Financialization – an economic system or process that attempts to reduce all value that is exchanged (whether tangible or intangible, future or present promises, etc.) into a financial instrument…and make it easier for people to trade these financial instruments.
-Wikipedia
Until last month, the drive-through car wash I go to had a team of a dozen workers to listen to my preferences, take my payment, and then clean my car, inside and out. The car wash was sold to a company that installed an ATM-style computer to take my order of washes and waxes before sending me through a dark tunnel full of newly-installed spinning rollers, flashing lights, and colorful foam. After my car gets foamed, flogged, sprayed, and blow dried, daylight finally appears, and a green light blinks GO. As I drive off, my car is still dirty in the all nooks and crannies that the car wash workers used to clean without a second thought.
In this changeover, someone got rich: the previous car wash owner. Someone will get rich, the new company that bought the car wash. Someone got screwed, the previous workers and the consumer. I now have to finish the process of cleaning all the spots a machine can’t reach, like the door jams. Essentially, everyone got screwed, except the prior owner and perhaps the shareholders of the acquiring company. This process is happening ad infinitum at a larger scale everywhere in this economy.
The rise of wealth inequality is certainly having an impact on politics around the world, as seen in the rapid rise of anti-establishment candidates like Sanders and Trump and the surprising result of the Brexit vote. There are many explanations for rising wealth inequality including “globalization” of the economy (jobs getting outsourced to countries with cheap labor), “institutional or structural factors” (workers without the right skills), and “technological change” (warehouse workers replaced by robots). Until recently, the conversation has ignored financialization as the principal driver of income inequality.
46% of labor’s falling share resulted from financialization, 19% from globalization, 10% from technological change and 25% from institutional factors.
– UN’s International Labor Organization
In recent years, there has been little tolerance for short-term lapses in profit growth. Long-term investments, including R&D and employee training, quickly give way to short-term maneuvering to protect the bottom-line. Company executives are incentivized to get out from under these pressures (and onto their very own mega-yachts) by getting acquired by larger entities.
The pace of acquisitions is breathtaking. Each year, acquisitions number in the thousands. What’s driving this phenomenon? Central banks are driving down the cost of capital to stimulate the economy with monetary policy. While this has helped everyday people borrow money at low rates to acquire cars and homes, this has also helped corporations and private equity groups borrow money at record low rates to acquire all kinds of companies, from local plumbing shops to global tech giants, eager to de-risk, cash out, and escape the pressure of investor short-termism. Of course, by the time the borrowed money comes due, the bankers and executives will have long ago absconded with their cash, sailed off to the Caymans.
While missing short-term profit targets does create career risk, making a bad acquisition does not. Look at Carly Fiorina who reaped a massive payout after she steered HP’s right into the disastrous $25B acquisition of Compaq and walked away very rich.
According to the Harvard Business Review, companies spend more than $2 trillion on acquisitions every year. Yet study after study puts the failure rate of mergers and acquisitions somewhere between 70% and 90%.
With many large-scale acquisitions, companies are dismembered, workers are fired en masse, salaries are cut, assets are auctioned off. Jobs are moved offshore to countries with cheaper labor, though often re-shored later at lower wages. The perfect example is Hostess Brands (the maker of Twinkies) which filed for bankruptcy to shed its debt and pricey union contracts, while auctioning off the rights to its baked products (like Hostess cupcakes) to Apollo Management (a private equity group) under the name HB Holdings LLC. Two years later, Apollo is now overseeing the IPO of Hostess Brands for $2.3B. This is a classic example of financialization.
Meanwhile, a few stakeholders including corporate executives, private equity financiers, and investment bankers walk away very rich. In the short-term, these maneuvers appear to trim the fat in a free market that should naturally be moving towards leaner operations and rising productivity. Unfortunately, the lust for short-term profits inherent in financialization sacrifices long-term growth and causes deeper inequality as most (70-90%) of the acquisitions are doomed from the start. These failures extract value from the economy rather than add value to the economy.
“We’ve sort of exerted all of the levers we can to extract value from corporations based on cheap financing. We’ve seen tons of [mergers], lots of share buybacks—you know all sorts of financial mechanisms to generate earnings growth but nothing real,”
-Savita Subramanian, Bank of America Strategist
So what does this mean for individuals investors? Financialization exacerbates the problem we have with corporate boards out-of-control. While corporate assets are owned by stockholders, they are controlled by managers who often extract an excessive share of corporate profits for themselves by pulling financial “levers” to conjure up rising valuations without long-term organic growth.
Some argue that actively selecting individual stocks through overpriced mutual funds and financial advisors allows you to avoid those individual companies using financial smoke and mirrors. However, unless you sit in the boardroom yourself, you have no idea when a company is going to pull the trigger on a horribly misguided acquisition, like HP’s acquisition of Compaq.
More recently, Microsoft had been the darling of actively-managed dividend-focused mutual funds, but then POW!, Microsoft’s CEO, under pressure to invest in something exciting, announced their acquisition of LinkedIn for $26B. The problem is that this whopping sum prices in boatloads of “synergy.” This imagined synergy, achieved by combining technology and cutting cost, is likely to vaporize once they actually try to integrate such disparate lines of business. Yes, some will walk away very rich from this deal, but the Microsoft shareholders will pay the price for years to come.
It is best to dilute the impact of such bad management decisions by investing in index funds with thousands of different stocks.
It seems like a smart idea to invest in companies that sell things that people living paycheck-to-paycheck need, as consumer wages stagnate around the globe. Unfortunately, everyone and their granny has the same idea. Look at the inflated value of Netflix, which is the alternative of people who cannot afford the movies anymore. Look at the inflated value of Kimberly-Clark, as everyone needs toilet paper. Look at the inflated value of Costco, as people try to buy that toilet paper at the cheapest price they can. Look at the inflated value of American Water Works, as everyone needs running water. They are all very richly valued.
Buying the stocks that Wall Street calls boring has paid off over the past six months—but now this “defensive” strategy is starting to look pretty risky…Utilities, a sector traditionally viewed as a safety play in times of market turmoil, have risen 21.2% in the first half of 2016—the sector’s best first-half performance in over 25 years. But if you ask some analysts, the run-up in prices leaves the sector extremely overextended and valuations dangerously high; some analysts believe the sector is in bubble territory.
-Marketwatch
Unfortunately, individual investors don’t have a bag of financial tricks like corporate financiers. For individual investors, returns will not be as good as they have been in the past. It’s the most unsatisfying of answers, but we should simply lower our expectations for future returns and focus on what we can control: earn more, spend less, and keep investment fees and taxes as close to $0 as possible.
In a future post, I will discuss “commoditization” of the worker and the resulting angst and generalized sense of insecurity that is driving both skyrocketing sales of military-grade weapons to anyone with a pulse and the election of anti-establishment candidates.
-AK
American Kimchi 