Financialism leads to agony for GE and Sears

The internet has been buzzing with the news that General Electric lost its standing on the Dow Jones Industrial Average (DJIA) this week. That does not mean General Electric will no longer be traded, as some posts seem to claim. It means that General Electric is no longer one of the 30 firms that economists measure to calculate the Dow average.

Walgreens will replace GE on the DJIA, making this a bitter blow to the prestige of General Electric and signaling the increasing wealth and prominence of insurance related companies.

David Blitzer of Dow Jones had this to say about the current business environment:

“General Electric was an original member of the DJIA in 1896 and a member continuously since 1907. Since then the U.S. economy has changed: Consumer, finance, health care and technology companies are more prominent today and the relative importance of industrial companies is less.”

Only a few years ago General Electric was the most valuable publicly traded company. General Electric joined the DOW in 1907 and gained fame as an innovative company aggressive snaring the best engineers and scientists and making remarkable contributions to the industrial economy in the 20th century. General Electric built its fortunes on invention manufacture and sale of consumer electronics in the early 20th century and later moved onto big ticket industrial goods..

Robert J Gordon has written an explosive book offering a convincing argument for what has happened to our economy. In The Rise and Fall of American Growth Gordon argues that the century spanning 1870 to 1970 was an era in which “Great Inventions” powered by electricity and gasoline disrupted the economy and created great wealth. Since 1970 or so, the economy has moved ahead by the slow evolution of improvements to the inventions of the previous era.

A good metaphor might be the Interstate Highway System. The federally funded, high speed, all weather highway system replaced the interlocking network of two lane state funded highways.

Constructing the Interstate Highway Stems was costly, but created many jobs and funded many businesses and industries everywhere the system was built. Once built, however it became a static part of the economy and transportation systems. Incremental improvements were made over the years, but there was no opportunity for additional disruptive change that might create great wealth.

Here is how Gordon puts it:

Progress after 1970 continued but focused more narrowly on entertainment, communication, and information technology, in which areas progress did not arrive with a great and sudden burst as had the by-products of the Great Inventions. Instead, changes have been evolutionary and continuous. (Gordon, 2016, p. 23).

After 1970, the business climate became more competitive. Corporation began to look for new niches for expansion. At about the same time Wall Street “arbitrage artists” realized that many industrial companies were worth more for their assets than their future value. They constructed complex deals using borrowed money to buy old name American companies like US Steel and Rubbermaid, tear out anything of value and sell it to emerging economies in Asia, Africa and South America.

Called “hostile takeovers” these deals caused a great deal of emotional consternation. Most Americans did not understand the cold economics of “creative destruction” – the natural evolution of business – and the arbitrage artists became villains of Wall Street.

The best personification of these Wall Street entrepreneurs is the amoral corporate raider Gordon Gekko, played by Michael Douglas in the drama Wall Street, for which Douglas won the Academy Award for Best Actor and uttered the catchphrase, heard even today, “Greed is Good”.

The threat of financial creativity was not lost on large corporations in the last quarter of the 20th centuries. Although General Electric had established GE Capital in the 1932 to manage the new consumer product of credit, purchasing it now expanded into many other areas of consumer and corporate finance.

Rana Foroohar details General Electric decent into financialism in her excellent book, Makers and Takers.

When Jack Welch became CEO of GE in 1981 and immediately shifted from sales of jet engines, nuclear reactors and mining equipment to buying and selling other companies and even its own divisions in order to increase its stock price.

Acquiring debt was a large part of this shift, and GE Capital became the largest issuer of commercial paper – short-term loans to large corporations – in the world. GE Capital became a major profit center for General Electric and the company began to focus on “Not making, but taking, across every possible era of finance from equipment leasing to leveraged buyouts and even subprime mortgages”, (Foroohar, 2016, p. 154).

When the industrial economy finally crashed in 2008, General Electric’s new CEO, Jeffery Immelt, was forced to make a personal visit to Warren Buffet asking for $3 billion to save the company. Six years later in April 2015 Immelt announced that GE would be leaving the finance sector and the company would return to its original mission of invention and manufacture.

Another big name traditional American company, Sears, has been moving down a similar path.

If you have been following business news for the last couple of years, you know that Sears has been struggling to maintain its place in consumer sales. Its retail operations have been shedding cash for years and it has been running on borrowed money to survive. Sears has been selling its real estate – its stores – to offset the cost of borrowing essential to its survival. The details make for interesting reading.

For example, in 2015 Sears bundled 235 of its stores into a Real Estate Investment Trust (REIT), then leased the same stores back to itself. Its retail divisions, already losing money at an astonishing rate, now has the added burden of lease payments to Sears Holdings Corporation.

Sears borrows its money from ESL Investments, a hedge fund owned by Sears Holding CEO Eddie Lampert. (Yes, Lampert is CEO of both companies.) Every time Lampert injects money or lays off employees, Sears stock price increases a bit, and every time he closes another store, ESL gains another property.

There is a perverse secret to making money in real estate – debt financing. Most of us think of debt as something to avoid because there is no real upside. That isn’t true for big players, though. There are huge tax advantages to debt financing. Money a company borrows can be written off as businesses expenses and at the same time, an REIT is generating cash through the leases on property. It’s a win-win.

This is just one small example of how the economy has changed at a very basic level. The idea that debt can be an advantage to a company is difficult for most of us to accept, and that illustrates a larger issue – nobody is quite sure how to measure and manage this new economy.

In The Only Game in Town, Mohamed El-Erians’ interesting and very readable book on modern economics, quotes William Dudley, New York Federal Reserve President on the state of knowledge of our financial leaders in this era of financialism:

“We still don’t have well developed macro-models that incorporate a realistic financial sector”, (El-Erian, 2017, p. 33).

In other words, the Federal Reserve doesn’t really know how to measure economic consequences of large companies moving away from traditional trade and towards debt financing.

 

 

These books re referenced in this article:

El-Erian, M. A. (2017). The only game in town: Central banks, instability, and avoiding the next collapse. New York: Random House.

Foroohar, R. (2016). Makers and takers: The rise of finance and the fall of American business (First edition. ed.). New York: Crown Business.

Gordon, R. J. (2016). The rise and fall of American growth: The U.S. standard of living since the Civil War. Princeton: Princeton University Press.

 

 

 

Leave a Reply

This site uses Akismet to reduce spam. Learn how your comment data is processed.