David Einhorn’s proposal to GM that it split its stock into dividend and capital appreciation shares got us thinking about the bedrock principles of public equity ownership. Other catalysts for this examination: recent IPO SNAP’s lack of shareholder voting rights, the reluctance of venture capitalists to list their “Unicorns”, and the dearth of IPOs generally. The critical question here is “Does the traditional one-size-fits-all model of publicly-held equity still work in a world that increasingly values customization?” Further, will other social and economic trends force a change in this structure, such as aging demographics in the US population and the investment-heavy nature of major technological developments like autonomous cars, workplace automation, and artificial intelligence? Bottom line: “public equity” needs to be a fluid concept that responds to the changing needs of both providers and users of capital. If it is true that we learn the most from our mistakes, then I would posit that we can glean a lot of useful information from analyzing troubled industries rather than just focusing on commercial “Winners”. For example, I have studied the US auto industry for the last 25 years as both a sell side and buy side analyst, and more recently in the context of the macro work I do in these notes. It has been an education that has served me very well, even if the group has historically presented limited long term investment potential. Here is a summary of everything I know about this auto industry:
- Demand is economically sensitive and volatile in major markets like the US, Europe and Japan. Since it takes years to design a new vehicle and that process is expensive, automakers have high fixed costs. This leads to significant variability in earnings over a typical economic cycle and the threat of bankruptcy in a bad downturn is real. “Hot” product offerings can mitigate this pressure, but not reliably so.
- There is too much supply. The auto industry employs a lot of people both in final assembly and in the supply chain. These tend to be good-paying jobs, which means governments are perennially throwing money at car companies to set up shop in their jurisdiction. Moreover, those same governments don’t ever want to see a plant close. This makes capacity very sticky, and in some places like Europe there are still too many auto plants.
- Those two factors make it very hard to earn a decent return on capital over a cycle. Boom times bring excellent free cash flow, but those earnings are later consumed by the lean years. As a result of both industry structure (point #2) and company-specific earnings volatility (point #1), public equities in the sector tend to have very low normalized valuations.
I was therefore intrigued by investor David Einhorn’s proposal, made public today, to split GM’s stock into two pieces: a dividend paying equity and a capital appreciation “stub”. To be clear, I have no idea if it would improve the company’s equity market valuation. You can read a description here and see the 2017-03-28/david-einhorns-presentation-how-gm-can-unlock-between-13-and-38-billion-value. His proposal got me thinking about the nature of public equity capital. His thesis is that GM’s equity does not have a clean and distinct ownership base. Dividend-seeking investors are put off by the company’s share buyback program since it drains cash for purposes they don’t value, and capital appreciation-focused investors would prefer that GM just use all their cash generation to repurchase shares. Split the stock and the conflict goes away, or so the idea goes.
Regardless of the merits of the idea for GM, Greenlight’s proposal raises a provocative macro question: “Is a one-size-fits-all equity structure really the best approach to both maximizing corporate value and giving shareholders the types of investments they desire?” Once you pose the question that way, a raft of other capital market trends pop up:
* Voting rights. The vast majority of public stocks feature a “One share, one vote” structure of corporate governance. Shareholders can elect Boards, vote on major corporate actions like takeovers and mergers, and lobby for changes in management if they feel the business is being mismanaged.
* The recent high-profile SNAP IPO had an unusual feature, however: no voting rights at all. While novel, this is the continuation of a trend among technology companies, which in many prominent cases have dual classes of stock with different voting rights. The intention here is to limit public shareholders’ traditional rights in favor of management’s/core shareholders’ long term business plans and judgment.
* Dearth of IPOs. Look at a long term chart of the number of Initial Public Offerings in US markets, and you’ll see a significant decline in the number of new issues from the 1990s to now. The good times were in the late 1990s, of course, when it was customary to see 30-80 IPOs per month. Now, that number is more like 10-20.
* Venture capital’s reluctance to list “Unicorns”. You might argue that capital markets are simply more selective now and the 1990s IPO cycle was an outlier. But then why are so many truly revolutionary companies like Airbnb, Uber, Lyft, Palantir, and other “Unicorns” all still private? These are transformational businesses, but the venture capitalists that fund them see no need to take them public.
Now, I am sure that Uber’s shareholders are happy just now that the company isn’t subject to the daily vagaries of the stock market, but on balance the absence of “UBER” as a symbol on the NYSE or the NASDAQ is troublesome.
At its core, the social compact between public equity markets and society is simple: over time, any investor should have access to the equity of important enterprises created by that society. If that isn’t happening by virtue of some misalignment of incentives, then those need to be fixed. The alternative, that the winners stay private but the losers are public, is untenable. Investors will choose to hoard cash and capital will slowly stop circulating to its best possible use.
Given the pace of innovation that seems to be on its way, this problem may only get worse. If the futurists are correct, there are several societal sea changes just over the horizon, from artificial intelligence to workplace automation to driverless cars, all in various stages of development. The home for that capital right now too often has a Sand Hill Road address rather than 11 Wall Street.
We’ve come a long way from what now seems like a pretty humble proposal regarding one car company, so let’s put on bow on all this. A few summary points:
- For all the innovation on offer in American industry, the concept of public equity is perhaps overly reliant on an outdated concept where one equity security with proportional voting rights is the only flavor available. It is, at least, a topic worth discussing.
- Investors, in their role as consumers, are used to custom solutions in every facet of their life, so why not think about how to apportion the value of a company to fit their needs? Yes, equity and debt are the traditional solutions. But why do you think Exchange Traded Funds are so popular? In part it is because they target investor needs in creative ways. Corporate boards and investment bankers might take a page from that book.
- Demographics and technology may force the issue. An aging US population might embrace novel approaches to accessing the corporate cash flows of public companies. And if there is a new wave of innovation ready to drop on us, the only nature hedge might be to have access to the equity of those businesses. Even if they don’t carry voting shares or other traditional features.
*) Now, one caveat: all of this needs sufficient regulation to curtail abuse. The mortgage market of the early 2000s is the cautionary tale here, of course. Changes to the notion of public equity need careful scrutiny to make sure disclosures are complete and structures are sound.
But in the end, “Equity” will need to evolve in the same way everything else does in a capitalist society, in a way that serves both investors and users of capital....