Wednesday, May 27, 2015

Strategic Planning Analogy #551: You Only Sell it Once

Let’s assume that Bob sells his house for $100,000. A few days later, the person Bob sold it to resells the house for $200,000. Then, a few days after that, the newest buyer resells Bob’s former house for $300,000.

Bob gets excited and thinks, “Wow! That house is more valuable than I thought.” So he re-buys his former house for $400,000.

So, in the end, he’s back in his same house as before, but $300,000 poorer. Yet he is happy because now he feels like he is living in a more valuable house than before.

In the story, Bob is happy when the price of his former house keeps going up. But why is he happy? After all, he did not gain any benefits from the price rising. He still only had his $100,000.

In fact, he should have been angry, because he sold out too low and should have asked for a higher price when he sold it. The resellers got the money which could have been his.

And then he re-buys the house and is happy to pay $400,000 for it. Buy why is he happy to be where he started only poorer?

Buying and selling houses is a lot like buying and selling stock. Let’s change the story so that Bob is a company doing an initial public offering (IPO) rather than selling a house. Let’s say the company plans to issue 1 million shares at $100 per share. So, on the day of the IPO (when the stock is first issued to the public), the company earns $100 million.

A few days later, the people who bought that stock for $100 a share resell it for $200 a share. Then, the people who bought it at $200 a share resell it a few days later for $300 a share. The company is so excited that it buys back the shares at $400 per share.

So now, the company is right back where it started, except that it has $300 million less than it did before the IPO. But it is happy, because the company is valued higher than before.

Although not as dramatic as in the story, this type of behavior goes on all the time in business. The company is happy if the stock price goes way up after an IPO, even though the company never sees any of that gain (and missed out on pocketing some of that gain for the company). And then later, the company is happy to do a share buyback, paying more for the shares than their original price.

What’s going on here?

The principle here is that once a company sells its stock, most of the benefits/risks of the future price fluctuations go to someone other than the company. In general, the company’s cash flow is not impacted much by what happens to the stock price after it leaves the company’s hands.

When the stock price goes up, the company may feel wealthier, but where is the immediate impact on cash flow? It hasn’t changed. The only one who gained was the second party selling to the third party.

Therefore, strategy should be more concerned with actions that meaningfully impact the cash flow than merely focusing on every little tick of the stock market price.

One Way Relationship
In general, if you pursue a strategy which raises the company’s cash flow with costs below the cost of capital, the company is stronger for the long term and the stock price goes up. But the reverse is not always true. If you play games and tricks to boost the stock price, cash flow does not necessarily increase and the company’s long-term prospects may be worse.

Take, for example, the idea of borrowing money to buy back stock. This typically results in less cash flow, a weaker balance sheet, and less freedom to pursue long-term growth strategies. That doesn’t sound good for the company.

So, why do them? Who benefits from those types of buybacks? It’s the people who bought the stock many transactions past the IPO and did not contribute anything directly to the company in terms of cash flow. Just as Bob got no benefit from the second and third buyer of his house, companies get no benefit from the second and third buyers of their stock. So why pursue strategies that hurt the company and only benefit these people who contributed nothing to funding the business?

The IPO Swindle
And then there is the IPO. Companies set them artificially low and get excited when the stock jumps in the following days. Why are the companies so excited? Just as Bob got no financial benefit when his house kept reselling for higher and higher prices, companies get no cash when subsequent trades raise the stock price.

In fact, the company has a greater justification to be upset when the price jumps a lot after an IPO, because that means they didn’t get as much cash from selling the stock as they could have in the original IPO. The only ones who benefit from the rapid post-IPO rise are the investment bankers and the stock re-sellers. The company is no wealthier.

Years ago, I worked on an IPO. When the investment bankers showed me their suggested IPO price, I almost choked on the numbers. It was far, far, lower than the value produced by my fancy spreadsheets. I told them we could go a lot higher and still leave room for the initial investors to have gains.

The investment bankers tried to intimidate me with academic papers full of arcane words and long formulas which they said “proved” that the price needed to be so low. But those papers had nothing to do with the issue at hand and they did not intimidate me, so I kept fighting for a higher price. I lost the argument.

After the IPO, the price jumped a lot. If the company had listened to me and used my suggested price, they would have gotten a lot more money and the initial investors would still have seen a gain.

We all know that the primary reason the investment bankers wanted a low price had nothing to do with those academic papers. It was because the investment bankers (and their investing clients) personally had more to gain if the price started out low. If the investment banker can get a company to do an IPO at a lower price, then they pocket some of that gap rather than the company.

Excuse me, but don’t the investment bankers work for the company? The company does not work for the investment bankers. The company needs to look out for its own interests first, not those of the investment banker.

I was so happy when Mark Zuckerberg fought to get such a high price for the Facebook IPO. Zuckerberg made sure that Facebook got the highest benefit from the IPO, not the subsequent traders or the investment bankers.

Where to Point the Strategy
So given all that was said above, it appears that strategic efforts should not be laser focused only on stock prices. Your business mission should not be “to create the highest possible stock price.” Yes, higher stock prices may benefit someone, but it is not always the company which benefits. Why focus on a strategy which primarily benefits people who contributed nothing to the cash position of the company?

Instead, the strategy should be looking at ways to improve the performance of the business model. If you do that, then pretty much all stakeholders benefit, including (and especially) the company.

This is consistent with the thinking of Warren Buffett and his company Berkshire Hathaway. They don’t try to make their money on constant trading and stock price manipulations. They just try to run good businesses for the long haul. The businesses benefit, and because the businesses are better, the shareholders benefit.

Yes, this is a rather simplistic argument. There are many nuances which go deeper than allowed in the space of a blog. But I still stand by the primary direction of this line of reasoning.

When a company’s stock goes up and down, the primary loser/gainer is not the company. After all, the company got its money when the stock was first issued at the IPO. That amount does not change based on subsequent trading. Consequently, strategies which only seek to raise stock prices (at any cost) may not necessarily benefit the company (and its long-term viability in producing a cash flow). Therefore, the preferred approach would be to create a strategy which seeks to improve that long-term viability to create a cash flow. That would provide a greater likelihood that not only does the stock go up, but the company benefits as well.

The biggest risk to putting the company first is that there are activist investors out there who want to put themselves first and will intervene to do so. To keep the activist investors at bay, you may need to give a little. Just don’t give in. Better yet, if you focus on running your businesses as well as Berkshire Hathaway, then the activists will have little opportunity to intervene.

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