It is a fraud to borrow what we are unable to pay.
– Publilius Syrus
Corporations are using share buyback programs to manipulate earnings, by reducing the float of outstanding shares. This ploy was not as ubiquitous before, but today it is being used rather indiscriminately by companies as a way to boost EPS. This modern form of alchemy turns would-be losses into profits or can be utilized to make modest profits appear to be impressive in nature. We are now in the paradigm of lies and deceit. In these conditions, the truth does not thrive.
Many experts predict that share buybacks and dividend payments by US companies are expected to reach new highs in 2015. The troubling factor is that it appears that companies are taking the easy path in their quest to boost profits. Rather than investing in the future, they are spending inordinate sums of money on buying back their own shares.
Goldman Sachs forecasts that an 18% jump in buybacks for 2015.
“Corporate activity in early 2015 supports our view that the S&P 500 will return more than $1 trillion of cash to investors this year,” said David Kostin, chief U.S. equity strategist at Goldman in New York said in an April 24 note to clients. Full Story
The Fed’s balance sheet has swelled to roughly $2.4 trillion since the start of QE. S&P 500 companies have spent $2.41 trillion on buying back their own shares since the beginning of this bull market. Thus, it would be fair to state that US corporations have taken over from where the Fed left off. What could be construed as alarming is that in the first quarter S&P 500 companies returned more money to shareholders than they earned? This occurred in the 4th quarter of 2008, when the entire S&500 reported a net loss but still forked out over $110 billion on dividend and share buybacks. Something is off here and based on Howard Silverblatt comments (a senior index analyst at the S&P down Jones indices) it would seem that he concurs:
“It’s the addiction now,” Silverblatt said. “We’re trading in one for another.”
Silverblatt said about 12% of companies in the S&P 500 are already on track to reduce shares by about 4% or more, compared with the second quarter a year ago. He expects that to grow to about a fifth of the S&P 500 when all the numbers are in. That provides a significant tailwind to earnings per share or EPS.
Last year, corporations deployed approximately $540 billion to purchase their own shares. Other experts state the number is closer to $700 billion. Whichever, figure is used the numbers are immense. Why would they do what could be construed as reckless behavior? Money is cheap, and executive’s compensations are tied to share performance. If executives can create the illusion that all is well, and they have access to easy money, then they will keep playing this game for as long as they can.
In the days gone by, a large percentage of earnings found their way back into the economy via higher wages and increased investments in plants and equipment. No longer, these buy backs drain trillions of dollars out of the economy and inflating share prices while producing nothing of value. Corporate executives have always been under pressure to increase EPS; once the only option was to actually do something by improving earnings via selling more products or services, today they can simply increase the EPS by reducing the number of outstanding shares; it’s modern alchemy at its best.
James Montier challenges the fixation with “shareholders value maximization,” in a paper titled “The World’s Dumbest Idea”. He goes on to illustrate how this obsession with stock buybacks and dividends has actually reduced business investment; Montier states that shareholders are not providing capital to corporations but are instead extracting it. He goes on to show that since 1980, public companies have repurchased more equity than they have issued.
How did we get to this stage? Prior to regulations being loosened in 1982 by John Shad, corporate executives avoided share buybacks because they were afraid of being prosecuted. The change in rules and the shift towards stock-based compensation for executives changed the financial landscape forever. For those of you looking for more details, this article does a pretty good job of that.
The situation is so pervasive now, that expert’s estimate over 25% of S&P 500 have used this strategy to inflate their earnings and this indirectly inflates share prices, which gives them even more impetus to perform the same dirty deeds repeatedly. These shenanigan’s are not restricted to small players; big companies such as Apple are also using this trick. Soon every company that has access to easy money will employ this tactic. Hey, why spend time trying to improve business, if you can just borrow the money and give the impression that business is booming, even though profitability might actually be declining.
In 2012 the 500 highest-paid executives named in proxy statements of U.S. public companies received, on average, $30.3 million each; 42% of their compensation came from stock options and 41% from stock awards. By increasing the demand for a company’s shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly earnings per share (EPS) targets. Full Story
When compensation is based on share performance, then individuals will take the easy way out as the sums of money involved are huge. The era of cheap money only adds gasoline to an already raging fire. For the time being, the average Joe does not have access to this cheap money. Towards the end of the game, a path will miraculously open that allows the average Joe to take on large amounts of debt; this is what led to the housing bubble. After all, someone has to buy all this crap at an inflated price right. The feds officially stopped QE, but the corporate world has taken over where the Feds left off, and this is all due to the easy money the Fed is providing them. So forever, QE is still going on. This also explains why share prices continue to trend higher despite an economy that has a pathetic growth rate. Against this backdrop of wonderful growth (us being sarcastic), share prices have doubled over the past five years and so has corporate debt. Coincide, we think not.
Many successful investors disagree with the way the corporate world is foolishly squandering such large sums of money. Corporate debt has $3.5 trillion in 2007 to roughly $7 trillion.
“I think it’s nuts,” said billionaire Stanley Druckenmiller. “If you’re running a business for the long term, the last thing you should be doing is borrowing money to buy back stock.”
BlackRock CEO, Larry Fink in a letter to the chief executive officers of the Standard & Poor’s 500 Index, made the following comments.
“It is critical … to understand that corporate leaders’ duty of care and loyalty is not to every investor or trader who owns their companies’ shares at any moment in time, but to the company and its long-term owners,” Fink wrote in the letter, dated March 31, 2015.
Against the backdrop of cheap money, these programs could continue for quite some time. The only way these programs will end, is when the credit spigots dry up. According to Brian Reynolds Chief Market Strategist at New Albion Partners, Pension funds are being used to provide easy funding for these corporate vultures to enrich themselves.
“Pension funds have to make 7.5%,” so they are putting their money “in these levered credit funds that mimic Long-Term Capital Management in the 1990s.” Those funds, in turn, “buy enormous amounts of corporate bonds from companies which put cash onto company balance sheets…and they use it to jack their stock price up, either through buybacks or mergers and acquisitions…It’s just a daisy chain of financial engineering and it’s probably going to intensify in coming years.”
There is no way this way this will end well; eventually this will trigger another financial crisis, as a sharp decline in stock prices could push one of these large corporations into default and that could trigger a domino effect, much like the financial crisis of 2008. However, there is a vast difference between being right and being right at the right time. Wall Street is lined with tombstones of individuals who were right but could not stay solvent long enough to reap the gains. We anticipate corporate debt to ascend to levels that might make the current levels appear to be sane in comparison. Perhaps this is a good definition of insanity, doing the same thing over and over again and expecting a different outcome.
I doubt if a single individual could be found from the whole of mankind free from some form of insanity. The only difference is one of degree. A man who sees a gourd and takes it for his wife is called insane because this happens to very few people.
– Desiderius Erasmus
