Is SBC Using Options Less Bad?
Especially for companies owned by passive investment vehicles
Introduction
This post is triggered by this excellent interview of
by about passive investing, and a Ponzi market. The topic of price-insensitive buying by passive investing vehicles due to “flows” is complex, thought-provoking, and with potentially wide-ranging real-world consequences (e.g. if the music stops and retirement funds lose value because flows reverse by people liquidating to fund their retirement).As many are aware, investor David Einhorn stated that he adapted his strategy to seek undervalued stocks that are able to “pay” back the investor because of the shift from active stock selection towards passive investing.
if we buy these things we're not going to get the same kind of return that we used to get so what we have to do now is be even more disciplined on price so we're not buying things at 10 times or 11 times earnings we're buying things at four times earnings five times earnings and we're buying them where they have huge BuyBacks and we can't count on other long only investors to buy our things after us we're going to have to get paid by the company so we need 15 20% cash flow type of uh type of numbers and if that cash is then being returned to us we're going to do pretty well over time so I I'm I'm intrigued by that
Source: David Einhorn: Market Structures Are Broken | Masters in Business; YouTube Transcript, February 8th, 2024. Highlight by Author
Maybe this is not as bad, or it goes on for a long time, but the pessimist in me harps on this. Consequently, I wonder if I need to adapt my own investing process.
Why the Title?
I focus on SBC as one subtopic of the wide-ranging interview.
SBC expense and its cash impacts is a debated topic and e.g. this 2023 paper by Michael Mauboussin argues for dealing with the cash flow impacts of SBC expenses not in the cash flow from operations but in the cash flow from financing (and thus effectively avoiding adjusting for it in the free cash flow definition):
The rationale is that SBC is in effect one figure that captures both financing and compensation. A firm issues shares (financing) and uses the proceeds to remunerate employees (compensation).
When I own a company's shares, my share of ownership - and hence my claims to the company's residual cash flow - drops if the company dilutes me by issuing shares. Paying employees with shares or share options is accounted for in earnings, but the Cash Flow From Operations statement reverts that charge. Some companies attempt to reduce shareholder dilution by buying back shares issued to employees, but that reduces cash available to shareholders just the same (though the denominator of per-share metrics benefits, of course). Anyway - I do check for signs of dilution when I analyze a company but so far I never discriminated between options or shares (restricted or unrestricted).
In the interview, Michael Green referenced a very recent paper that seems to say that the largest provider (i.e. seller) of shares to passive investing vehicles were companies. As passive vehicles receive inflows, the companies in the index experience rising prices as the vehicles are price insensitive. As a consequence, employee stock options come into the money, employees exercise the options and pay cash to the company for receiving the shares as defined by the options. So, in the case of stock options, the company receives money inflow and potentially the issued shares are sold to the passive vehicle by the employees.
To circle back to my stock analysis process, depending on the the pricing of the option, my share of the company is diluted by the employees’ exercise of the option but the company receives cash somewhat offsetting my dilution. Compared to a competing company, that company has a satisfied (in a monetary sense) employee and has an improved cash position - without any operational effort. This cash can be used productively… so this kind of SBC is probably preferable to shares issued straight as a form of compensation… I have to think about that more. Definitely, the long-term effect of dilution cannot be outweighed by a one-off option exercise cash inflow into the company - so unless the cash inflow is used to outcompete other companies, to save the company from harmful levels of debt, to invest (e.g. M&A), or to keep outperforming employees (hard to quantify) - it still reduces my per share rights to residual cash flow.
When Does The Music Stop?
The interview sounds concerning. Eventually the “Ponzi market” will have to come to a halt and investment flows will reverse, e.g. due to inefficiently allocated capital, a bifurcated and unequal society, or simply when the demographics demand that retirees liquidate their holdings to fund their “Ruhestand”. If (when?) this occurs, the price-insensitive buyers would turn into insensitive sellers crashing the top index holdings stronger than components with a lower index weight. However, the music will probably keep going:
Probably there are strong incentives and motivations to keep the music going. Not just from the wealthy, but e.g. Investopedia indicates that pension funds do also invest in ETFs (among other asset classes). If the ETFs evaporize the pensions may not be backed by assets anymore and there are real-world consequences.
Worker immigration (or a baby boom) would contribute flows into retirement vehicles (I assume pre-dominantly passive vehicles) that could offset demographic pressures. Also, as asset prices are already inflated, retirees would not have to liquidate as many “shares” as years ago to get the same Dollar amount. So: less selling, new workers’ inflows would offset outflows.
As Michael Green mentioned, retirees are more heavily invested in active vehicles than younger people, i.e. their outflows have a lower multiplier effect, see footnote 1 below. (It sounds correct that younger people prefer passive vehicles more than older people, but I have no statistics to back that up).
What Now?
Maybe nothing?
If flows were to reverse and flow out of passive vehicles, owning undervalued companies with a strong balance sheet might be a safer place. On the other hand, “in a panic all correlations go to 1”, and thus, also smaller companies would be punished by a sell-off. However, there might be forced sellers, and conservatively financed companies may be able to acquire bargains.
SBC from options seems less bad to me than directly issued shares, but in both cases I as a shareholder get diluted.
Going forward I probably should follow David Einhorn’s approach more closely and put an even higher emphasis on shareholder yield (Dividends + Buybacks).