We activist investors get accustomed to the articles, essays, manifestos, and screeds that blame us for all of society’s ills. Lately, we catch flack for share buybacks that allegedly starve companies of capital spending and prompt layoffs. Let’s use some recent especially sloppy examples to make a few new points about these criticisms. 

As for capital spending, critics claim that activist investors’ demands for cash shunts funds from R&D and other investment. As evidence we have random anecdotes about companies that spent more on share repurchases than they did capital spending, and a few CEOs that complain that they cut R&D because of pressure from investors to return cash. Yet, other factors also explain what’s going on with capital spending at US companies.

Capital allocation is a really complicated proposition at most companies. The system for investment decisions is at best flawed, and mostly seriously screwed up:

1. ❖When companies have a process for identifying and analyzing prospective R&D and capital projects, it’s convoluted and arbitrary or they don’t follow it.
   

2. ❖The standards for choosing projects defy reason. They entail hurdle rates that have nothing to do with corporate finance theory or financial market reality.
   

Consulting firms like Fortuna Advisors make a nice living advising companies about how to do this better.

To the extent that R&D spending has declined, and we haven’t seen aggregate data that show this, we might even cheer that development. Perhaps it means that companies spend less because they have fewer worthwhile projects to spend on.

These two explanations absolutely contradict. Companies can’t both lack discipline in investment analysis, and then decide that a disciplined process leads them to reduce capital spending because projects don’t satisfy investment criteria. The point is, we have many explanations for why R&D investment is at one or another level, or rises or falls from year to year.

Either way, we have only anecdotes about the reasons why. CEOs complain how activist investors demand cash, which then forces cuts to R&D spending. We have yet to see a rigorous (or even shoddy) analysis, with a credible sample of companies, of how returning cash to shareholders causes a decline in productive capital investment.

An even more absurd analysis suggests that returning cash to shareholders leads to layoffs. Again, we have a few cherry-picked anecdotes about companies that both layoff people while they repurchase shares.

Again, we’d prefer a rigorous analysis with a credible sample of companies that links layoffs and buybacks. It’s easy to cherry-pick examples, replete with the routine human interest stories about robber baron hedge fund activist investors buying another mansion at the expense of simple, hard-working company men.

Worse, the whole narrative gets the corporate finance theory entirely wrong. Layoffs pertain to the income statement (flows). Buybacks involve the balance sheet (stocks). Layoffs improve cash flow, which companies can then devote to more productive uses. Buybacks return cash to shareholders that the company can’t profitably employ. Companies just as easily channel improved cash flow from layoffs into capital spending as into share repurchases. Other than both pertain to “cash”, they have little to do with each other.

We continue to press our portfolio companies to use cash wisely, including on productive capital investment. When they don’t have productive uses, we want the cash back. We will also press portfolio companies to operate efficiently, which sometimes leads to layoffs.

We have portfolio results that show this works. Our critics have only biased anecdotes based on flawed interpretations of corporate finance theory. We’d love to see a logical financial framework that leads to rigorous analysis of credible data to prove us wrong.