The boom witnessed in the U.S. equity market over the past few years has begun to echo the latter stages of the high tech bubble of the early 2000s, right down to the investor interest ultimately gravitating toward five stocks that have posted substantial gains, and obtained an almost cult-like status among their respective devotees. In 2002, it was Lucent, Cisco, Microsoft, Dell, and Intel. Today, it’s Facebook, Apple, Amazon, Netflix, and Google. They’ve even got an acronym among their followers: FAANG. Taken in aggregate, these five stocks account for approximately one-quarter of the NASDAQ’s total market capitalization. In fact, just three months ago, Apple alone became the first publicly traded U.S. company to reach a $1 trillion market capitalization. But just as the Big 5 of the last high tech boom ultimately came unstuck, so too, one by one, today’s tech titans are gradually being “de-FAANG-ed,” as investors have come to reassess their growth prospects on the grounds of anti-competitive/anti-trust considerations,abuse of privacy, and deteriorating top-line growth. Apple is the most recent example, but it tells a much bigger tale, which speaks to a longstanding disease infecting the overall U.S. economy: namely, financialization.
“Financialization” — which denotes “the increasing importance of financial markets, institutions and motives in the world economy” — manifests itself clearly in the case of Apple. It is becoming another example of an American company that is increasingly valuing financial engineering over real engineering, as its core businesses get hollowed out amid product saturation and declining global sales.
Like General Electric some 25 years under Jack Welch, Apple under current CEO Tim Cook increasingly represents a microcosm of the changing role of U.S. markets as they have become less a vehicle for capital provision, more akin to a wealth recycling machine in which cash piles are used less for investment/research and development, more for share buybacks (which are tied to executive compensation, elevating the incentive for, at a minimum, quarterly short-termism and, at worst, fraud and corporate looting). All in the interests of that flawed concept of “maximizing shareholder value,” in which the company’s stock price, rather than its product line, drives corporate decisions, determines senior management compensation, and becomes the ultimate measuring stick of success.
Usually, when this trend becomes ascendant, it doesn’t end well. Perhaps the adverse reaction to Apple’s recently reported earnings is the first warning of what could follow.
To be sure, this is not the first rough patch for Apple since its resurrection under Steve Jobs when he returned to the company in 1997. In the early 2000s, the company came under scrutiny for the manner in which it improperly backdated stock optionsand didn’t report this to the SEC. As a result, Apple was found to be systematically understating its profits and defrauding its shareholders (stock options were classified as “non-expense expense,” which allowed them to be omitted from the profit and loss account, thereby artificially bolstering reported earnings). Having already obtained iconic status in Silicon Valley, then-CEO Steve Jobs got off lightly. Likewise when Jobs was directly implicated in a wage-fixing cartel with Google, among others. More recently, Apple’s aggressive tax avoidance strategies have come under scrutiny.
The backlash has hitherto been comparatively muted, however, because many of the foregoing practices came at a time when Apple was producing one hit product after another, inspiring a cult-like devotion among consumers, and generating investor enthusiasm on Wall Street. Unfortunately for the iPhone manufacturer today, the “hit parade” of new, earth-shattering products appears to have dried up, and the global market is increasingly being saturated with comparable products, creating prices pressures and declining market share.
Apple is increasingly deploying its substantial cash pile, not for investment/innovation, but for share buybacks (which refers to the repurchasing of shares of stock by the company that issued them). Buying back shares helps to support the share price both by reducing overall supply and also by inducing “herding behavior” by institutions, encouraged by the vote of confidence conferred by management insiders (who presumably understand the company’s prospects better than most). Additionally, by reducing the number of shares outstanding, this practice is accretive to earnings per share, which helps dress up the financial statements further. As a “growth stock,” Apple’s investors generally evince a preference for earning momentum, as opposed to a heavy stream of dividend payments (which is generally preferred by “income”-oriented investors).
For all of the theoretical reasons why share buybacks are supposedly a good thing, the dirty little secret is that the real reason for them is that they help to enrich senior management directly, because their compensation (via extensive grants of stock options) is increasingly tied less to the performance of the company, more to the company’s share price. Like so many other major listed companies, Apple has been starting to embrace this trend with more gusto. As Eric Reguly of the Globe and Mail wrote earlier this year: “In May, Apple announced that it would vacuum up another $100 billion of its own stock, taking the total buyback since the end of the Jobs era to roughly $300 billion.”
To be fair to Apple, it is hardly unique. As early as 2010, market analyst Rob Parenteau noted that company managements, “ostensibly under the guise of maximizing shareholder value, would much rather pay themselves handsome bonuses, or pay out special dividends to their shareholders, or play casino games with all sorts of financial engineering thrown into obfuscate the nature of their financial speculation, than fulfill the traditional roles of capitalist, which is to use profits as both a signal to invest in expanding the productive capital stock, as well as a source of financing the widening and upgrading of productive plant and equipment.” Likewise, Professor William Lazonick noted in his work, “Profits Without Prosperity,” that the 449 companies that were publicly listed between 2003 and 2012 “used 54% of their earnings — a total of $2.4 trillion — to buy back their own stock, almost all through purchases on the open market.”
Share buybacks were effectively illegal under SEC rules until 1982, in the midst of the Reagan deregulation wave, when SEC Rule 10b-18 was introduced. Until that time, buybacks had been considered a form of stock manipulation. As early as the mid-1980s, more and more companies have resorted to them, and the practice has grown exponentially.
But as the title of Lazonick’s paper makes clear, the buybacks created a lot of prosperity for the corporate executives and shareholders, but did little for the underlying profitability for the companies themselves, largely because cash piles were diverted away from productive uses such as R&D and capital investment. “Maximizing shareholder value” provides a fancy and bogus rationale for blatant stock manipulation, this time tied to executive compensation. The arguments for the tight restriction of buybacks pre-1982 are, if anything, even stronger today, given the scale and the corresponding degradation of corporate balance sheets as a consequence of the practice. Like the pigs at the trough making one last grab for cash before the bubble finally bursts, it creates enormous incentives for “control fraud.”
Apple has not fully crossed over to the dark side, but it is probably more than coincidental that their share buybacks have accelerated just as their explosive rate of growth appears to have stalled. Wall Street analysts seldom give outright sell recommendations on hitherto beloved stocks (the corollary also applies, which can amplify booms and busts). But there was enough in the last Apple earnings result to provide some cause for concern.
This presents a classic chicken and egg problem: Is Apple now using its cash to buy back stock because it is failing to produce new earth-shattering products like the iPhone or iPod (or, earlier, the Macbook), or is it the case that a lack of innovation a direct outgrowth of deploying the cash largely to buy back stock?
Either way, there is no exciting new epoch-changing product in the pipeline that would drive unit sales. The new Apple Watch certainly hasn’t been a game-changer. And, as Reguly argues, “Every dollar devoted to buybacks is a dollar not devoted to uses such as research and development, employee training, acquisitions and community giving.”
Tellingly, what Apple isn’t going to do in the future hints at bigger problems ahead. In addition to projecting weaker-than-expected holiday sales, the company surprised investors when it indicated that the company would no longer break out how many iPhones it sold each quarter. The obvious conclusion to be drawn is that is because Apple will soon have to rely on price, not volume of unit sales, to keep the show going. Which likely means more stock buybacks to support the share price.
Unfortunately, that’s not a particularly healthy scenario, coming at a time when smartphone sales are coming under pressure globally, which is being reflected in major product price cuts across the entire industry. Consider Samsung’s Galaxy S8, which can be purchased on Amazon.com for anywhere from 30 to 50 percent below the original launch price (depending on phone company). That’s significant because Apple has been losing global market share to companies like Samsung for something like five years now. And if Samsung is experiencing these kinds of pressures, then Apple’s strategy of trying to offset the loss of market share by raising prices (or resorting to tricks in which Apple uses software updates to intentionally slow down the iPhone and deliberately impair the battery life) is likely to prove problematic.
Much like Microsoft after its first phase of growth, Apple is morphing into a slower-growing cash cow. It’s hard to sustain a $1 trillion market cap under those operating conditions. Increased functionality in a smartphone can only go so far; there are only so many ways to improve taking a selfie or enhancing facial recognition for security protocols. And those kinds of marginal improvements are likely insufficient to create a huge new wave of global sales. The smartphone has evolved considerably over the past decade, but at this stage of its product development, the incremental improvements are marginal. So the cash pile will continue to go toward buybacks, an increasingly destructive strategy during a time of falling markets and declining sales, when the cash should be husbanded as a defensive measure, not dissipated and replaced with debt.
Apple is neither the first nor the last company to find itself in this position. Slowing product growth and the inexorable pull of untold wealth that could be derived from a stock market bubble is a deadly combination that has infected companies well beyond the hitherto beloved creation of Steve Jobs. The misallocation of capital via share buybacks (at a cost of sacrificing innovation, research and development) is yet another example of the fantasy of efficient financial markets and the notion that markets are always the optimal means of intelligently allocating capital. We see the development of a bogus theory of “maximizing shareholder value” used increasingly to mask blatant stock manipulation. The practice appears particularly perverse when one sees companies’ core businesses dissipate against a backdrop of balance sheet deterioration (as the cash is replaced with debt). As financialization increasingly hollows out Apple’s core, it provides a broader symptom of everything that is wrong with America’s bubble-ized capitalism today.