The Behavior of Stock Market Manias

Posted on Posted in Books, Case Studies

I’ve heard more and more commentary/concern about the level of the overall market lately. With the market relentlessly marching to new all-time highs just about every day, I’ve even begun to hear the word “bubble” being used. While I certainly don’t think the market overall is cheap, and while I certainly believe it’s very possible that a bear market could occur at any time, we are definitely not in a bubble. Anyone who thinks that the current market is reaching levels that would correspond to previous manias should study previous manias. The late 1990’s saw unbridled enthusiasm among individual investors, reckless behavior by corporate managers, and significant complicity by lawmakers and regulators.

Even though the late 90’s bubble wasn’t that long ago, I think it’s easy to forget how crazy some of the valuations were and how egregious some of the behavior was among market participants and management teams.

I recently read the book Bull by Maggie Mahar, and I thought I’d highlight just one example that illustrates the speculative fervor that existed at the time.

One of the perks about being CEO of a publicly traded company of the 1990’s was that you could pay yourself with huge amounts of stock options, but yet not count those stock options as an expense on your company’s financial statements. It was creating money out of thin air. You, as public company CEO (along with other top executives) could mint multi-million dollar pay packages each year that seemingly had no strings attached (because it wasn’t an expense as far as the income statement was concerned). This was obviously a complete fallacy. The options were an expense—a significant one. Doling out millions of stock options to yourself and your friends might not have shown up in that year’s income statement, but it did show up in the shareholder’s equity statement in the form of increasing the overall amount of shares outstanding. Obviously, more shares outstanding means lower earnings per share for all other shareholders. Even without counting the options as an expense, the pie was the same size and each shareholder’s slice was now smaller.

Not counting this form of compensation as an expense was a ridiculous accounting practice, and one that was supported by ridiculous arguments by lobbyists and the lawmakers who wanted to protect their corporate constituents who were getting rich. These options were akin to lottery tickets that couldn’t lose, and, in the bull market of the late 1990’s, were sure to win.

But as it turned out, granting options wasn’t a free lunch. As mentioned, the obvious cost was that it increased the shares outstanding, thus lowering earnings per share. But this practice also led to a second derivative behavior, and one that is still practiced today (and is a pet peeve of mine)—companies began buying back their own stock to “offset dilution” that occurred from giving out options to management.  Buying back shares—like any other capital allocation decision—only makes sense if the value you’re getting exceeds the price you’re paying. Overpaying for anything—including your own company’s shares—will lead to value destruction. What annoys me about this behavior, which is practiced very often today as well, is that for some reason corporate managers seem to act like these buybacks—when they are earmarked for the purpose of offsetting stock options—exist in a vacuum where the laws of economics are suspended. The act of buying back shares of stock is a separate capital allocation decision, regardless of the reason why you’re buying those shares. Doing so without any regard for value (simply to “offset” the dilution that you created with a previous decision) is completely illogical. Yet it occurs all the time. And in the late 1990’s, it was running rampant.

At least now these options are counted as compensation (although most companies try to avoid this by using magical terms like “adjusted EBITDA” which essentially does what GAAP accounting allowed in the 90’s—not counting this form of compensation expense as an expense). But regardless of the accounting treatment in the 90’s, these options became very expensive (and cost real cash) when companies began buying back their shares to offset the dilution that these options were causing. This practice has a bit of irony attached to it, because the corporate managers who fought tooth and nail to prevent these options from being called what they were (an expense) began paying for these options by draining the company’s cash to hide the true impact and cost that the options were creating in the first place.

One bad decision (granting excessive stock-based compensation and not expensing it) led to a second bad decision (using real cash to buy back extremely overvalued shares in the open market to keep overall shares outstanding from skyrocketing). Of course, shares of stock are fungible. As CEO, the shares you buy back in the open market are economically identical to the shares you created and gave yourself. In effect, by buying back shares to offset dilution, the irony is that the company was paying for the very shares that they were giving themselves, despite their unwillingness to call it an expense.

Dell—Superb Computer Maker, Financial Innovator

This post isn’t an attempt to pick on Dell, but that company was highlighted in the book as one of the firms that practiced this type of behavior. Other companies were doing the same thing, but Dell was one of the excessive practitioners. Michael Dell paid himself huge amounts of options (in 1998 he gave himself 12.8 million options to buy Dell’s stock, while at the same time unloading 8 million shares in the open market). To finance these generous option grants, Dell began ramping up his company’s buyback program. In 1998, Dell Computer spent a whopping $1.5 billion buying back its own stock—which by the end of the year was trading hands at 70 times earnings.

Although Dell (the founder) was personally selling his own shares, he clearly he wasn’t concerned about using Dell (the company) cash to buy back excessively overvalued shares. In fact, the company readily admitted that the shares repurchased weren’t done with any sort of benchmark to value, they were done simply to offset the dilutive effects of the huge number of options that the company executives gave themselves.

I went back and looked at the 2000 10-K, and here is why the company bought so many shares:

“During fiscal year 2000, the Company repurchased 56 million shares of common stock for an aggregate cost of $1.1 billion, primarily to manage dilution resulting from shares issued under the Company’s employee stock plans.

Dell issued 82 million shares in 2000 for stock-based comp. It then bought back 56 million shares for $1.1 billion, to partially offset the dilution. This $1.1 billion was real cash that the company shelled out for something that wasn’t called an expense in 2000. $1.1 billion equaled about half of Dell’s pretax earnings for the year. Moreover, $1.1 billion for 56 million shares only equaled about 2/3rds of the shares that Dell issued for compensation (in other words, Dell didn’t completely offset the dilution). Dell earned $2.5 billion in pretax income in 2000. So the real cash cost ate up about half of Dell’s net income, and had the company offset the entire amount (in other words, called the compensation an actual expense), Dell’s income would have been 64% lower than actually what was reported.

To paraphrase what Buffett said about options:

If options aren’t a form of compensation, why did Dell spend $1.1 billion to “manage dilution”? And if $1.1 billion isn’t an expense, what is it? And, if $1.1 billion shouldn’t go into the calculation of earnings, where in the world should it go?

The answer, as Dell exemplified, is that stock options were an expense, often paid for with real cash dollars that showed up in the company’s cash flow statement (and should have showed up on the income statement).

When the Widget Maker Becomes a Hedge Fund

These rampant stock buybacks led to yet another behavior (now a third derivative of the decision to grant excessive options). This next level is what separates bad corporate behavior (which can be found in any environment) from bubble-behavior that typically only is found in manias. Companies not only began using cash to buy back common stock of their own company, they began using cash to buy call options of the common stock of their own company! To be clear, I’m not talking about the options that were given to managers as compensation, I’m talking about the options that traders use to make short-term bets on the price of the stock (puts and calls).

From the book Bull:

“Meanwhile, in order to try to offset the cost of buying back its shares, Dell Computer decided to gamble on its own stock. In an effort to make buybacks less expensive, the company began buying call options that gave it the right to purchase Dell shares at a preset price for a defined period of time…”

Amazingly, Dell not only bought calls on its own stock, it also sold puts to finance the cost:

“Dell’s foray into the options market did not stop there. To pay for the call options, the company began selling “put” options on its stock.”

Dell was using options as a way to be “long” its own stock without shelling out much cash (buying a call and selling a put at the same strike price is an “equivalent long position”, as option traders would say). But it was really just a bet that Dell’s stock price would go higher.

Dell casually explains the use of options in its 2000 10-K:

If the stock rose, Dell profited. If the stock fell, Dell would have to put up cash. (Hint: this program was ramped up in 1999 after Dell’s stock gained 216% in 1997 and another 248% in 1998. You can guess what happened shortly thereafter). But for a while, Dell the Hedge Fund did as good or better than Dell the Computer Maker—in one quarter it made more money trading options than it did selling computers!

Dell built up a truly massive position in options on its own stock. At the end of 1999, the company owned call options on 118 million shares and had sold put options on 69 million shares, and amount that equaled billions of dollars of notional value of Dell common stock—real cash that Dell would have to come up with if things went bad.

And things went bad. Dell lost billions of dollars over the next few years on the puts—they had to shell out over $1.2 billion in one year alone to buy back millions of shares of stock that had lost half their value in the previous year—this was more than they made selling computers that year.

By 2004, Dell seems to have learned their lesson, as I found some subtle changes in the paragraph titled Capital Commitments, which was where they previously tallied their bets on the puts and calls they traded:

Translation: We tried our hand at option trading, but we’ll stick to selling computers and using our cash to do buybacks the old-fashioned way.

To be clear, they are still buying back stock for illogical reasons. But at least they kicked the hedge fund experiment to the curb.

Manias Often Exhibit Extreme Behavior and Pervasive Aggressive Accounting

I didn’t highlight this example to disparage Michael Dell, whose business acumen I have a huge amount of respect for. I think Michael Dell is an incredible entrepreneur, and the business model he developed for Dell Computer allowed him to reap incredible rewards from an industry with commodity characteristics, mean-reverting profit margins, and low barriers to entry. Combined with rapid growth, these conditions led to extreme competition. But Dell succeeded, and built a business that—at least for a period of time—had some strong advantages.

But it’s interesting to observe the behavior from Dell and others (Dell was certainly not the only, nor the most egregious offender), who—as Mahar put it in the book—turned their companies into hedge funds.

The mania of the 1990’s was extreme, and while we will most likely see similar excesses at some point, we are nowhere close right now. There are almost always isolated areas of excess, fraud, or aggressive accounting, but it gets widespread during manias.

That said, this was not a post about the overall market valuation level. It was just a post to comment on a section of a book I found to be really interesting. I have no idea where the general market is going. Over time, it will go up. Over the next few years, I really don’t know. Nor do I really care much, as long as I’m able to find a few investment ideas that offer compelling value. In the short-term, the market’s tide will raise and lower all boats, but value investing works in the long-run, and unless you’re in a late 1990’s type mania, I think it probably is best to completely ignore the overall market and just focus on looking for undervalued stocks of individual companies that you think will be doing more business in five years than they are now.

But I love reading about market history, and Bull is a great book filled with interesting stories from the bull market that started in 1982 and culminated in early 2000. It’s a quick, fun read, and it has some good takeaways to think about regarding corporate management practices, market efficiency (or lack thereof), and individual investor behavior—all things that I think are useful to keep in mind as an investor in the stock market.

John Huber is the portfolio manager of Saber Capital Management, LLC, an investment firm that manages separate accounts for clients. Saber employs a value investing strategy with a primary goal of patiently compounding capital for the long-term.

To read more of John’s writings or to get on Saber Capital’s email distribution list, please visit the Letters and Commentary page on Saber’s website. John can be reached at

25 thoughts on “The Behavior of Stock Market Manias

  1. I like to think that stock market bubble is a very philosophical subject rather than a theoretical economic subject.

    I agree with you, we are not in a bubble yet. Let me explain my reason.

    Bubble is formed when rational people performing irrational stunts. Most of the times, most smart people can think straight and make wise decisions. Their behavior will only change when jealousy and greed kick in.

    Some experts are now saying that stocks are too high, which to be fair they are not entirely wrong. Wise investors should actually trim their equity holdings at this time. BUT, if stocks continue to rally for, say, another 1-2 years, and your plumber/cab driver/janitor say “I told you so!”, how would you — the wise investor — react?

    Few wise investors will continue to stay out, but many envious and greedy investors will start chasing, and there you go.

    For Michael Dell, however intelligent he is, he is not immune to envy and greed. I mean, for him as a tech company CEO in 2000, market would have laughed at him big time had he not participated in the mania. So I wouldn’t blame him for such irrational behavior, only non-tech guys had a higher chance of immunity (even Mohnish Pabrai couldn’t escape).

    As for the current market, I like to think that people are still rational in playing the gravity game with interest rates, albeit the recent optimism is slightly far fetched, but I think it’s fine. Of course, bargains are getting scarcer nowadays for sure.

  2. It’s interesting to note how the way informationis presented in annual reports has changed during the last 10-15 years.Dell was a company doing 25+ billion in revenues in 2000 and they had a 50 page 10-K.All the information needed to analyze the business and evaluate management practices was there.Simple and Concise. Good luck finding any 10-K nowadays from a company doing 25+billion in sales !!

    1. Yeah, it’s funny you mentioned that. I was thinking the same thing as I was reading some of those old 10-K’s. The filings today have probably the same amount of information, but now for some reason lawyers think they have to repeat it two or three times throughout the filing. For a 150 page 10-K, I bet 50 pages or more are redundant.

  3. Interesting. I was just mulling over a similar concern about Markel’s buyback program which seems to be constant and targeted at offsetting dilution from their compensation plan and how un”business-like” that decision and pattern of behavior is and how that should shape my understanding of their capital allocation and general acumen.

  4. An excellent read, as always, thanks a lot!

    I totally agree with your conculsion in the end. Buffett said (paraphrasing): You can buy bonds at a pe ratio of 40 (having no growth) or you can buy stocks with pe ratios being much lower.

    I totally agree with you and with Buffett; nonetheless there’s one question, that came to my mind regarding market valuations: Assuming bonds and interest rates go even lower as they are today, at which level (pe ratio or Shiller pe ratio – or whatever metric you’d like to take) would I call the market of today a bubble?

    I mean – there’s obviuosly no clear, defined bar to answer that question. And you and me could just answer “I don’t care about the market, as long as stocks are cheap”; and in real life both of us do exactly say this. Nonetheless I find the question interesting. I live in Germany and German bonds (treasuries; 10 years) yield 0,42%. That’s a pe ratio of around 250. If German stocks would yield 2,5% that would be a pe ratio of 40; so it would be much cheaper than bonds, nonetheless I wouldn’t be happy buying an ETF on the German DAX at a pe ratio of 40 in this example.

    this is just playing around with numbers, I know; but I would be happy reading your thoughts about comparing bonds and stocks on the basis of pe ratios – I think that metric has it’s limits; but how to deal with that, if the market should go higher and which other metric would you take, do you take today. Market cap to GDP? I ask myself if there was a theoretical point, where cash/bills might get an option instead of treasuries or stocks?

    1. Yeah, I think those are good points. I don’t think comparing relative value between bonds and stocks is a great way to determine whether stocks are attractive. Your German treasury example is a good illustration of this. By that logic, even 100 P/E for stocks would be much cheaper than bonds, which is obviously crazy at that level. I’ve heard people, and even Buffett, talk a lot about stock prices being attractive at 25 P/E because the US 10-year trades at 40 or 50 P/E (2% to 2.5% yield). If everything doesn’t move, this makes sense. Stocks are much better option there because a) they are twice as cheap, and b) earnings will grow on stocks over time, whereas with bonds you’re paying 50 times earnings with guaranteed no growth.

      To me, this is an argument against bonds (who would pay 40-50 P/E for a stock that, even though it will produce guaranteed earnings, it also is guaranteed to provide 0% growth)? The problem I’ve always had with the stocks vs bond yield argument is that if rates rise, the whole thing doesn’t make sense. All of sudden stocks are expensive again at 25 P/E. I do think there is merit in looking at general rates (we likely won’t return to the rate environment of the early 1980’s for example), but I wouldn’t be getting excited about stock prices at these levels for the sole reason that bond yields are really low. That can change quickly.

      All of this said, I honestly gave this more thought just now than I’ve given it in the last year or so. I really think as long as you hunt for good companies at good prices, and focus on finding just a few opportunities each year, none of the general market valuation levels will matter much. They’ll certainly provide short-term tailwinds or headwinds as general stock prices rise and fall, but over longer periods, good companies will do well, and stock prices of those companies will respond accordingly over time. So unless it’s bubble territory (or 2008 type pricing at the opposite end of the spectrum), I really don’t pay much attention to the overall market.

      1. Thank you for your time and the feedback.
        Any thoughts about other valuation metrics regarding the market, that you prefer? I mean: I generally agree, that it’s all about single stocks; and in that perspective, market valuation in general isn’t interesting at all. On the other hand I am scratching my head and asking myself: Is it in addition to the fact that it’s “all the same?”, a fact, that we don’t have any usfeul, good metric as long as interest rates are at rock bottom?

        By the way: You haven’t been writing about Markel in a while. Do you plan to reevalute MKL any time soon? I really like your writings about MKL and read them from time to time.

        Do you think about Market cap to GDP?

    2. I second John’s relative value point, but add one aspect on the positive side of bonds.
      If the “pe” of bonds and stocks is both high, bond principals will at least not lose nominal principals when interest rates rise. Not true for stocks. But except for this I agree.

      In short, we can summarize my point and John’s point in two sentences:
      Mr. Bogle breaks down the total return of stocks to multiple expansion & earnings growth. For bonds there is neither multiple expansion (or shrinkage!!) nor earnings growth.

      1. PCT, they won’t lose nominal principal, but they will lose actual principal in the form of buying power as a result of inflation, and interest rates and inflation go hand in hand to a certain degree.

  5. Terrific piece (as always). I worry that the market may underestimate the impact of rising rates on equities. But that’s a very different matter from manias/bubble behavior..

  6. “In effect, by buying back shares to offset dilution, the irony is that the company was paying for the very shares that they were giving themselves, despite their unwillingness to call it an expense.”

    I might also point out that when they buy back shares, they do so with profits– that is, after-tax dollars– whereas if they simply paid CEOs more the extra salary would come from pre-tax dollars.

    I am, however, curious.

    John, you’ve talked about “time arbitrage” before, and how you engage in it– in effect, taking advantage of the short-termism of most other shareholders. If these companies have capital to allocate, and can’t reinvest it attractively in the business, make sensible acquisitions with it or pay down debt, they have to either keep it around as cash equivalents or return it to shareholders. Most companies don’t seem to like to keep much around. If their share price is too high to make buybacks sensible, their likely move returning it is to increase the dividend. Right? So, if they increase the dividend, don’t they increase the attractiveness of the company to short-termers? And if they do that, doesn’t that make time arbitrage more difficult?

    1. This is a great point about taxes Matt.

      As for capital allocation, I think it’s smarter to pay out excess cash flow as dividends if the stock isn’t cheap. But companies rarely have a flexible approach to capital allocation like this (they usually have a set dividend that they pay out each year, often steadily raising it by a few pennies each year, and then they buy back shares without much mention of value). I rarely see any companies that let the market price of their shares determine whether they should dividend cash or buyback shares, but it would be great if more companies thought this way. I don’t think either of these impact the time arbitrage approach, which is based more on psychology.

      1. Thanks. I’ll follow up my question, if you wouldn’t mind, with sort of a rephrasing of it to better reflect what I meant. Don’t higher dividends usually drive stock prices higher as people with the short-term perspective of investing for yield pile into them? I’ve heard, in fact, that executives will sometimes increase a dividend in order to increase the value of their options or to hit performance targets tied to share price. I agree that buybacks at a high valuation are likely foolish, but increasing the attractiveness of the stock to those focused on the immediate payback would seem to make acquiring more shares at a good price more difficult.

  7. So I read your TARO analysis with great enthusiasm. Shanghvi has never had a track record of doling out options to himself and I don’t think he needs it.

    But if he wants to acquire TARO in whole, isn’t it in his interest to reward himself with copious amounts of options as 1. it’ll reduce the percentage of shares held by outside shareholders and 2. it’ll be very profitable for himself to have SUN acquire his shares?

    I mean the only thing stopping him from doing such a thing would appear to be having morals.

    1. Oh and I forgot that it has the further benefit for Shanghvi of potentially depressing the share price so that it would be cheaper for him to acquire.

  8. I disagree John, because the data indicates that the stock market prices are quite high relative to fundamentals. Some excerpts from a Facebook post I had a month ago:

    U.S. stock market valuations are extremely high: Shiller P/E 29.5 (just about tied for 2nd highest since the 1880s with the 1929 Black Tuesday peak and the dot com peak in 2000), S&P 500 P/E 26.8 (4th highest peak since the 1880s), market cap to GDP of 133% (second highest peak since 1950). Ten and twenty year historical returns of holding U.S. stocks are these valuations have generally been negative.

    In response to the invariable comment that “there is nothing to do but speculate that U.S. stocks will keep going up by remaining long U.S. stocks with the same portfolio weighting, plus U.S. stocks are cheap if interest rates stay permanently low, ” I commented:

    ‘If one wishes to financially express a speculative thesis like “interest rates will stay permanently low,” one might wish to consider the way to express said thesis that gives the most upside, with the least risk.

    For example, one could go through all country stock markets worldwide, and find ones with a combination of low Shiller P/E and low/negative interest rates. By the same reasoning as in the linked blog, these two conditions should not both be permanent. For example, Czech (Shiller PE 8.9, central bank rate 0.05%), United Kingdom (Shiller PE 14.8, central bank rate 0.25%), or Poland (Shiller PE 10.1, central bank rate 1.5%) stand out as more interesting than the U.S. (Shiller PE 29.5, central bank rate 0.75%) [2] [3]. Again, this is assuming that one buys the assumption.’

  9. If a company buys back stock every single year seemingly without regard to the stock price (or if they specifically say it’s to offset dilution which some companies do) I generally move the repurchase expense into an operating cash flow deduction. In my opinion, at that point the repurchases are a part of their normal operating business as they basically go hand in hand with how they’re paying their executives. There are some companies where doing this one simple adjustment makes the financials look significantly worse.

    1. Travis, I can’t agree with that as a blanket statement. It seems to me that the question is whether the number of shares outstanding is going down overall. If not, then you’re right. If they are, though, then it sounds like it’s a more complex situation, and you should move the repurchase expense only to the extent of the compensative dilution.

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