The Law Of Unintended Consequences or Supply Meets Demand

"Buy land.  They're not making any more."

Will Rogers

While driving long distances the mind tends to wonder and I started thinking, for lack of anything better to do, of Sarbanes Oxley and the law of supply and demand.  Not necessarily in that order but they, in combination, are another reason why stocks are attractive right now, at least as opposed to most other things.  And this is not about land but what Will said about land is now applicable to stocks.

First, I don't know the slightest thing about Sarbanes Oxley.  I don't think I even spelled it right.  But I do know that Sarbanes Oxley is not effective and is annoying and a drag on earnings.  My experience is mostly anecodotal but when I call up old friends still at the salt mine and ask "Hey, what's going on?" about half the time I hear something about Sarbanes Oxley.  And it isn't good.  Busy work.  Non-productive report filing that means hiring more 'corporate staff' which means accountants and lawyers.  And CEO's hate accountants and lawyers.  Also, Sarbanes Oxley requires the Chairman to sign a note saying that all the numbers reported are the truth, the whole truth and nothing but the truth.  Think about that--I have 30,000 employees out there worldwide doing who knows what and I have to sign something that says every number they produce is correct.  No thanks. 

But that is the basis of Sarbanes Oxley.  And people are doing something about it.  Investment bankers are slithering around whispering in CEO's and CFO's ears.  "Want to get rid of that silly signing thing?"  "Want to get rid of some lawyers?"  "Want to get rid of some accountants?"  "How about dumping the annual report and quarterly report and shareholder meetings and analyst meetings and 10k's and all the other k's out there?"  "Interested?"  You bet.  Tell me more.

What the investment bankers are saying is Go Private.  Remember the inverse of the PE ratio?  If a stock has a PE of 20 that is really a return of 5% when 1 is divided by 20.  And 5% is higher than or near the borrowing cost so basically management or somebody can borrow the money and buy the company and come out ahead.  And where is the money coming from?  From those investment bankers who will set up the deal and get the money to take you private.  No more Sarbanes Oxley and a mass execution of accountants and lawyers.

And a reduction of readily available stocks to buy.  Yeah, so what?  Well, remember supply and demand?  When the supply of something goes down, the value of that supply goes up.  Look at gasoline.  The same goes for stocks.  The fewer the stocks out there, the more valuable those remaining stocks become because they are the only game in town.

So why don't companies issue more stock and provide more supply?  Some have but not in any great number because CFO's and corporate treasurers know that debt is cheaper than issuing equity and lot less hassle.  Call up your investment banker and borrow a couple of billion.  Plunk down your low interest rate payment and deduct the interst on your tax return. 

Want to issue some stock?  Your call goes to the other end of the investment banking house and you are now filling out government required forms, prospectuses, and hiring legions of lawyers and accountants.  You are also going to dilute the value of the shares of the existing shareholders because there will be more shares out there and they don't like that.  And they might sell which drives down the stock price and you get less money for your new stock issue.  And the cost of equity is not tax deductible.  Hassles and you are not a hero to the CEO.  Stick with the debt.

Finally, there was a time when issuing equity was all the rage.  And take note of what happened.  The time was the dot.com bubble of the late '90s.  Even sock puppets were issuing equity and when that happens the SUPPLY goes up.  And when supply goes up, PRICE inevitably goes down.  And it did and billions, trillions of shareholder wealth was wiped out along with slew of sock puppets.

So times are good for stock because 1) government regulation is pushing management toward going private, 2) you can go private because debt is cheaper than equity and when that happens supply dries up and prices go up as well. 

Will it hold up?  I don't know but look at the market and see what is going on.  Also look at M&A activity which we will talk about on Monday.

Comments

[klauss]

Good perspective. Never considered that. All I hear is that indices are at all time highs. Well I hope so. I don't expect the market to stay in a range forever, but again Japan's market was hurting since I have been in pampers. Love the blog Bill