Destroying Capital with the Printing Press

0:00I want to talk about the stock market, because it's been on a terror, right? And what's that terror all about? Well, that terror is all about mergers and acquisitions. Last year ended up being a blockbuster for global mergers and acquisitions. There was a total of $2.4 trillion worth of global M&A that went on out there. That's a 20% increase went on out there, that's a 20 percent increase over the previous year, private equity buyouts had increased over 7 percent, it was the strongest year since 2007, activity in M&A more than doubled in Australia, the Asian Pacific region saw M&A deals reach their highest level on record, M&A deals jumped in Europe by 37% but of all the regions it was emerging markets posted the most impressive year. Emerging markets groups saw over 2,700 deals for half a trillion dollars. That was a 20% increase in deal volume and a whopping and 60% increase in deal value.

1:20Now, while it was deals, deals, deals worldwide, it wasn't exactly a big M&A year in the United States. There were only 3% increase in merchants and acquisitions in 2010. But that's changing. The M&A talk in the United States is heating up, and the fast money traders at CNBC, and I know if you're like me, that's where you get all your investment advice. That was for that table over there. They say that M&A is a major market theme. and, you know, there's tech, there's retail, there's mining, there's even deals in financial services and real estate.

2:18And Byron Wien, who's supposedly a seer of these things, he's the vice chairman of Blackstone Advisory Partners. He listed in one of his ten surprises for 2011 that merger and acquisition activity becomes intense and the market reaches a blow-off euphoria. So mergers and acquisitions are all the talk right now, all the rage. In fact, just last week you had Duke Energy and Progress Energy entering into a merger that was about $14 billion. You had DuPont agreeing to buy Denisco, which is an industrial enzyme and food ingredient producer.

3:08That was a $6 billion deal in cash. Simon Properties has agreed to buy Capital Shopping Centers, which has agreed to buy Trafford Center Mall, ABB, which is a Swiss engineering company. They extended a $3 billion offer for Baldor Electric, Lundin Mining, and InMint Mining. They've agreed to merge. They're going to become Cimtiara, which will be a Canadian copper mining company and have a $9 billion market cap. That was just last week. So we've got all kinds of merger and acquisition activity going on.

3:56And what's driving it other than CEO ego? Well first, cheap money. Wall Street began to fall apart in the summer of 2007. M2 money supply was standing at $7.3 trillion and then the Fed hit the monetary gas of course. We've had TARP, we've had TAUP, we've had who knows what all. In between, I think the New York Times estimated it at $9 trillion worth of bailouts. And so by November of 2010, just a couple of months ago, M2 was just short of $8.8 trillion.

4:43So we've had more than a 20% increase in the M2 money supply. That's made money cheaper. Prime Lending Rate, which any of you here that are in business know that if you're the average business person on the street, you're not borrowing money at treasury rates, you're borrowing money at prime, probably. And prime, back in the summer of 2007, was 8.25%. Now it's 3.25%. Six-month LIBOR. A few may get the opportunity to borrow at that rate. That's the London Interbank offered rate. That was 5.37 in July of 2007. Last month it was 45 basis points, or 0.45%.

5:31So no wonder somebody on CNBC the other morning said that at these low rates, all of these deals, all of these mergers and acquisitions will be accretive to earnings. In other words, they will increase earnings just because of the fact that the capital is so cheap. A lot of deals will work on paper with rates this low. Now second, firms have a lot of cash on their balance sheet. We keep hearing about this every day and it's not earning anything. US treasuries, there's probably a few people in the room that U.S. Treasuries are kicking off anywhere from 13 to 27 basis points for 12 months, lending this government money and only getting 13 and 27 basis points, seems to be somewhat of a fool's bet.

6:34I think there's essentially, when you lend money to something, there's the three C's and one of them is character and the government I always thought failed that test but bank CD rates somewhere around 1% for 12 months it's tough out there to get yields so of course our rates low because people are delaying consumption in keeping high cash balances well no of course we've got the central bank that are keeping rates low so businesses will So rates are low, and everybody from retirees to CEOs want to earn something on their money, they don't want to earn half a percent or whatever, so CEOs are especially, they have this cheap money that's burning a hole in their corporate pockets, so their balance sheets, and they could pay out this money in a dividend, but they don't want to earn half a percent.

7:39They probably figure, well, what are the shareholders going to do with it? They can't earn anything with it, so it might as well be in my very trusted hands and I'll do something with it. The CEOs could hire more people, they could produce more goods and services, but no matter what the Business Cycle Dating Committee of the National Bureau of Economic Research says, it's still a recession. is not that good, things are not that good out there and people are expensive to hire and they are more importantly more expensive to fire, if you can fire them at all. Now the third thing driving these mergers and acquisition waves is something that Peter Klein who is a senior fellow at the Mises Institute has found and his specialty is entrepreneurship in the firm, and Peter Klein has found that the firms make acquisitions when faced with increased uncertainty.

8:46He cites regulatory interference and tax changes as major causes of uncertainty. It's not like we have any uncertainty over tax changes going on right now. So when faced with increased regulatory interference, firms respond by experimenting, he says. They make riskier acquisitions and consequently they make more mistakes. Klein found that unprofitable acquisitions tend to come in industry clusters and that these clusters are likely to arise from intensified regulation. So while money's cheap, government's getting more intrusive and CEOs figure they, hey, Let's Roll the Dice and Buy Another Business.

9:34But according to Max Landesberg, Thomas Kell, a couple of consultants in this area, they find that 74% of mergers and acquisitions fail, 74%. And that seems to be backed up by the literature, at least from Harvard, Harvard Management and Updates says two-thirds of newly formed companies perform well below the industry average. Financial Executive Magazine says up to 70% of mergers fail to create value, but that doesn't slow anything down, they say. The Journal of Property Management says 60 to 80 percent of all business combinations undergo a slow painful demise. So CEOs think that 2 plus 2, when they do the deal, 2 plus 2 equals 5, when in fact when they do the deal it turns Now, leadership consultants would say a large company needs more executive leadership than a small one, and that companies must consider their leadership capacities when confronted by change of completing an acquisition.

11:08Human Resource Consultants would say these managers don't work because, or these mergers don't work because the executives manage the business integration and they forget the human integration and these managers are eager for the gains anticipated and they treat the acquisition like a series of financial transactions or financial reports instead of considering the the Human Element for these proud and vibrant organization. But what's really going on here? What's really going on when companies are out there merging and buying other companies? Well, they're buying stocks. I mean, that's really what they're doing.

11:53Sure, they call these things mergers. They call them acquisitions. They call them buyouts. They call them takeovers. But really, what are they doing? They're buying stocks. And they typically buy them at a premium to what the stocks have been trading for. Forget about volume discounts. Have you ever noticed that? They never get volume discounts. These guys aren't buying a cow or two. They're buying the whole ranch. And they have to buy at a premium to boot. Now, why is that? Well, unfortunately, the government regulations causes this anomaly. Companies acquiring large blocks of stock and companies must register their intentions, of course, with the SEC and with the government, and they alert the market as to what they're up to.

12:43So it's not like they can acquire large blocks of stock without anybody knowing about it. Tell the government, and the government essentially protects targeted firms from hostile takeovers, And the result of that is that they raise the price of these buyouts. And just where is it that these acquirers come up with the numbers that they pay for these acquisitions? Well, a former director at Coopers and Liebrands told author Mike Searauer, he said, Lotus is the culprit in failed acquisitions.

13:30That's Lotus, the spreadsheet. It's too easy, he says, to assume anything you want in perpetuity without any understanding of economics of an industry and package it in a beautiful report, unquote. Now, in his book, The Synergy Trap, So here says valuation models turn on three things, free cash flow forecasts, residual value, and discount rate. Well, the cost of capital is integral to making all these assumptions, and the lower the assumed interest rate, or cost of capital, The higher the price that can be justified for the acquisition of the models that they're trying to justify.

14:20And if anyone is assuming today that today's Fed-induced microscopic interest rates will last forever, if they're plugging these into their Lotus spreadsheets, well, now might be the time to sell rather than buy. Now, once interest rates go up, these valuation models will be blown up just like the government employee pension plan assumptions that we keep hearing about. So it's hard to make something work out economically if you overpay in the first place. And that is what most often happens. Companies overpay for the firms they acquire.

15:08As Warren Buffett put it in his 1982 Berkshire Hathaway annual report, he said, The market, like the Lord, helps those who help themselves. But unlike the Lord, the market does not forgive those who know not what they do. A too high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments. And although he wasn't writing about stock market boom driven by mergers and acquisitions, Ludwig von Mises could have been when he wrote this, the moderated interest rate is intended to stimulate production and not to cause a stock market boom.

16:07However, stock prices increase first of all. At the outset, commodity prices are not caught up in the boom. They are stock exchange booms and stock exchange profits. Yet the producer is dissatisfied. He envies the speculator his easy profit. Those in power are not willing to accept the situation. They believe that production is being diverted and deprived of money which is flowing into the stock market. Besides, it is precisely in the stock market boom that the serious threat to a crisis lies hidden. So when we look back at mergers, many mergers and acquisitions, there's been some spectacular failures.

16:58You remember Daimler-Benz. They had this great idea to buy Chrysler. $37 billion. They merged in 1998. By 2007, Daimler-Benz ended up dumping Chrysler for $7 billion. So they lost a smooth $30 billion on that deal. Mattel bought the Learning Company for $3.5 billion in 1999. Less than a year later, the Learning Company lost $206 million. It took down Mattel's profit and Mattel sold the Learning Company at the end of the very next year, 2000. Eddie Lambert, he had the great idea to buy Sears and Kmart, put them together, call them Sears Holdings.

17:48In 1924, Lambert was named America's Worst CEO. Quaker Oats had the great idea to buy Snapple in 1994, paying $1.7 billion for Snapple. Twenty-seven months later, Quaker Oats sold Snapple for $300 million. If you do the math, that meant that they lost $1.6 million per day for every day that they owned Snapple. Now who can forget AOL and Time Warner? This was supposed to be the dream merger, this is 2001, old school media, Time Warner, Consolidating with the absolute cutting edge of technology, America Online, the internet provider and Time Warner, the magazine maker, they put together it was $111 billion, but by 2009 the CEO of Time Warner announced that the marriage of AOL and Time Warner was dissolved. So, anyway, we have all these examples. 74% of mergers fail, big ones, small ones.

19:20I mean, is it just personal and cultural issues or are companies just flat over paying? What's going on here? Well, the Austrian School of Economics actually has done some work on this and they've made some insights Insights into the limits to the size of a firm, and as much as the left constantly ring their hands, you can always hear these guys, oh, oh my gosh, Exxon's going to get so big they take over the world, or this one, or Walmart, or whatever it's going to be, we're all going to shop at Walmart, and we're all going to buy gas from Exxon, it'll be terrible. There's limits to how big a firm can get. It just doesn't work out the way people think. And it's because Ludwig Fried von Mises famously came up with the idea that he determined that socialism can't function because there are no market prices in a socialist economy to distinguish between the more or less valuable uses of social resources.

20:30But Peter Klein again, who studied Mises' work, points out that Mises wasn't just talking and about Socialism. He was talking about all markets. Mises was addressing the role of prices of capital goods. And entrepreneurs make guesses about future prices. That's what they do. Allocate resources accordingly to satisfy customer wants and turn a profit doing it. And if there is no market for capital goods, Resources won't be allocated efficiently, whether it's a social economy or otherwise. The market economy requires well-functioning asset prices.

21:18Without these prices, decision-making is destroyed. If one can't calculate and compare the benefits and costs of production using the structure of Monetary Prices Determined at Each Moment in the Market, then as Joe Salerno points out, the human mind is only capable of surveying, evaluating and directing production processes whose scope is drastically reduced to the compass of the primitive household economy. Mises pointed out that one cannot play speculation and investment. The speculators and the investors expose their own wealth, their own destiny.

22:04This fact makes them responsible to customers, the ultimate bosses of the capitalist economy. And Murray Rothbard also extended Mises analysis to considering the size of firms and the problem of resource allocation under socialism to the context of vertical integration in the and Size of an Organization. He says the ultimate limits are set on the relative size of the firm by the necessity of markets to exist in every factor in order to make it possible for the firm to calculate its profits and losses. To make explicit estimates, there must be, to make implicit estimates, there must be explicit markets.

22:53When an entrepreneur receives income, in other words, he receives a complex, various functional incomes. To isolate them by calculation, there must be an existence of an external market to which the entrepreneur can refer. So what this means is as firms get too big, economic calculation gets muddled because These firms, they don't receive the profits and loss signals for their internal transactions. Managers are lost as they try to allocate land and labor to provide maximum profits to serve customers best.

23:38And as these firms grow, especially by acquisition, one part of the company often becomes the provider and another part of the company becomes the customer. that there are no market prices to allocate resources efficiently. Rothbard wrote, economic calculation becomes ever more important as the market economy develops and progresses. As the stages of the complexities of type and variety of capital goods increase, ever more important for the maintenance of the advanced economy, then is the preservation The Klein makes the point that as soon as a firm expands to the point where there is at least one external market that has disappeared, the calculation problem exists.

24:36The difficulties become worse and worse and more external markets disappear and as islands Degrees of non-calculable chaos swell to the proportions of masses and continents, as the idea of incalculability increases the degrees of irrationality, misallocation, loss, impoverishment, etc., become greater. So when firms get big, they get this big overhead, that they don't know how to allocate it. There is difficulty in allocating overhead on any fixed cost for that matter amongst various divisions of the firm.

25:23If an input is essentially indivisible or non-excludable, then there is no way to compute the opportunity cost for just that portion of the input. Firms with high overhead costs should thus be at a disadvantage to firms able to allocate costs more precisely between business units. Now you know what overhead looks like, it's what Scott Adams describes as organizations riddled with hamster brain sociopaths in leadership roles, sitting around having meetings, looking at PowerPoint presentations, M&Ms kill prosperity, not the candy, managers in meetings are what of Kilt Productivity.

26:12Too much management is required when firms get too big. And if managers knew how to manage, they wouldn't be buying by the dozens these new management books that constantly come out, like Who Moved My Cheese, Who Made My Cheese, Who Moved My Secret, Who Moved My Soap, Who Moved My Church. I mean, people trying to manage, they're so desperate. By the way, I hear Rudy's running again. That's my newsflash for you today. Keith Oberman lost his job last night. Rudy Giuliani is running.

27:02So the result of the CEO buying sprees spurred by cheap fed money produced by Money and Credit. They don't produce new jobs, they don't produce new products that make our lives better. These corporate shopping extravagances are just wasteful malinvestments that destroy capital. The Federal Reserve monetary policy over the past couple decades has produced no real economic growth, but bubble after bubble after bubble, and each bubble and each contemporaneous bubble made bigger in the aggregate and more damaging than the one that preceded it. Kevin Dowd explains that these bubbles destroy part of the capital stock by diverting capital into economically unjustified uses.

27:55Central banks artificially lower interest rates, make investments appear more profitable than they really are. And this is especially true for investments with long time horizons. Or, in other words, in the Austrian terms, there is an artificial lengthening of the investment horizon. Now, there is nothing more long-term than buying a company, which is not just buying a group of employees and the current inventory of goods and services, but buying a company is buying the package of previously made long-term capital investments. So this lowering of interest rates distorts the view of making those acquisitions appear profitable.

28:45These distortions and resorting losses are magnified further once bubbles take hold, inflicts its damage to the end result is a lot of ruined investors, bubble blight, massive overcapacity. in the sectors affected, and this has happened time and time again, whether it's tech, whether it's real estate, whether it's treasury, whether it's financials, junk, municipals are on their way, and I would contend, mergers and acquisitions will again, in hindsight, look like a fool's errand. So the Fed's printing press is destroying the capital base of the U.S. economy in so many ways that many people don't realize.

29:38Savers have been punished, they've been encouraged to risk capital on ventures that don't make economic sense. But CEOs see cheap money as the path to building empires, fooled by the faulty assumptions buried in their Lotus valuation models. However, these empires will inevitably crumble and destroy precious capital in the process.