A topic not
raised in the article, but a frequent theme of ours, is the role that share
buybacks have played in this bull market. Corporations have not only been the
largest buyer of stocks over the last few years, but share buybacks result in misleading
earnings per share data, which warp valuations and makes stocks look cheaper. Over
the last five years, corporations have been heavily leaning on the issuance of
corporate debt to facilitate share buybacks. In doing so, earnings per share
appear to sustain a healthy upward trajectory, but only because the denominator
of the ratio (number of shares) is being reduced as debt on the balance sheet
rises. This corporate shell game is one of the most obvious and egregious
manifestations of imprudent Federal Reserve policies of the past decade.
importance of debt to share buybacks, we provide two graphs below which
question the sustainability of this practice.
graph below compares the growth of corporate debt and corporate profits since
the early 1950s. The growing divergence, especially as of late, is a clear warning
that debt is not being used for productive purposes. If it were, profits would be
rising in a manner commensurate or even greater than the debt curve. The
unproductive nature of corporate debt is also seen in the rising ratio of
corporate debt to GDP, which now stands at all-time highs. Too much debt is
being used for buybacks that curtail capital investment, innovation,
productivity, and ultimately profits.
Data Courtesy St. Louis Federal
graph uses the same data but presents the growth rates of profits and debt since
2015. Keep in mind the bump up in corporate profits in 2018 was largely due to
Data Courtesy St. Louis Federal
present a favorite chart of ours showing how the universe of corporate debt has
migrated towards the lower end of the investment-grade bucket. Many investment-grade
companies (AAA – BBB-) are issuing debt until they reach the risk of a credit
downgrade to junk status (BB+ or lower). We believe many companies are now limited
in their use of debt for fear of downgrades, which will naturally restrict
their further ability to conduct buybacks. For more on this graph, please read The
Corporate Maginot Line.
Quick Take: IPO Surge
Pinterest, Zoom, Lyft and a host of other companies led a surge in Initial Public Offerings (IPOs) over the first four months of 2019. Totaling nearly $1 trillion in new offerings, 2019 is already closing in on the annual record set in 2000.
line in the chart above, courtesy Sentiment Trader, compares the S&P 500 to
the annual amount of IPOs. The easy takeaway, given that two of the three prior
high water marks in IPO issuance were 2000 and 2007, is that the current surge
in IPOs bodes poorly for the stock market. Such logic follows that IPO’s,
especially for companies with little to no earnings yet high growth expectations,
are easiest to bring to market when investor complacency is high.
today’s IPO issuance to prior examples may prove wrong as it did in 2014.
Investors must consider the overall supply of shares outstanding in the entire
market before jumping to conclusions. The graph below, courtesy Ed Yardeni, shows
net stock issuance, IPOs and share repurchases included, have been in decline
over the past decade. It is possible that IPO issuance is just a small offset to
the massive number of shares that corporations have bought back over the last
few years and therefore it is not the warning sign some market prognosticators
make it out to be.
Powell Keeps The Bond Bull Kicking
In a widely expected outcome, the Federal Reserve announced no change to the Fed funds rate but did leave open the possibility of a rate hike next year. Also, they committed to stopping “Quantitative Tightening (or Q.T.)” by the end of September.
The key language from yesterday’s announcement was:
“Information received since the Federal Open Market Committee met in January indicates that the labor market remains strong but that growth of economic activity has slowed from its solid rate in the fourth quarter. Payroll employment was little changed in February, but job gains have been solid, on average, in recent months, and the unemployment rate has remained low.
Recent indicators point to slower growth of household spending and business fixed investment in the first quarter. On a 12-month basis, overall inflation has declined, largely as a result of lower energy prices; inflation for items other than food and energy remains near 2 percent. On balance, market-based measures of inflation compensation have remained low in recent months, and survey-based measures of longer-term inflation expectations are little changed.”
What is interesting is that despite the language that “all is okay with the economy,” the Fed has completely reversed course on monetary tightening by reducing the rate of balance sheet reductions in coming months and ending them entirely by September. At the same time, all but one future rate hike has disappeared, and the Fed discussed the economy might need easing in the near future. To wit, my colleague Michael Lebowitz posted the following Tweet after the Fed meeting:
This assessment of a weak economy is not good for corporate profitability or the stock market. However, it seems as if investors have already gotten the “message” despite consistent headline droning about the benefits of chasing equities. Over the last several years investors have continued to chase “safety” and “yield.” The chart below shows the cumulative flows of both ETF’s and Mutual Funds in equities and fixed income.
This chase for “yield” over “return” is also seen in the global investor positing report for March.
Clearly, investors have continued to pile into fixed income and safer equity income assets over the last few years despite the sharp ramp up in asset prices. This demand for “yield” and “safety” has been one of the reasons we have remained staunchly bullish on bonds in recent years despite continued calls for the “Death of the Bond Bull Market.”
The Reason The Bond Bull Lives
Importantly, one of the key reasons we have remained bullish on bonds is that, as shown below, it is when the Fed is out of the “Q.E” game that rates fall. This, of course, was the complete opposite effect of what was supposed to happen.
Of course, the reasoning is simple enough and should be concerning to investors longer-term. Without “Q.E” support, economic growth stumbles which negatively impacts asset prices pushing investors into the “safety” of bonds.
As the Fed now readily admits, their pivot to a more “dovish” stance is due to the global downturn in economic growth, and the bond market has been screaming that message in recent months. As Doug Kass noted on Tuesday:
“Which brings me to today’s fundamental message of the fixed income markets – which are likely being ignored and could be presaging weakening economic and profit growth relative to consensus expectations and, even (now here is a novel notion) that could lead to lower stock prices. That message is undeniable – economic and profit growth is slowing relative to expectations as financial asset prices move uninterruptedly higher.
The yield on the 10 year U.S. note has dropped below 2.60% this morning. (I have long had a low 2.25% forecast for 2019)
The (yield curve and) difference between 2s and 10s is down to only 14 basis points.
High-frequency economic statistics (e.g. Cass Freight Index) continue to point to slowing domestic growth.
Auto sales and U.S. residential activity are clearly rolling over.
PMIs and other data are disappointing.
Fixed business investment is weakening.
No country is an economic island – not even the U.S.
Europe is approaching recession and China is overstating its economic activity (despite an injection of massive amounts of liquidity).”
He is correct, yields continue to tell us an important story.
First, three important facts are affecting yields now and in the foreseeable future:
All interest rates are relative. With more than $10-Trillion in debt globally sporting negative interest rates, the assumption that rates in the U.S. are about to spike higher is likely wrong. Higher yields in U.S. debt attracts flows of capital from countries with negative yields which push rates lower in the U.S. Given the current push by Central Banks globally to suppress interest rates to keep nascent economic growth going, an eventual zero-yield on U.S. debt is not unrealistic.
The coming budget deficit balloon. Given the lack of fiscal policy controls in Washington, and promises of continued largess in the future, the budget deficit will eclipse $1 Trillion or more in the coming years. This will require more government bond issuance to fund future expenditures which will be magnified during the next recessionary spat as tax revenue falls.
Central Banks will continue to be a buyer of bonds to maintain the current status quo. As such they will have to be even more aggressive buyers during the next recession. The next QE program by the Fed to offset the next economic recession will likely be $2-4 Trillion and might push the 10-year yield towards zero.
As I have discussed many times in the past, interest rates are a function of three primary factors: economic growth, wage growth, and inflation. The relationship can be clearly seen in the chart below.
Okay…maybe not so clearly.
Let me clean this up by combining inflation, wages, and economic growth into a single composite for comparison purposes to the level of the 10-year Treasury rate.
As you can see, the level of interest rates is directly tied to the strength of economic growth, wages and inflation. This should not be surprising given that consumption is roughly 70% of economic growth.
As Doug notes, the credit markets have been right all along the way. At important points in time, when the Fed signaled policy changes, credit markets have correctly interpreted how likely those changes were going to be. A perfect example is the initial rate hike path set out in December 2015 by then Fed Chairman Janet Yellen. This was completely wrong at the time and the credit markets told us so from the beginning.
The credit markets have kept us on the right side of the interest rate argument in repeated posts since 2013. Why, because the credit market continues to tell us an important story if you are only willing to listen.
The bond market is screaming “secular stagnation.”
Since 2009, asset prices have been lofted higher by artificially suppressed interest rates, ongoing liquidity injections, wage and employment suppression, productivity-enhanced operating margins, and continued share buybacks have expanded operating earnings well beyond revenue growth.
As I wrote in mid-2017:
“The Fed has mistakenly believed the artificially supported backdrop they created was actually the reality of a bright economic future. Unfortunately, the Fed and Wall Street still have not recognized the symptoms of the current liquidity trap where short-term interest rates remain near zero and fluctuations in the monetary base fail to translate into higher inflation.
Combine that with an aging demographic, which will further strain the financial system, increasing levels of indebtedness, and lack of fiscal policy, it is unlikely the Fed will be successful in sparking economic growth in excess of 2%. However, by mistakenly hiking interest rates and tightening monetary policy at a very late stage of the current economic cycle, they will likely be successful at creating the next bust in financial assets.”
It didn’t take long for that prediction to come to fruition and change the Fed’s thinking.
“At some point, the Federal Reserve is going to step back in and reverse their policy back to “Quantitative Easing” and lowering Fed Funds back to the zero bound.
When that occurs, rates will not only go to 1.5%, but closer to Zero, and maybe even negative.”
What I didn’t know then was that literally the next day the Fed would reverse course.
The chart below shows the rolling 4-week change in the Fed’s balance sheet versus the S&P 500.
The issue for the Fed is that they have become “market dependent” by allowing asset prices to dictate policy. What they are missing is that if share prices actually did indicate higher rates of economic growth, not just higher profits due to stock buybacks and accounting gimmickry, then US government bond yields would be rising due to future rate hike expectations as nominal GDP would be boosted by full employment and increased inflation. But that’s not what’s happening at all.
Instead, the US 10-year bond is pretty close to 2.5% and the yield curve is heading into inversion.
Since inversions are symptomatic of weaker economic growth, such would predict future rate hikes by the Fed will be limited. Not surprisingly, that is exactly what is happening now as shown by yesterday’s rapid decline in the Fed’s outlook.
Let’s go back to that 2017 article:
“However, the issue of rising borrowing costs spreads through the entire financial ecosystem like a virus. The rise and fall of stock prices have very little to do with the average American and their participation in the domestic economy.Interest rates are an entirely different matter.
Since interest rates affect ‘payments,’ increases in rates quickly have negative impacts on consumption, housing, and investment which ultimately deters economic growth.”
All it took was for interest rates to crest 3% and home, auto, and retail sales all hit the skids. Given the current demographic, debt, pension, and valuation headwinds, the future rates of growth are going to be low over the next couple of decades – approaching ZERO.
While there is little left for interest rates to fall in the current environment, there is also not a tremendous amount of room for increases. Therefore, bond investors are going to have to adopt a “trading” strategy in portfolios as rates start to go flat-line over the next decade.
Whether, or not, you agree there is a high degree of complacency in the financial markets is largely irrelevant. The realization of “risk,” when it occurs, will lead to a rapid unwinding of the markets pushing volatility higher and bond yields lower. This is why I continue to acquire bonds on rallies in the markets, which suppresses bond prices, to increase portfolio income and hedge against a future market dislocation.
In other words, I get paid to hedge risk, lower portfolio volatility and protect capital.
Bonds aren’t dead, in fact, they are likely going to be your best investment in the not too distant future.
“I don’t know what the seven wonders of the world are, but the eighth is compound interest.” – Baron Rothschild
Stock Buybacks Aren’t Bad, Just Misused & Abused
There has been a lot of commentary as of late regarding the issue of corporate share repurchases. Even Washington D.C. has chimed into the rhetoric as of late discussing potential bills to limit or eliminate these repurchases. It is an interesting discussion because most people don’t remember that share repurchases were banned for decades prior to President Reagan in 1982.
Even after the ban was lifted, share repurchases were few and far between as during the “roaring bull market of the 90’s” it was more about increasing outstanding shares through stock splits. Investors went crazy over stock splits as they got more shares of the company they loved at half the price. Most didn’t realize, or understand the effective dilution; but for them it was more of a Yogi Berra analogy:
“Can you cut my pizza into four pieces because I can’t eat eight.”
However, following the financial crisis stock splits disappeared and a new trend emerged – share repurchases. Like stock splits, share repurchases in and of themselves are not necessarily a bad thing, it is just the least best use of cash. Instead of using cash to expand production, increase sales, acquire competitors, or buy into new products or services, the cash is used to reduce the outstanding share count and artificially inflate earnings per share. Here is a simple example:
Company A earns $1 / share and there are 10 / shares outstanding.
Earnings Per Share (EPS) = $0.10/share.
Company A uses all of its cash to buy back 5 shares of stock.
Next year, Company A earns $0.20/share ($1 / 5 shares)
Stock price rises because EPS jumped by 100%.
However, since the company used all of its cash to buy back the shares, they had nothing left to grow their business.
The next year Company A still earns $1/share and EPS remains at $0.20/share.
Stock price falls because of 0% growth over the year.
This is a bit of an extreme example but shows the point that share repurchases have a limited, one-time effect, on the company. This is why once a company engages in share repurchases they are inevitably trapped into continuing to repurchase shares to keep asset prices elevated. This diverts ever-increasing amounts of cash from productive investments and takes away from longer term profit and growth.
As shown in the chart below, the share count of public corporations has dropped sharply over the last decade as companies scramble to shore up bottom line earnings to beat Wall Street estimates against a backdrop of a slowly growing economy and sales.
(The chart below shows the differential added per share via stock backs. It also shows the cumulative growth in EPS and Revenue/Share since 2011)
The Abuse & Misuse
As I stated, share repurchases aren’t necessarily a bad thing. It is just the misuse and abuse of them which becomes problematic. It’s not just share repurchases though. In “4-Tools To Beat The Wall Street Estimate Game” we discussed how companies not only use stock repurchases, but a variety of other accounting gimmicks to “meet their numbers.”
“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day or recognizing revenues before sales are made, while a good quarter is often the time to hide a big ‘restructuring charge’ that would otherwise stand out like a sore thumb.
What is more surprising though is CFOs’ belief that these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.“
The reason that companies do this is simple: stock-based compensation. Today, more than ever, many corporate executives have a large percentage of their compensation tied to company stock performance. A “miss” of Wall Street expectations can lead to a large penalty in the companies stock price.
As shown in the table above, it is not surprising to see that 93% of the respondents pointed to “influence on stock price” and “outside pressure” as the reason for manipulating earnings figures.
The use of stock buybacks has continued to rise in recent years and went off the charts following the passage of tax cuts in 2017. As I wrote in early 2018. while it was widely believed that tax cuts would lead to rising capital investment, higher wages, and economic growth, it went exactly where we expected it would. To wit:
“Not surprisingly, our guess that corporations would utilize the benefits of “tax cuts” to boost bottom line earnings rather than increase wages has turned out to be true. As noted byAxios, in just the first two months of this year companies have already announced over $173 BILLION in stock buybacks. This is ‘financial engineering gone mad'”
Share buybacks are expected to hit a new record by the end of 2019.
“Share repurchases aren’t bad. It is simply the company returning money to shareholders.”
There is a problem with that statement.
Share buybacks only return money to those individuals who sell their stock. This is an open market transaction so if Apple (AAPL) buys back some of their outstanding stock, the only people who receive any capital are those who sold their shares.
So, who are the ones mostly selling their shares?
As noted above, it’s the insiders, of course, as changes in compensation structures since the turn of the century has become heavily dependent on stock based compensation. Insiders regularly liquidate shares which were “given” to them as part of their overall compensation structure to convert them into actual wealth. As the Financial Times recently penned:
“Corporate executives give several reasons for stock buybacks but none of them has close to the explanatory power of this simple truth: Stock-based instruments make up the majority of their pay and in the short-term buybacks drive up stock prices.”
A recent report on a study by the Securities & Exchange Commission found the same:
SEC research found that many corporate executives sell significant amounts of their own shares after their companies announce stock buybacks, Yahoo Finance reports.
What is clear, is that the misuse and abuse of share buybacks to manipulate earnings and reward insiders has become problematic. As John Authers recently pointed out:
“For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing. Both pushed up asset prices.”
In other words, between the Federal Reserve injecting a massive amount of liquidity into the financial markets, and corporations buying back their own shares, there have been effectively no other real buyers in the market.
“Without that $4 trillion in stock buybacks and in a market where trading volume has been falling for decades they never would have been able to soar as high as they have. The chart below plots ‘The Buffett Yardstick’ (total equity market capitalization relative to gross national product) against total net equity issuance (inverted). Since the late-1990’s both valuations and buybacks have been near record highs. Is this just a coincidence? I think it’s safe to say it’s not.”
The other problem with the share repurchases is that is has increasingly been done with the use of leverage. The ongoing suppression of interest rates by the Federal Reserve led to an explosion of debt issued by corporations. Much of the debt was not used for mergers, acquisitions or capital expenditures but for the funding of share repurchases and dividend issuance.
The explosion of corporate debt in recent years will become problematic if rates rise markedly, further deterioration in credit quality locks companies out of refinancing, or if there is a recessionary drag which forces liquidation of debt. This is something Dallas Fed President Robert Kaplan warned about:
U.S. nonfinancial corporate debt consists mostly of bonds and loans. This category of debt, as a percentage of gross domestic product, is now higher than in the prior peak reached at the end of 2008.
A number of studies have concluded this level of credit could ‘potentially amplify the severity of a recession,’
The lowest level of investment-grade debt, BBB bonds, has grown from $800 million to $2.7 trillion by year-end 2018. High-yield debt has grown from $700 million to $1.1 trillion over the same period. This trend has been accompanied by more relaxed bond and loan covenants, he added.
This was recently noted by the Bank of International Settlements.
“If, on the heels of economic weakness, enough issuers were abruptly downgraded from BBB to junk status, mutual funds and, more broadly, other market participants with investment grade mandates could be forced to offload large amounts of bonds quickly. While attractive to investors that seek a targeted risk exposure, rating-based investment mandates can lead to fire sales.”
While share repurchases by themselves may indeed be somewhat harmless, it is when they are coupled with accounting gimmicks and massive levels of debt to fund them in which they become problematic.
“While the financial media cheers buybacks and the SEC, the enabler of such abuse idly watches, we continue to harp on the topic. It is vital, not only for investors but the public-at-large, to understand the tremendous harm already caused by buybacks and the potential for further harm down the road.”
Money that could have been spent spurring future growth for the benefit of investors was instead wasted only benefiting senior executives paid on the basis of fallacious earnings-per-share.
As stock prices fall, companies that performed un-economic buybacks are now finding themselves with financial losses on their hands, more debt on their balance sheets, and fewer opportunities to grow in the future. Equally disturbing, the many CEO’s who sanctioned buybacks, are much wealthier and unaccountable for their actions.
This article may be best summed up with just one word:
Fraud – frôd/ noun:
Wrongful or criminal deception intended to result in financial or personal gain.
United Technologies (UTX) Faces Reality- Will Other Companies Follow Suit Before It’s Too Late.
On November 27, 2018, the CFO from United Technologies (UTX) stated that his company will focus on deleveraging and not stock buybacks. This announcement comes as General Electric (GE) is struggling mightily to retain investment grade status and its stock is nearing levels last seen during the depths of the financial crisis. While there is much to attribute to GE’s decline, massive stock buybacks in 2016 and 2017 are largely to blame.
To wit: “The root problem at GE — and why the stock is where it is — is poor capital allocation,” said RBC Capital Markets analyst Deane Dray.
Corporate debt now stands at record levels versus GDP as shown below. While the debt has been used to fund expansion and R&D it has also been used to fund record numbers of share buybacks. The pitfalls of such a strategy are now encroaching upon GE’s ability to survive. We suspect that UTX is the first of many companies to acknowledge this realization.
In February of 2016 we wrote an article on Conoco Phillips (COP). The missive, which is one of six articles we have written criticizing stock buybacks, describes how COP was forced to cut a reliable dividend and capital expenditures as they were strapped for cash. The price of oil at the time was hurting cash-flows. Unfortunately COP, like GE, had previously bought back a significant number of shares which greatly reduced their liquidity status when it was needed most.
While the article is nearly three years old we think it is every bit as important today as it was then. It exemplifies how precarious a company’s ability to survive financial weakness and/or an economic downturn is when capital is squandered in efforts to temporarily boost share prices. This story is likely to become a common theme for the next few years especially if, as we suspect, economic growth declines and stocks prices fall.
As the Tide Goes Out, Effects of Buybacks are Exposed : The ConocoPhillips Poster Child
“The words of men may temporarily suspend but they do not alter the laws of financial dynamics. The fundamentals always take precedence eventually”- 720 Global 11/30/2015
The quote above was from an article we wrote that scrutinized stock buybacks and the unforeseen impacts they may have. In that piece as well as an earlier missive, “Corporate Buybacks; Connecting Dots to the F-word”, we rebuked the short-termism stock buyback fad. Both articles made the case that corporate executives, through buybacks, promote higher short-term stock prices that serve largely only to benefit their own compensation. The costs of these actions are felt later as the future growth for the respective companies, employees and entire economy are robbed.
This case study details how the “the laws of financial dynamics” have caught up with ConocoPhillips (COP) and demonstrates how shareholders are suffering while executives prosper.
On February 4th, 2016 COP, in reaction to their fourth quarter earnings release, slashed its quarterly dividend from $0.74 to $0.25 per share, a level not seen since March 2005. COP also lowered its current year capital expenditure (capex) budget by $1.31 billion, marking the second reduction in as many months. The actions are a direct response to the plummeting price of oil and the damage it is having on COP’s bottom line. The company’s net loss for the fourth quarter 2015 was $3.50 billion or $0.90 per share.
While the losses and expense cuts are not shocking given the severe decline in oil prices, the dividend cut was a jolt to many investors. COP has consistently paid a dividend, as shown below, since 1990. During that 25 year period the dividend was increased 19 times but COP had never decreased it, until now. Even during the financial crisis of 2008/09, COP raised its dividend despite the price of crude oil dropping $100 per barrel.
Maybe the biggest cause for the shock is not the steadfastness of their prior dividend policy, but official corporate presentations. On the first page of their 2016 Operating Plan (Analyst & Investor Update – December 10, 2015) they make the following statements: “Dividend is highest priority use of cash” and “DIVIDEND Remains Top Priority”. The statements are repeated in the summary on the final page. The cover of their most recent annual report has a word cloud diagram with “dividend” shown among other key corporate values.
What Could Have Been
The dividend and capex reductions are prudent measures undertaken by management to help manage corporate assets and bolster their financial conditions during an historic swoon in revenue. This article does not question those actions, it instead asks if such drastic measures would be necessary had management not spent enormous sums of capital on stock buybacks in the preceding years.
Since 2011, COP repurchased 251.316 million shares representing roughly 20% of their shares outstanding, at an approximate cost of $14.168 billion. The majority of these purchases occurred between 2011 and 2012 when the stock traded between $48 and $58 per share. Today the stock trades at $32 per share, matching prices last seen 12 years ago. The graph below charts the share price of COP with an overlay of the share repurchases by quarter.
Now let us contemplate what COP’s current financial situation might look like had management and the board of directors not engaged in repurchases. First of all, COP would still have the $14.168 billion spent on buybacks since 2011, which could be used to support the $0.74 per share dividend for almost 5 years. More importantly, the company could be in the envious position of employing the capital to buy assets that are being liquidated by other companies at cents on the dollar. Shareholders are suffering in many ways from the abuses of management in years past and will continue to do so for years to come.
The Rich Get Richer…
Fortunately for James Mulva, COP’s CEO during the 2011/2012 stock buyback era, his overly generous compensation is beyond COP’s ability to reclaim. Mr. Mulva retired in June of 2012 after repurchasing approximately 20% of the company’s outstanding shares. Upon retirement he received a $260 million golden parachute from the company. That was on top of $141 million in total compensation he received in 2011.
The board of directors and shareholders must have been enamored with Mulva’s performance despite poor earnings trends in his final 2 years. From 2011 to 2012 the company earnings per share fell 25% from $8.97/share to $6.72/share. Had the board factored in the effect of buybacks on earnings per share when determining Mr. Mulva’s compensation, they would have realized that earnings per share were actually 40% lower at $5.37 per share.
We provide the following snippets on James Mulva to better gauge the potential motivations behind the tremendous buyback program.
While the financial media cheers buybacks and the SEC, the enabler of such abuse idly watches, we continue to harp on the topic. It is vital, not only for investors but the public at-large, to understand the tremendous harm already caused by buybacks and the potential for further harm down the road. Unfortunately, COP is not an isolated case. Hess Oil, for instance, just sold 25 million shares at $39 per share to improve their capital position. Sadly for Hess shareholders, many of whom likely supported buybacks, this shareholder dilution was unnecessary had Hess not bought nearly 63 million shares at a price of nearly $60 per share in the 3 years prior. Money that could have been spent spurring future growth for the benefit of investors was instead wasted only benefitting senior executives paid on the basis of fallacious earnings-per-share.
As stock prices fall, companies that performed un-economic buybacks are now finding themselves with financial losses on their hands, more debt on their balance sheets, and fewer opportunities to grow in the future. Equally disturbing, many CEO’s like James Mulva, who sanctioned buybacks, are much wealthier and unaccountable for their actions.
This article may be best summed up with the closing to our first article on buybacks.
Fraud – frôd/ noun:
wrongful or criminal deception intended to result in financial or personal gain.
How The Bubbles In Stocks And Corporate Bonds Will Burst
As someone who has been warning heavily about dangerous bubbles in U.S. corporate bonds and stocks, people often ask me how and when I foresee these bubbles bursting. Here’s what I wrote a few months ago:
To put it simply, the U.S. corporate debt bubble will likely burst due to tightening monetary conditions, including rising interest rates. Loose monetary conditions are what created the corporate debt bubble in the first place, so the ending of those conditions will end the corporate debt bubble. Falling corporate bond prices and higher corporate bond yields will cause stock buybacks to come to a screeching halt, which will also pop the stock market bubble, creating a downward spiral. There are extreme consequences from central bank market-meddling and we are about to learn this lesson once again.
Interestingly, Zero Hedge tweeted a chart today of the LQD iShares Investment Grade Corporate Bond ETF saying that it was “about to break 7 year support: below it, the buybacks end.” That chart resonated with me, because it echos my warnings from a few months ago. I decided to recreate this chart with my own commentary on it. The 110 to 115 support zone is the key line in the sand to watch. If LQD closes below this zone in a convincing manner, it would likely foreshadow an even more powerful bond and stock market bust ahead.
Thanks to ultra-low corporate bond yields, U.S. corporations have engaged in a borrowing binge since the Global Financial Crisis. Total outstanding non-financial U.S. corporate debt is up by an incredible $2.5 trillion or 40 percent since its 2008 peak, which was already a precariously high level to begin with.
U.S. corporate debt is now at an all-time high of over 45% of GDP, which is even worse than the levels reached during the dot-com bubble and U.S. housing and credit bubble:
Please watch my presentations about the U.S. corporate debt bubble and stock market bubble to learn more:
Billionaire fund manager Jeff Gundlach shares similar concerns as me, saying “The corporate bond market is going to get much worse when the next recession comes. It’s not worth trying to wait for that last ounce of return, or extra yield from the corporate bond market.” Another billionaire investor, Paul Tudor Jones, put out a warning this week, saying “it is in the corporate bond market where the first signs of trouble will emerge.” GE’s terrifying recent credit meltdown may be the initial pinprick for the corporate debt bubble, but make no mistake – it is not an isolated incident. GE may be the equivalent to Bear Stearns in 2007 and 2008 – just one of the first of many casualties. Anyone who thinks that the Fed can distort the credit markets for so long without terrible consequences is extremely naive and will be taught a lesson in the days to come.
If you have any questions about anything I wrote in this piece or would like to learn how Clarity Financial can help you preserve and grow your wealth in the dangerous financial environment ahead, please contact me here.
15 Bullish Assumptions
If all goes well for nine more months, the post-financial crisis economic expansion will become the longest economic expansion in recent U.S. history. The U.S. stock markets are also on a tear, having just become the longest bull market since World War II. Regardless of your views about these trends continuing, the fact of the matter is that they are both much closer to ending than a beginning. Ray Dalio recently quantified this continuum, declaring that the economy is in the 7th inning, implying another one to three years of continuation.
While the markets can certainly keep motoring ahead, as Dalio and many others expect, there are some factors supporting the bullish case that investors should contemplate.
While this list is not by any means exhaustive, it does offer many of the most important assumptions supporting the market and some details to provide context and clarity.
1. Corporate managers have become so adept at their jobs that profit margins and equity valuations will remain at, or rise from current nearly unprecedented levels.
Market Cap : GDP – 99% historical percentile according to Goldman Sachs Investment Research (GS)
GMO 7-Year real return forecast -4.90% for U.S. large cap, -2.30% for U.S. small cap and -3.80% for U.S. high quality
Doug Short’s (Advisor Perspectives) Average of the Four Valuation Indicators is 117% overvalued as shown below and nearly 3 standard deviations from the mean
2. Bond yields will remain historically low and the 30-year downward trend will not reverse
The 10-year U.S Treasury yield is slightly above a key 30-year resistance line at 3.11%
The 30- and 10-year U.S. Treasury yields are testing multi-year highs of 3.23% and 3.12% respectively
Since the lows of 0.70% in November 2016, the 2-year U.S. Treasury yield has risen 300% to 2.80%
3-month LIBOR, a key global interest rate for floating rate financing, has risen 282% from 0.62% in June 2016 to the current level of 2.37%
Implied volatility on Treasury note futures is at historically low levels indicating extreme complacency
GMO’s 7-Year real return forecast is -0.20% for US bonds
3. Future Fed rate hikes and possible yield curve inversion will not cause economic contraction
The Federal Reserve (Fed) currently expects to hike rates an additional 1.50% bringing the Fed Funds rate to 3.50%, by the end of 2019
The 2s/10s U.S. Treasury yield curve stands at 26 basis points and has flattened 110 bps since December 2016
The Fed appears increasingly comfortable with inverting the yield curve “Over the next year or two, barring unexpected developments, continued gradual increases in the federal funds rate are likely to be appropriate to sustain full employment and inflation near its objective.” – Lael Brainard – Fed Governor
The last five recessions going back to 1976 were all preceded by a 2s/10s yield curve inversion
All six recessions going back to 1971 were preceded by Fed interest rate hikes. Two exceptions where rates hike did not lead to recession were in 1983-84 and 1994-95
4. Weakness in interest rate sensitive sectors will not have a dampening effect on the economy or markets
Total automotive vehicle sales have declined 7.8% since the Fed started raising rates
New and existing home sale have steadily declined since November 2017 as mortgage rates risen by over 0.50% over the this period
5. Wage growth will not accelerate further thus stoking inflationary pressures
Employees gaining leverage over employers as jobless claims and the unemployment rate both stand near 50-year lows
Wage growth is at a 9-year high
Spike in the “quit rate” to 18-year high suggests more wage growth pressure coming
6. Annual fiscal deficits over $1 trillion will power economic growth with no consequences
Current deficit equals 4.4% of GDP and is projected to rise to 5.5% in 2019 ($1.2T)
Recent projections of budget deficits have been revised aggressively higher
Interest expense rose 10% this past fiscal year and now accounts for $500 billion spending. To put that in context, the defense budget for 2019 is $717 billion.
7. Domestic political turmoil will not roil markets or inhibit consumer and corporate spending habits
The potential for the Democrats to take a majority in the House and/or Senate and advance calls for Trump impeachment as well as impede further tax reform and possibly other corporate-friendly legislation
8. Possible additional U.S. dollar appreciation and the resulting financial crises engulfing many emerging markets will not cause financial contagion or economic slowdown to spread to developed nations or to the world’s largest banks
9. Geopolitical turmoil will not roil markets or stunt global growth and trade
10. The performance of U.S. stocks can diverge from the rest of the world
The following developed markets are all negative year to date and have a 50-day moving average below its 200-day moving average
United Kingdom -5%
Hong Kong -9%
South Korea -6%
World Index EFA (blue) vs. S&P 500 (orange) (Graph below courtesy Stockcharts.com)
11. Trade wars and increasing tariffs benefit the economy and global markets
12. Corporations, via stock buybacks, will continue to be the predominant purchaser of U.S. stocks
Buybacks will reach a record high in 2018 (Graph below courtesy Trim Tabs)
Corporate debt can continue to rise to fund buybacks despite rising interest rates and risk of credit downgrades
Corporate debt as a percentage of GDP is now the highest on record
13. Liquidity in the markets will remain plentiful
14. Central Banks can permanently prop up asset prices if they are to fall
And…The most important factor long-term bulls must assume to be true:
15. This time is different
A Walking Contradiction – Warren Buffett
“I have ways of making money you know nothing about.” – John D. Rockefeller
Contradiction- A situation in which inherent factors, actions, or propositions are inconsistent or contrary to one another- Merriam-Webster’s Dictionary
Investors and the media can’t seem to get enough of Warren Buffett. They hang on his every word as if he was sent from the heavens offering divine words of wisdom. Unfortunately, Buffett is a mere mortal, and like the rest of us, he tends to promote ideals that benefit his self-interests over yours.
The purpose of this article is not to degrade Buffett, as we have a tremendous amount of respect for his success and knowledge. In this article we look at a few recent statements and actions of Buffett’s to highlight some contradictions that lie in their wake. Our conclusion is that it is far better for investors to watch what “The Oracle” does as an investor rather than hang on his words.
This article also serves as a reminder that the most successful investors think and act for themselves. These investors are not easily persuaded to take action from others, even from the best of the best.
Buffett on Stock Buybacks
Warren Buffett has, for a long time stated that corporate stock buybacks should only occur when the following two conditions are met:
“First,the company has available funds — cash plus sensible borrowing capacity — beyond the near-term needs of the business and, second,finds its stock selling in the market below its intrinsic value, conservatively calculated.”
The quote above was from nearly 20 years ago, however based on more recent quotes his thoughts about buybacks remain the same. The following comes from a recent CNBC article:
At the 2016 meeting, Buffett said that buyback plans were getting “a life of their own, and it’s gotten quite common to buy back stock at very high prices that really don’t do the shareholders any good at all.”
“Can you imagine somebody going out and saying, we’re going to buy a business and we don’t care what the price is? You know, we’re going to spend $5 billion this year buying a business, we don’t care what the price is. But that’s what companies do when they don’t attach some kind of a metric to what they’re doing on their buybacks.”
Buffett added: “You will not find a lot of press releases about buybacks that say a word about valuation,” but he clearly believes they should.
Knowing his opinion of buybacks, let’s explore his own firm, Berkshire Hathaway (BRK/A). It turns out BRK/A is now “seriously considering” buying back their own stock. Given their cash and cash equivalent hoard of over $320 billion, such an action would seem to fit right in line with Buffett’s first qualification noted above. Unfortunately, the stock is far from cheap and fails his second test. Currently BRK/A trades at a price to book value of 145% and at a price to earnings of 28 (28 is considered a very high multiple for a company that has consistently grown earnings at a 4% clip over the last 8 years). Altering the firm’s buyback policy would require relaxing or eliminating Buffet’s price-to-book value requirement of “below 120%”.
“When stock can be bought below a business’s value, it is probably the best use of cash.”
The bottom line: Buying back BRK/A at a price to book value of 145% and P/E of 28 is clearly not the “best use of cash”, and the market certainly is not valuing BRK/A at “below intrinsic value.” To counter his contradiction, it would be nice if he either came out and said he has changed his opinion about the optimal factors promoting buybacks, or stated that BRK/A does not have reasonable opportunities to grow earnings and returning cash to shareholders is the best option.
In the end, Buffett is unreliable on this topic, and BRK/A does not make a habit of returning cash to shareholders. In the long history of the firm, they have only conducted a few very small share buybacks and only once issued a dividend of $0.10 in 1967. It seems to us he is feeding the buyback frenzy occurring in the market today and will likely avoid meaningful buybacks in BRK/A.
Buffett on Valuations : Market Cap to GDP
One of the most widely followed equity valuation gauges is what is commonly referred to as the Buffett Indicator. The indicator, Buffett’s self-professed favorite, is the ratio of the total market capitalization to GDP. Currently, as shown below, the indicator stands at 132% and dwarfs all prior experiences except the final throes of the Tech boom in the late 1990’s.
Question to Warren Buffett: “One of the things you look at is the total value of the stock market compared to GDP. If you look at that graph it’s at a high point, the highest it’s been since the tech crash back in the late 90’s. Does that mean we’re overextended? Is it a better time to be fearful rather than greedy?”
Eric Cinnamond (EC): What a great question, I thought. I couldn’t wait for his answer. Let him have it Warren! It’s your favorite valuation metric flashing red – tell everyone how expensive stocks have become! I was very excited to hear his response. Buffett replied,
Warren Buffett (WB): “I’m buying stocks.”
EC: But in 1999 when this valuation was actually less than today he said this…
WB: “Let me summarize what I’ve been saying about the stock market: I think it’s very hard to come up with a persuasive case that equities will over the next 17 years perform anything like–anything like–they’ve performed in the past 17. If I had to pick the most probable return, from appreciation and dividends combined, that investors in aggregate–repeat, aggregate–would earn in a world of constant interest rates, 2% inflation, and those ever hurtful frictional costs, it would be 6%. If you strip out the inflation component from this nominal return (which you would need to do however inflation fluctuates), that’s 4% in real terms. And if 4% is wrong, I believe that the percentage is just as likely to be less as more.”
Our take: Stocks are far from cheap. Based on Buffett’s preferred valuation model and historical data, as depicted in the scatter graph below, return expectations for the next ten years are as likely to be negative as they were for the ten-year period following the late ‘90’s. To read more about this graph click on the following link –Allocating on Blind Faith.
The article provides a glimpse of the value added in our new service RIA Pro.
The more compelling question for Mr. Buffett is not whether or not he generally likes stocks but which stocks he likes. As a value investor, he ardently discriminates on price within the context of which companies operate with unique pricing power. This characteristic, more than any other, best defines Buffett’s investment preferences. He routinely speaks about the competitive “moat” that he likes for his companies to have. Understanding what he means by that is important. The following quote captures the essence:
“If you’ve got a good enough business, if you have a monopoly newspaper or if you have a network television station, your idiot nephew could run it.”
Keyword: Monopoly. That is how a company retains pricing power. The empire of the perceived champion of American capitalism and free markets is built on monopolistic companies. Yes, I think we can add that to the list of contradictions.
Buffett on Bullish Market Prospects
The following recent quotes are from a CNBC interview of Mr. Buffett on June 7, 2018 about bullish market prospects:
“The decision on the stock market should be made independent of the current business outlook. When you should buy stocks is when you think you’re getting a lot for your money not necessarily when you think business is going to be good next year. The time to buy stocks in America generally has been always with a few exceptions because the long-term outlook is exceptionally good and I don’t think you should buy stocks based on what you think the next 6 months or year is going to bring.”
“I like buying stocks. I’m a net buyer.”
“I’m no good at predicting out 2 or 3 or 5-years from now although I will say this, there’s no question in my mind that America’s going to be far ahead of where we are now, 10, 20 and 30-years from now.”
If the economic outlook is so constructive, and you can afford and are willing to hold investments for long periods, why does BRK/A hold so much dry powder as shown below?
A growing war chest of over $300 billion in cash certainly appears to be inconsistent with his stated outlook.
Buffett’s True Concerns
The general platitudes of market and economic optimism Buffett shares in his CNBC interviews, letters to investors and shareholder meetings often run counter to the actions he has taken in his investment approach. Not only does he seek out companies with monopolistic characteristics and pricing advantages, he seems to be increasingly positioning to protect against imprudent central bank policies that have fueled this bull market.
His purchase of Burlington Northern Santa Fe (BNSF) railroad is an acquisition of hard assets. Control of BNSF affords a multitude of other benefits in the form of rights of way and adjacent mining rights, and it allows him to move other energy resources he has been steadily accumulating as well.
Four of his top ten holdings are financial services companies such as Wells Fargo (WFC), Bank of America (BAC), and American Express (AXP). Additionally, he is also known to hold large offshore assets in Asia and elsewhere which generate non-dollar profits that can be held tax-free.
The common theme behind these holdings, besides the fact that they each have their monopolistic “moat”, is that they serve as a firebreak against an uncontrolled outbreak of inflation. If monetary policy sparked serious inflation, the hard assets he owns would skyrocket in value, and the off-shore holdings in foreign currencies would be well protected. As for the financial institutions, inflation would effectively minimize the costs of their outstanding debt, while their assets rise in value. Further, their net interest margin on new business would likely increase significantly. All of that would leave BRK/A and Buffett in a position of strength, allowing them to easily buy out bankrupt competitors from investors at pennies on the dollar.
Warren Buffett is without question the modern day icon of American investors. He has become a living legend, and the respect he receives is warranted. He has certainly been a remarkable steward of wealth for himself and his clients. Where we are challenged with regard to his approach, is the way in which he shirks his responsibilities as a leader. To our knowledge, he is not being overtly dishonest but he certainly has a way of rationalizing what appears to be obvious contradictions. Because of his global following and the weight given to each word he utters, the fact that his actions often do not match the spirit of his words is troubling.
Reflecting back on the opening quote from John D. Rockefeller, Buffett has ways of making money that we know nothing about, and he seems intent on obscuring his words to make sure we don’t figure it out. Putting that aside, Warren Buffett did not amass his fortune by following the herd but by leading it.
Cliff Asness On Buybacks – Boosting Returns or Liquidating Companies?
Asset manager Cliff Asness recently wrote an op-ed piece in the Wall Street Journal wondering if those who decried companies buying back their stock didn’t suffer from “buyback derangement syndrome.”
Asness allowed that net investment, normalized by total assets or total market capitalization, was recently lower for companies in the Russell 3000 Index than it was in the 1990s, “but positive and much higher than during the 2008 financial crisis.”
It seems strange to crow that investment is better now than during the financial crisis.
And Asness offers no opinion or interpretation on why investment should be lower now than in the 1990s, especially given that low interest rates after the financial crisis were supposed to stimulate investment. Granted, his purpose isn’t to comment on Federal Reserve policy, but one might think he’d have something to say about lower investment immediately after a financial crisis – when investment is most needed. Asness also doesn’t say how much lower investment is now. That’s strange, given that he will conclude by asserting the buyback arguments amount to “innumerate nonsense.”
Asness mentions that companies aren’t shrinking away by buying their stock, because they are also borrowing a lot of money. “Think of this as a debt-for-equity swap,” he says – again neutrally or flatly. Is it good or bad – and for whom? — that companies are exchanging equity for debt? Asness doesn’t say. Moreover, later Asness will defend the argument that buybacks are indeed a form of liquidation.
Next, Asness argues that investors do not spend the money paid out in buybacks frivolously. Instead, investors buy other stocks and bonds with their buyback bounty, thereby shifting capital from companies that don’t need it to those that do. But that’s a little too neat. An investor buying stock on the secondary market isn’t giving money to a company in exchange for shares. Rather the investor is buying from another investor a claim to profits on capital already raised by a company previously.
Then things get stranger in Asness’s article. He argues that there’s no way to tell how much buybacks have boosted stock market returns since the financial crisis. And returns have been prodigious – around 15% annualized. But in making this argument Asness admits that it’s possible buybacks have boosted stock returns. Yet when turning to arguments about Apple – that the firm is a scam fueled by buybacks – he relies on the argument that buybacks are a form of liquidation that reduce market capitalization.
So do buybacks boost stock market returns or reduce market capitalization? It’s hard to know what Asness thinks. Clearly reducing share count and elevating earnings-per-share – the obvious immediate effects of buybacks — should increase the share price. But Asness doesn’t say whether a higher share price should compensate for fewer shares precisely and keep market capitalization stable, or whether it should alter market capitalization. He only says that it’s difficult to know if buybacks have boosted stock market returns, but also that it’s crazy to think Apple’s market capitalization shouldn’t be reduced instead of elevated by share buybacks.
Perhaps Asness is consistent is asserting that buybacks probably haven’t boosted market returns and certainly haven’t boosted Apple’s market capitalization. But he doesn’t think it’s impossible that buybacks have boosted stock returns, leaving himself vulnerable to the charge that he is confused about whether buybacks boost returns (and market capitalization) or amount to a liquidation and shrinkage of market capitalization.
Ultimately, Asness is upset that people are examining what corporations do with their profits when Americans have so many other things to debate. But when profit margins are so persistently high and a higher percentage of profits are returned to capital, perhaps he shouldn’t be so naïve to think a political debate wouldn’t commence about corporate profits and share buybacks. Moreover, despite calling the buyback arguments “innumerate nonsense,” it seems Asness has some thinking to do about whether buybacks boost market returns or are a form of liquidation.