Repeating the mistakes of 2007...
Repeating the mistakes of 2007... An unbelievable new record... Why are companies so foolish?... One question you must ask today...
If you've been with us for long, you know stock buybacks – or corporate share repurchases, as they're officially known – are a double-edged sword.
If you're not familiar, this is simply when companies purchase their own shares and "retire" them.
All things being equal, this reduces the number of shares outstanding and makes each remaining share more valuable.
When companies use buybacks appropriately, they can be great for investors.
But this is easier said than done. As Extreme Value editor Dan Ferris explained earlier this year in the April 13 Digest...
Share buybacks are hard to time well. They only work when a company buys back shares at a discount to the value of the business...
To do share buybacks right, the first thing a company has to do is hang onto its cash when the stock is expensive. That's hard, because investors will criticize it for holding too much idle capital. Think of how bullish you and everyone else were in late 2007... right before the S&P 500 peaked that October.
Then, when the market finally falls, companies have to be brave enough to step in and start buying their own shares – hopefully at a discount to what the business is worth.
Think of how bearish you were in the spring of 2009, when everyone was scared to death that another Great Depression was coming. Well, the folks running big corporations are human just like you. They bought back their own shares like crazy at the top and bought back very little at the bottom.
Unfortunately, companies appear to be repeating the mistakes of 2007 all over again. Porter highlighted just how crazy the situation has become in the September 4 Digest...
In the first quarter of 2015, the 500 largest publicly-owned companies in the U.S. paid out more capital to shareholders (through dividends and share buybacks) than they earned from their business operations.
It should be obvious to everyone that companies can't spend more buying back shares and paying out dividends than they earn – at least not for long.
This heavy corporate buying has been a major "leg" supporting the bull market. Goldman Sachs predicted earlier this year that U.S. companies would buy $1 trillion worth of shares in 2015. That represents a large percentage of the total capital flowing into the stock market. And it's not only the direct buying power of U.S. corporations that supports the market. By reducing the number of shares outstanding, U.S. corporate investing reduces the supply of stock, making the remaining shares more valuable.
Why would companies make such a (seemingly) obvious mistake?
Because their interests – or at least, the interests of their management teams – aren't necessarily the same as those of the companies' long-term investors. More from Porter...
Over the last 20 years or so, stock buybacks (as opposed to simple dividend increases) have become far too popular with management teams. There's a good reason why: Stock buybacks allow managers to convert additional debt into higher earnings per share. By reducing share counts, the same amount of earnings will look bigger on a per-share basis.
Warren Buffett has commented frequently about the poor ethics of management teams who use their balance sheet to inflate their earnings per share, all to the long-term detriment of their shareholders. He wrote in his 1999 letter to Berkshire Hathaway shareholders:
"If a company's stock is selling well below intrinsic value, repurchases usually make the most sense. In the mid-1970s, the wisdom of making these was virtually screaming at managements, but few responded... That day is past. Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price... it appears to us that many companies now making repurchases are overpaying."
In other words, management teams – whose compensation is often tied to share prices and earnings-per-share growth – are willing to risk their companies' long-term health for short-term boosts in share prices.
And if the latest data is correct, the situation could be even more concerning than previously reported...
In an analysis published yesterday, news service Reuters reported that spending on buybacks and dividends hit a new record last year... and exceeded companies' combined earnings by nearly $40 billion for the full 2014 fiscal year. From the report...
In the most recent reporting year, share purchases reached a record $520 billion. Throw in the most recent year's $365 billion in dividends, and the total amount returned to shareholders reaches $885 billion, more than the companies' combined net income of $847 billion.
The analysis shows that spending on buybacks and dividends has surged relative to investment in the business. Among the 1,900 companies that have repurchased their shares since 2010, buybacks and dividends amounted to 113% of their capital spending, compared with 60% in 2000 and 38% in 1990.
And among the approximately 1,000 firms that buy back shares and report [research and development] spending, the proportion of net income spent on innovation has averaged less than 50% since 2009, increasing to 56% only in the most recent year as net income fell. It had been over 60% during the 1990s.
This means the worrisome trend Porter highlighted earlier this year is even bigger – and has been going on even longer – than many investors realize. This trend has only accelerated in 2015... and it's coming at the expense of research and development and other capital spending for the future.
More important, the report noted that this is the first time in history this has happened outside of a recessionary period.
As Porter has explained, share buybacks have played a bigger and bigger role in companies' earnings per share growth in recent years. And this has been a major "leg" supporting the bull market in stocks.
But according to a note this week from Deutsche Bank strategist David Bianco, share buybacks are no longer just boosting earnings-per-share growth... they're now almost entirely responsible for it. Without share buybacks, second-quarter earnings-per-share growth would have been close to 0%... and will likely drop into negative territory for the third quarter.
In other words, debt-fueled share buybacks have been covering up a significant decline in companies' real earnings. And this has occurred during a period when the economy is still officially growing.
If the economy slows – or worse, "contagion" from the high-yield bond market spreads to other markets – many of these companies could find themselves in real trouble.
If you didn't take Porter's advice in September, we urge you to reconsider today...
I hope you'll take the time to review your own portfolios for companies that have been engaging in aggressive share repurchases at the expense of their balance sheets. Companies that have been adding significantly to their debt loads in an effort to buy back stock are going to be badly hurt during the next few years.
Over the past 20 years the balance sheet of the average American business has become a lot more encumbered. We've gone through a long period of low interest rates. That has encouraged managers to add debt, to "lever-up" their businesses, and earn bigger profits. A lot of the managers who have done so don't care about the long-term ramifications of these decisions.
A lot of businesses are going to get hurt as this period of credit excess reverses. One way to spot which companies might be in the most jeopardy is simply to ask: Have the managers been spending more on stock than the company's earnings can support?
New 52-week highs (as of 11/16/15): Lancashire Holdings (LRE.L) and Sinclair Broadcast (SBGI).
In the mailbag, more praise for Porter's five-part bond series. As always, send your questions and comments to feedback@stansberryresearch.com.
"Mr. Stansberry, thank you so much for taking the time to explain exactly how the bond market works for investors. As I'm sure many of your readers have always done, I assumed that bond trading was limited to institutional investors, investment funds and professional traders. While the distressed bond market may be out of reach for me based on your portfolio size recommendations, I appreciate the opportunity to learn exactly how these vehicles behave, how one can make money on them, what risks to be watchful for and how to actually make trades.
"A quick check with my online brokerage firm, OptionsXpress (owned by Schwab) revealed an easy to use online bond pricing and ordering tool for corporate issues if you know what you want to buy. It does appear that your research would be nearly indispensable, and I applaud you for making it available for those who can afford to profit from the information. Thanks again!" – Paid-up subscriber David Lash
"Thank you for all the information you have given us in the past few days about buying bonds. I have never bought bonds before but I am going to buy them in the future. I have bought smart notes in the past and done well with them. One of the smart notes was GMAC during the 2008 down turn. That was a bit of a worry at the time!! You have opened up a new road for wealth for those who are willing to follow your good advice. Again thank you!" – Paid-up subscriber Ed Imel
"Porter: You did a great job educating me about opportunities in bonds using your research. I knew little or nothing about corporate bonds and less about analyzing possible investment yields. I added your service to my Flex account yesterday. I will be a seller of non-gold stocks in my trading portfolio Monday." – Paid-up subscriber Neil Lynch
Regards,
Justin Brill
Baltimore, Maryland
November 17, 2015
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