Wednesday, November 5, 2008

Why Stock Probably Doesn't Work

My buddy Nick left a comment on my last post asking why anyone would "loan" a company money when they could just as easily "buy stock" in that company. I was initially going to try to address this idea in the comments section, but then I realized that the thought might mandate a longer discussion - thus, this post's existence.

Buying stock is a great thing and is one of the fundamental tenets of western capitalism. When you buy a stock of a company, you "own" an infinitesimally small fraction of equity in that company. When the company becomes more valuable, the value of your ownership increases, and when the company makes profit, you are entitled to your tiny slice of that profit in the form of dividends. Stock ownership is a great thing.

When a company tries to raise capital (cash), it has the option of issuing additional stock for purchase. There are three main reasons why I think that a stock issuance is not the correct path for these companies at this point in their lives. I believe all three of these reasons tie together, so try to bear with me to the end. I also would like to state that in no way do I think this is the absolutely correct or best solution, but I am looking for the best option, and am happy for any ideas that anyone may provide.

1) OUR companies (GM, Ford, and Chrysler) already have an abundance of debt with an incredibly high interest rate owed to several banks. Have you ever refinanced your credit card debt? Here's the rundown: you owe an average of 20% on three credit cards. Instead of paying 20% every month on these cards, you take a loan out on your home for 8%. You can then immediately pay off the credit card debt, and instead, have one loan that you are paying at 8%. You are still paying interest, but saving significantly every month. These savings are compounded because you are avoiding compounding interest. I am suggesting that we, as Michigan, provide the capability for these companies to refinance a portion of their debt. Instead of paying 14% on their loans, we request 6%, thereby making money for us and saving money for them. So then why not sell stock to raise cash and refinance their debt? Because...

2) Issuing more stock significantly dilutes the equity held by current shareholders. This, in turn, will drive down the price of a share of stock (which must be defined prior to the stock issuance event), resulting in an unpredictable quantity of money that the company can raise. If the price of a share of stock goes down below the price set at issuance, it will not be possible to sell the new shares - instead, people will just purchase them on the open market, resulting in no additional cash whatsoever. And why not let the companies take the risk anyway? The common understanding is that these companies put themselves into this position on their own, right? Because...

3) Stock purchases are typically made at an institutional or individual level. A series of individuals must each decide whether they want to purchase stock in a company or not. Understandable. These companies need a massive infusion of cash, and I don't believe they can acquire the financing they need if every individual has the opportunity to decide whether or not they would like to contribute (and again as mentioned in point 2, the cash made available from a stock issuance is unpredictable). In this instance, we need to decide as a state unit whether or not this is an investment that we would like to make to mitigate job loss and uphold housing values. Not everyone voted for Obama, but he is our president-elect because the country decided that he is the best hope for our future. Everyone in Michigan may not want to contribute to the auto companies, but we, as a state, should have the opportunity to decide what is best for our state's future.

I don't know - I'm no economic genius, but I'm trying to suggest solutions. If you disagree with me, that is perfect, as long as you have a better idea. If your better idea is "let them burn", I would argue that your better idea is the worst idea in the world and that you are, in fact, a smelly pants. Don't be a smelly pants.

6 comments:

Zach said...

I think that you are very much neglecting a key point... its that you cannot 'bail out' or whatever you want to call what would be needed to be done to the big 3, without hurting some other people / area. The big 3 are terrible companies. GM isn't even significant anymore and is a small-cap company w/ a 5B market share. Why is it that toyota can turn a profitt w/ their plants in Indiana and Alabam, yet Ford GM Chrysler can't... well there's a lot of reasons. But to help those 3 is I think a selfish move. You are actually hurting the low-income famalies factory workers in Alabama. You will be hurting poor Indians (when Tata gets here). You will be surpressing and hurting ambitios young silicon vally-ers. This bail-out money doesn't exist in a vacuum. Michigan needs to look beyond the next 2 years of joblosses and create an environment really condusive to diverse growth. I don't think thats best served bailing out incompetant nearsigheted GM management or a UAW w/ a 1920's labor mentality...

Ken said...

I couldn't agree more that Michigan needs to move toward a more entrepreneurial mindset and work on diversifying its economy. Toward this end and my opinions regarding this, I'd like to direct you to this earlier post:

http://weareofmichigan.blogspot.com/2008/10/coping-with-possibility-of-doomsday.html

I clearly could not disagree more, though, with your underlying belief that these companies deserve to go the way of the buffalo. You are advocating a neo-conservative, 100% free market mentality, which has clearly failed with the current status of the U.S. economy. Why do the banks deserved to be saved? Not because of their contributions to national employment, but rather because saving these banks will prevent the collapse of wealth of those who are capable of investing in the stock market in the first place.

Why do we have taxes? And insurance? We are a country built on the concepts of capitalism and free markets with the inclusion of some concepts of socialism and "the greater good". And yes, I am selfish. I live in Michigan. No apologies for this. As a state, we have the right to do whatever is in our power to keep our industries running - hopefully with some necessary changes.

Ken said...

One other suggestion (seriously, not to be mean or mean-spirited) - I recommend you change to Firefox. Firefox includes a pretty decent version of a spell checker that runs on the fly, so if I type the word "incompetant" or "nearsigheted", Firefox will underline it in red and let me know that I'm looking illiterate. Or is that illetereat

Zach said...

I don't really think that the banks should have been bailed out... at least not the insolvent ones. Neither don't see the current crisis as a failure of the free-markets in the slightest (different topic). I don't mean to be hard on the big 3. They are symbols of American prowess, whose history is intertwined into the fabric of the US. These companies need to make a strong argument to taxpayers as to why this is only temporary help and not just throwing cash on a fire. I obviously don't know enough about their future plans, but these companies seem to have problems deeper than just needing a capital infusion. Particularly when it seems the alternative would be more of a shift in market-share rather than an industry collapse. Good call on firefox.

Ken said...

Wow - I have to say, I did not expect a conversational response. I was thinking it would be more along the lines of "hey, you're an idiot". Thank you for going the way you did! That said, you are right that we should not throw cash on a fire and that the Big 3 have a lot to explain and prove to taxpayers.

I guess my primary idea here is that I think Michigan residents should be given the opportunity to decide how they want "their portion" (of course extremely hard to quantify their portion) of the upcoming economic stimulus to prop up our native industry. If the majority decides that this would be a waste of money and these companies could not possibly be aided by our contribution, we would vote it down and then the rest will play out from there.

Good thoughts!

Nick said...

I know Ford has a loan system already in place. Ford Credit has their "Interest Advantage" which is an uninsured high yield savings account. This account pays at least .25% over the floating 7 day average of money market funds.

http://fordcredit.com/interestadvantage/index.jhtml

This money funds Ford's credit which they in turn provide to new car buyers and dealers, and that's what the Big 3 really need, people continuing to buy their (great) cars.

I think there will be losses in the Big 3, but I hope they survive. If the billions in cash the companies have now isn't enough, I don't think a few billion more is going to help them out, loan or stock. I don't have a good answer aside from complete restructuring.

On a not-so-related note, I hate how people refuse to buy an American product because Joey's sister's cousin's friend had a crappy K car once. I also hate how people think they are supporting the US economy by buying a Toyota just because it's manufactured in the US. Where do they think the big money is going? Not to Ken!