For the Truth the Turkey is in Comparison a much more respectable Bird, and withal a true original Native of America… He is besides, though a little vain & silly, a Bird of Courage, and would not hesitate to attack a Grenadier of the British Guards who should presume to invade his Farm Yard with a red Coat on.
– Benjamin Franklin, from a letter to his daughter “Sally,” Mrs. Sarah Bache (January 26, 1784)
By David Stockman
Today is Black Friday, the traditional beginning of the Christmas shopping season.
Naturally, given that the stock market closes a little early, I thought it important to offer something of particular value, as we hustle for savings, bargains, and deals all over town… or, more and more likely, the internet…
So, a couple weeks ago, I asked Michael Coolbaugh – Investment Editor for The Stockman Letter and Chief Investment Strategist of the forthcoming Delta Profit Trader – to take a look at the buyback issue.
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.
This is a vestige of Bubble Finance. And it has “dire consequences” written all over it.
Here’s Michael with a read that’s a little heavier than normal for a Friday after Thanksgiving but very well worth the time and effort…
Much Ado About Something
By Michael Coolbaugh
When David asked me to take a look at the “buyback issue,” my first reaction was, “Oh boy… Where do I even start…”
I’m only half-joking. There’s a big debate about buybacks among some extremely smart people playing out in mainstream outlets like MarketWatch.com and on Twitter. It’s a fraught issue.
Here’s why the DIY investor should care about not just the debate but buybacks in general:
- Operational weakness can often be masked by the impact of buybacks; look no further than General Electric, IBM, Texas Instruments, and Boeing.
- Contrary to public perception, buybacks are not typically a sign of management confidence in future prospects.
- Using cash flow and the balance sheet for buybacks has the potential to reduce a corporation’s ability to withstand future downturns; most often, corporations will issue stock at market lows, which dilutes the ownership for current holders if you don’t buy more stock.
- Emphasis on buybacks means reduced investment for future growth.
General Electric is the classic example. GE consistently reduces share count near the highs and increases share count near the lows.
Now, let’s dig in a little to what buybacks are and how they impact regular shareholders…
If we want to start from the most basic level of Corporate Finance 101 taught in business schools across America, CEOs and CFOs are 100% correct in utilizing buybacks.
I would assume most theoreticians would ascribe to this view that it’s nothing other than operating with the given incentive scheme and maximizing shareholder value by way of lowering its weighted average cost of capital (WACC).
From a mathematical perspective, WACC equals the cost of debt financing plus the cost of equity financing
It’s easy to figure the cost of debt financing; it’s simply the interest rate a corporation pays on its outstanding debt.
The cost of equity financing is a little more subjective, where, again, more theory comes into play. The most popular view is based on what’s known as the “capital asset pricing model” (CAPM).
Ultimately, the cost of equity financing is a combination of three things: the risk-free rate; the average historical market return; and a corporation’s historical equity sensitivity to market movements, what’s known as “beta.”
From a pure academic sense, the cost of equity financing is generally always more expensive (except certain distressed situations) because of its place on the capital structure.
In other words, equity holders require a higher return because they get paid last, after bondholders.
Let’s makes some assumptions and plug in some numbers to illustrate how it works….
Corporation A issued debt with a 10% interest rate. The same Corporation A has a historical equity sensitivity – or “beta” – of 1.50 times. The average historical return for “market” is approximately 12% per annum. The risk-free rate is 5%.
Here’s what the equation for equity financing via CAPM under this scenario looks like:
5% + [1.5 * (12% – 5%)] = 15.5%
Let’s say the company has been financed on a 50-50 basis. The equation would look something like this:
(0.5 * 10%) + (0.5 * 15.5%) = 12.75%
Now, let’s plug in a risk-free rate of 2% to illustrate the impact of the Fed lowering rates. Corporation A can now issue debt with a 7% interest rate (assuming no change in credit spreads):
2% + [1.5 * (12% – 2%)] = 17%
The 50-50 scenario looks like this:
(0.5 * 7%) + (0.5 * 17%) = 12%
What we see is that, holding everything equal, the cost of capital goes down. But what we notice is that when interest rates fall, the cost of debt financing also declines, whereas the cost of equity financing moves higher.
And this is where the theoreticians argue that it’s prudent corporate management and not greed. They’d argue it’s the smart move to shift financing towards more debt and less towards equity – to issue debt to buy back stock – as it reduces the company’s financing costs.
Within your traditional Corporate Finance 101 approach is the argument that whenever a company decides to undertake a new project, it must be what’s considered “positive NPV.”
“NPV” is “net present value,” a fancy way of saying that the sum of all the future cash flows from the project must exceed the initial cost (when adjusting for a minimum rate of return on your money).
In other words, if we issue debt at 5% to fund a new project, we have to assume that all the future cash flows (discounting by 5% per year because we otherwise would not be paying this 5% by issuing the debt) will exceed the initial investment.
Within this argument you, again, have the theoreticians who argue that the Fed lowering interest rates should reduce this “hurdle rate” and thus spur additional investment.
My Take: Theory Versus Reality
Both arguments above sound good, in theory. But this is where much of the disagreement comes into play.
GDP growth boils down to two components: productivity growth and working-age-population growth.
In my view, the unintended consequences of lowering the hurdle rate is that it doesn’t necessarily spur additional investment. Instead, it allows otherwise unproductive assets to stay alive (a la zombie corporations) and ultimately leads to overcapacity.
And, contrary to the textbook arguments, this is precisely why we have seen a massive bear market in commodities since the introduction of QE.
In fact, if we overlay interest rates and productivity growth, we can see that spikes in productivity growth coincide with spikes in interest rates.
There are certainly cases of management abusing buybacks. But, for those of us who aren’t forensic accountants, it’s often difficult to discern who exactly is abusing this tool. It’s generally much easier to find out after the fact.
For example, General Electric spent $20 billion to $25 billion on buybacks between 2016 and 2017. Wouldn’t you know, it was just announced that GE’s pension shortfall was about $25 billion?
This definitely factors into the inequality debate. GE could have used that same money to fill the pension deficit as opposed to management’s recent announcement that they’ll be cancelling approximately 10,000 pensions.
You also have the incentive system of how executives are compensated. Academia says that tying compensation to stock price will align your interest with shareholders. But what we find is that most incentive schemes are too short-lived to fuel true investment for long-term growth. By and large, most stock-based compensation vests in three or fewer years.
Executives of large corporations often have a massive amount of personal wealth tied up into a stock price. It seems pretty clear that the obvious self-preservation option would be to keep the stock price afloat until your shares vest so you can unload them before the stock price falls.
After all, you never know if you’ll still be CEO in five to 10 years and see the success or failure of a new plant.
What these two points show is that the first option is relatively risk-free, whereas the second involves a great deal of risk and uncertainty.
Whenever people argue for buybacks, I like to ask the simple question, “When is the last time you received a notice to tender your shares of Apple, Salesforce or Netflix?”
The answer, almost universally, is “never.”
What we do see is at the same time companies engage in massive buyback plans, corporate insiders are unloading shares.
This was actually a case study in business school. The question is, if corporate insiders are so good at timing purchases of their own stock (i.e. they have a lot of visibility into improving conditions), then why are corporations so bad at buying back their own stock?
If you study the patterns closely, corporations perform the most buybacks near market tops. But they don’t buy back stock at the lows; there were virtually no buybacks in 2008-09). Instead, insiders purchase shares themselves and receive massive stock-based compensation at the lows.
When stock prices are high, they are concentrating ownership to the public. And then, when the stock price is low, they often dilute ownership to the public by way of issuing stock. This comes back to the WACC formula, where issuing stock during crises may actually be the more cost-effective thing to do.
In my opinion, based on the weight of the evidence, there’s no question at all: Insiders use buybacks to cash themselves out.
What Do “Outsiders” Do?
This is the most politicized market in history. And the Tweeter-in-Chief is still in charge. So, the situation is changing almost by the minute.
It’s “Impeachment!” in Imperial Washington and all over the Mainstream Media. It’s “Easy Money!” on Wall Street and across Bubblevision.
And it seems as if the whole world has, indeed, gone mad.
Amid this chaos, prices will continue to rise and fall, trends will continue to develop and dissipate.
Well, The Stockman Letter is made for times like these. And we’ve updated our design to help us better navigate to not only the safest harbors but also the most promising opportunities.
The stakes are as high as they can be heading into 2020. Markets appear to be straining, catching up to an economy that’s been weak and getting weaker for years.
The Donald is tied up in the day-to-day movements of the major stock indexes like no president before him. The increasingly desperate incumbent will do anything he must to hold the White House.
It’s a major tipping point. And there’s no telling what the Donald’s great disruptions could do to your wealth.
You’ve got to be nimble to win in this market…
To common sense.