In Search of the Perfect Investment

I pondered Apple all day yesterday. It was down. I was afraid it would fall more in coming days. Earnings were coming out that night. They could be great — but still disappoint the market. That’s been happening lately. Big earnings. Stock falls.

All my friends and family have been buying iPhones. It had to be a blowout quarter for Apple sales and earnings. Mr. Market has got to be logical, for once.

At close to 4 PM, I bought some more Apple.

It was a blowout quarter. After hours Apple stock was up 8%. I was a genius — except I hadn’t bought enough. I should have invested my entire net worth and mortgaged the house.

I lack a basic gambling instinct. Opportunities like this come along very infrequently.

I’m buying a little DHR and a bit more SGOL this morning. I’m feeling a little more confident, especially about Europe.

This piece from my favorite author at the New Yorker is relevant — except that he forgets that there are leveraged buyout companies which suck their companies dry and there are private equity companies that give their companies equity money (but not debt) and help and encourage them to grow.

Private Inequity
by James Surowiecki January 30, 2012

At this point, the people who run America’s private-equity funds must be ruing the day Mitt Romney decided to run for President. His fellow Republican candidates, of all people, have painted a vivid picture of private-equity firms—including Bain Capital, where he worked for fifteen years—as job-destroying vultures, who scavenge the meat from American companies and leave their carcasses by the side of the road. Not since the days of “Wall Street” and “Barbarians at the Gate” have the masters of leveraged buyouts looked quite so bad.

Given the weak job market, it makes sense that the attacks have focussed on layoffs. But the real problem with leveraged-buyout firms isn’t their impact on jobs, which studies suggest isn’t that substantial one way or the other. A 2008 study of companies bought by private-equity firms found that their job growth was only about one per cent slower than at similar, public companies; there was more job destruction but also more job creation. And, while private-equity firms are not great employers in terms of wage growth, there’s not much evidence that they’re significantly worse than the rest of corporate America, which has been treating workers more stingily for about three decades.

The real reason that we should be concerned about private equity’s expanding power lies in the way these firms have become increasingly adept at using financial gimmicks to line their pockets, deriving enormous wealth not from management or investing skills but, rather, from the way the U.S. tax system works. Indeed, for an industry that’s often held up as an exemplar of free-market capitalism, private equity is surprisingly dependent on government subsidies for its profits. Financial engineering has always been central to leveraged buyouts. In a typical deal, a private-equity firm buys a company, using some of its own money and some borrowed money. It then tries to improve the performance of the acquired company, with an eye toward cashing out by selling it or taking it public. The key to this strategy is debt: the model encourages firms to borrow as much as possible, since, just as with a mortgage, the less money you put down, the bigger your potential return on investment. The rewards can be extraordinary: when Romney was at Bain, it supposedly earned eighty-eight per cent a year for its investors. But piles of debt also increase the risk that companies will go bust.

This approach has one obvious virtue: if a private-equity firm wants to make money, it has to improve the value of the companies it buys. Sometimes the improvement may be more cosmetic than real, but historically private-equity firms have in principle had a powerful incentive to make companies perform better. In the past decade, though, that calculus changed. Having already piled companies high with debt in order to buy them, many private-equity funds had their companies borrow even more, and then used that money to pay themselves huge “special dividends.” This allowed them to recoup their initial investment while keeping the same ownership stake. Before 2000, big special dividends were not that common. But between 2003 and 2007 private-equity funds took more than seventy billion dollars out of their companies. These dividends created no economic value—they just redistributed money from the company to the private-equity investors.

As a result, private-equity firms are increasingly able to profit even if the companies they run go under—an outcome made much likelier by all the extra borrowing—and many companies have been getting picked clean. In 2004, for instance, Wasserstein & Company bought the thriving mail-order fruit retailer Harry and David. The following year, Wasserstein and other investors took out more than a hundred million in dividends, paid for with borrowed money—covering their original investment plus a twenty-three per cent profit—and charged Harry and David millions in “management fees.” Last year, Harry and David defaulted on its debt and dumped its pension obligations. In other words, Wasserstein failed to improve the company’s performance, failed to meet its obligations to creditors, screwed its workers, and still made a profit. That’s not exactly how capitalism is supposed to work.

The people who ran Harry and David into the ground have a defense: economic conditions changed in unforeseeable ways. But that’s precisely why loading firms with debt in order to reap short-term benefits is bad. It leaves companies unable to weather tough times, and allows private-equity firms to make money even if things go wrong.

As if this weren’t galling enough, taxpayers are left on the hook. Interest payments on all that debt are tax-deductible; when pensions are dumped, a federal agency called the Pension Benefit Guaranty Corporation picks up the tab; and the money that the dealmakers earn is taxed at a much lower rate than normal income would be, thanks to the so-called “carried interest” loophole. The money that Mitt Romney made when he was at Bain Capital was compensation for his (apparently excellent) work, but, instead of being taxed as income, it was taxed as a capital gain. It’s a very cozy arrangement.

If private-equity firms are as good at remaking companies as they claim, they don’t need tax loopholes to make money. If we capped the deductibility of corporate debt, and closed the carried-interest loophole, it would not prevent private-equity firms from buying companies or improving corporate performance. But it would reduce the incentives for financial gimmickry and save taxpayers billions every year. Private-equity firms are excellent at gaming the rules. Time to change them. ♦

Inside Romney’s tax return. His income is from dividends and capital gains. He pays low taxes because these get taxed at 15%, not 35% for ordinary income. Another reason to favor high dividend paying stocks, stock options (if you work for someone)  and capital gains — if you can find them. Click here.

Useful phone trick. Want to know the number you’re calling from, dial 800-444-4444.

Harry Newton who spent too much time yesterday and this morning dealing with busted technology –the phone, a backup drive, Fidelity’s Active Trader Pro, my Sovereign Bank account, accounts that still use my old, dead hacked credit card, etc. Why are companies shutting us all off so quickly these days? It’s “for our protection,” they say. Give me a break.