I’ve heard more and more commentary/concern about the level of the overall market lately. With the market relentlessly marching to new all-time highs just about every day, I’ve even begun to hear the word “bubble” being used. While I certainly don’t think the market overall is cheap, and while I certainly believe it’s very possible that a bear market could occur at any time, we are definitely not in a bubble. Anyone who thinks that the current market is reaching levels that would correspond to previous manias should study previous manias. The late 1990’s saw unbridled enthusiasm among individual investors, reckless behavior by corporate managers, and significant complicity by lawmakers and regulators.

 

By Udo J. Keppler (a.k.a. Joseph Keppler, Jr.; 1872-1956), cartoonist [Public domain], via Wikimedia Commons
Even though the late 90’s bubble wasn’t that long ago, I think it’s easy to forget how crazy some of the valuations were and how egregious some of the behavior was among market participants and management teams.

I recently read the book Bull by Maggie Mahar, and I thought I’d highlight just one example that illustrates the speculative fervor that existed at the time.

One of the perks about being CEO of a publicly traded company of the 1990’s was that you could pay yourself with huge amounts of stock options, but yet not count those stock options as an expense on your company’s financial statements. It was creating money out of thin air. You, as public company CEO (along with other top executives) could mint multi-million dollar pay packages each year that seemingly had no strings attached (because it wasn’t an expense as far as the income statement was concerned). This was obviously a complete fallacy. The options were an expense—a significant one. Doling out millions of stock options to yourself and your friends might not have shown up in that year’s income statement, but it did show up in the shareholder’s equity statement in the form of increasing the overall amount of shares outstanding. Obviously, more shares outstanding means lower earnings per share for all other shareholders. Even without counting the options as an expense, the pie was the same size and each shareholder’s slice was now smaller.

Not counting this form of compensation as an expense was a ridiculous accounting practice, and one that was supported by ridiculous arguments by lobbyists and the lawmakers who wanted to protect their corporate constituents that were getting rich. These options were akin to lottery tickets that couldn’t lose, and in the bull market of the late 1990’s, were sure to win.

But as it turned out, granting options wasn’t a free lunch. As mentioned, the obvious cost was that it increased the shares outstanding, thus lowering earnings per share. But this practice also led to a second derivative behavior, and one that is still practiced today (and is a pet peeve of mine)—companies began buying back their own stock to “offset dilution” that occurred from giving out free options to management.  Buying back shares—like any other capital allocation decision—only makes sense if the value you’re getting exceeds the price you’re paying. Overpaying for anything—including your own company’s shares—will lead to value destruction. What annoys me about this behavior, which is practiced very often today as well, is that for some reasons corporate managers seem to act like these buybacks—when they are earmarked for the purpose of offsetting stock options—exist in a vacuum where the laws of economics are suspended. The act of buying back shares of stock is a separate capital allocation decision, regardless of the reason why you’re buying those shares. Doing so without any regard for value (simply to “offset” the dilution that you created with a previous decision) is completely illogical. Yet it occurs all the time. And in the late 1990’s, it was running rampant.

At least now these options are counted as compensation (although most companies try to avoid this by using magical terms like “adjusted EBITDA” which essentially does what GAAP accounting allowed in the 90’s—not counting this form of compensation expense an expense). But regardless of the accounting treatment in the 90’s, these options became very expensive (and cost real cash) when companies began buying back their shares to offset the dilution that these options were causing. This practice has a bit of irony attached to it, because the corporate managers who fought tooth and nail to prevent these options from being called what they were (an expense) began paying for these options by draining the company’s cash to hide the true impact and cost that the options were creating in the first place.

One bad decision (granting excessive stock-based compensation and not expensing it) led to a second bad decision (using real cash to buy back extremely overvalued shares in the open market to keep overall shares outstanding from skyrocketing). Of course, shares of stock are fungible. As CEO, the shares you buy back in the open market are economically identical to the shares you created and gave yourself. In effect, by buying back shares to offset dilution, the irony is that the company was paying for the very shares that they were giving themselves, despite their unwillingness to call it an expense.

Dell—Superb Computer Maker, Financial Innovator

This post isn’t an attempt to pick on Dell, but that company was highlighted as one of the firms that practiced this type of behavior. Other companies were doing the same thing, but Dell was one of the excessive practitioners. Michael Dell paid himself huge amounts of options (in 1998 he gave himself 12.8 million options to buy Dell’s stock, while at the same time unloading 8 million shares in the open market). To finance these generous option grants, Dell began ramping up his company’s buyback program. In 1998, Dell Computer spent a whopping $1.5 billion buying back its own stock—which by the end of the year was trading hands at 70 times earnings.

Although Dell (the founder) was personally selling his own shares, he clearly he wasn’t concerned about using Dell (the company) cash to buy back excessively overvalued shares. In fact, the company readily admitted that the shares repurchased weren’t done with any sort of benchmark to value, they were done simply to offset the dilutive effects of the huge number of options that the company executives gave themselves.

I went back and looked at the 2000 10-K, and here is why the company bought so many shares:

“During fiscal year 2000, the Company repurchased 56 million shares of common stock for an aggregate cost of $1.1 billion, primarily to manage dilution resulting from shares issued under the Company’s employee stock plans.

Dell issued 82 million shares in 2000 for stock-based comp. It then bought back 56 million shares for $1.1 billion, to partially offset the dilution. This $1.1 billion was real cash that the company shelled out for something that wasn’t called an expense in 2000. $1.1 billion equaled about half of Dell’s pretax earnings for the year. Moreover, $1.1 billion for 56 million shares only equaled about 2/3rds of the shares that Dell issued for compensation (in other words, Dell didn’t completely offset the dilution). Dell earned $2.5 billion in pretax income in 2000.

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