And I’ve got, I’ve been talking to the chairman of Columbia’s accounting. Department, and he’s very excited by that idea. In other words, the idea that macro actually suffers from the same problems that accounting suffered from, but finance is correct. Finances basically said, Look, accounting is just a point of departure, and you’ve got to look at many, many other things so you can get the stock prices. Macro economists are still stuck back with GDP, and they’re not looking they don’t trust stock prices. They just don’t

Gene Tunny 1:00:29

think, yeah, that’s true. And I think the reason is that economists suspect that that time, I mean, stock markets can the market pricing can be wrong for a significant period of time or divorced from fundamentals, so prior to the.com crash, for example. So I think that’s probably why the the macro economists are skeptical. Yeah, but yeah, I’ll let me reread that, because I must confess, I think I just skimmed that, whereas I focused on the the earlier chapters and the discussion of Jensen and Nick lean and but I’ll have to come back to you on that, because that’s a it’s an interesting argument. I agree with you about the difficulty of measuring productivity. I think that’s, yeah, that’s, that’s well appreciated by economists. And there’s a lot of you know, there’s a huge literature on this. There’s conferences, but it is something I haven’t looked at in a in a little bit, so I’ll have to, I’ll have to go back to that.

Donald Chew 1:01:24

Okay. No, I’d love to hear what you have to say. And one piece of business here, when we end up doing this recording, my thing will just be, will just be audio, if you should. Yes, yes. Confused to use, yeah, okay, that’s my hope.

Gene Tunny 1:01:44

Okay, yeah, yeah, just audio, yeah, just for sure, yeah. No, no problem at all. No, no, no,

Donald Chew 1:01:48

I have problem at all. All right, this is, it’s been a hell of a lot of fun. So

Gene Tunny 1:01:54

Excellent. Well, I hope you, hope you get on some other shows, and you your book is, you get, you get some good interviews out of it, and good coverage. Because I think it’s, it’s an argument that that needs to be made, and it’s, it’s a bit of, it’s counter to a lot of the popular understanding, the popular views on on corporate finance. So I think it’s, it’s definitely a welcome addition to the literature. So I

Donald Chew 1:02:22

ask you one more question. You think the book is written sufficiently clearly, or that it could actually be an introductory finance type? I view it as a supplement to a corporate finance and that’s what I’m trying to promote events. So if you’re teaching, if you’re using brilliant Myers in your finance 101, do you think undergrads or non finance types would be able to process the information in the book? Or do you think it’s too

Gene Tunny 1:02:56

maybe a third year a third year student or third year undergrad, yeah, yeah. Okay. I mean, that’s just, yeah, yeah. I think it could, I think it could be a good supplementary text, certainly that, like all of the history there, and the discussion of, I think, you know, the discussion on Jensen and mecklen is great, okay, and I think you’re very, you’re very clear about your, what your how you see this adding value and the market for corporate control. I think that’s all good stuff. Yeah. I think it certainly could be, could be, could be valuable there. I mean, it’s the sort of thing that, you know economists should read too. I mean, anyone doing a graduate graduate study should probably read as well, just to make sure that they understand how this matters in the real world. Like that’s what I think, is I like about the book, because often, you know, you see these, you know, there are these articles or these famous theories that are talked about, and they’re presented in a textbook, but you don’t often, some what’s hard to do is often relate it to the real world. So I think what you do, well in that book is is actually relate these concepts to the real world. So okay, good. Now that’s music my ears. Very good. Yeah. That might because your background in in working in the in the sector, or your journal, is it Journal of Applied corporate finance?

Donald Chew 1:04:20

Yeah, is your journey and win the way back past. I did a PhD in English and American Lit, so I was going to be an English professor. So then I got into this red took my first econ class when I was 27 so I’ve been, yeah, I’ve been trying to, like, I tried to communicate with my old finance, with my old literature, literature friends, and it’s two different disciplines. You know, everybody that I went to graduate school with shares all those beliefs that I end up they don’t find finance plausible or or socially constructive. You know, they. Mind stay, you know, exploitation, yeah, exploration of everybody but themselves. So anyway,

Gene Tunny 1:05:09

yeah, but I think you, I think you make a good case for for why that isn’t so, and why it’s actually added value. So I think, again, great, great contribution to the literature. Don, thanks so much. I’ll put a link in the show notes to your book, and I’ll encourage listeners to get a copy again. Yeah, terrific. Well done. And yeah, look forward to chatting with you some time again in the

Donald Chew 1:05:33

future. I hope you do it soon. Thank you very much. Gene, take care. Bye. Thanks. Don,

Gene Tunny 1:05:37

right. Oh, thanks for listening to this episode of economics explored. If you have any questions, comments or suggestions, please get in touch. I’d love to hear from you. You can send me an email via contact at economics explored.com or a voicemail via SpeakPipe. You can find the link in the show notes. If you’ve enjoyed the show, I’d be grateful if you could tell anyone you think would be interested about it. Word of mouth is one of the main ways that people learn about the show. Finally, if your podcasting app lets you, then please write a review and leave a rating. Thanks for listening. I hope you can join me again next week. You

Obsidian 1:06:25

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Credits

Thanks to the show’s sponsor, Gene’s consultancy business, www.adepteconomics.com.au. Full transcripts are available a few days after the episode is first published at www.economicsexplored.com. Economics Explored is available via Apple Podcasts and other podcasting platforms.

Tags corporate finance, debt, economics, private equity

Podcast episode

US Debt Ceiling: Why Trump is Right to Call for its Abolition & Gene’s Experience with Aussie Debt Ceiling – EP268

Post author By Alec Krishna
Post date December 31, 2024
No Comments on US Debt Ceiling: Why Trump is Right to Call for its Abolition & Gene’s Experience with Aussie Debt Ceiling – EP268

Show host Gene Tunny discusses the ineffectiveness of the U.S. debt ceiling, citing its frequent increases and the political grandstanding it entails. He notes that since 1960, Congress has amended the debt limit 78 times. Tunny argues that the debt ceiling does not enforce fiscal discipline and highlights the need for better fiscal rules, such as the Swiss Debt Brake or the Taxpayer Bill of Rights. He also shares his experience with Australia’s debt ceiling during the late 2000s financial crisis. Tunny concludes that Trump’s criticism of the debt ceiling is justified.

If you have any questions, comments, or suggestions for Gene, please email him at contact@economicsexplored.com.

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