- Blue Chip companies have increasingly traded off capital formation for share buybacks over the last 15 months.
- Data show that 27 out of 30 DOW companies since the end of 2012 have reduced shares outstanding, and that buy-backs in aggregate exceeded economic profitability.
- Breaking the data down by company, a large sub-set of weak companies surface which will only be able to recover by raising price levels or executing strategic M&A transactions.
Back in the year 2000, I got a call from a broker wanting me to take a look at a particular large cap financial stock. His pitch was "the company has lagged its peer group, but has announced a major share re-purchase program." I asked what the company plans were for growth. Awkward silence was evident on the other end of the line. I then said, "So you are asking me to buy-out certain shareholders who don't want to own the company anymore because the management team is struggling to find ways to invest?" Needless to say, I did not invest in the company. But I did follow it. Sure enough, it did rise in the following months, only to be cut in half within the next 2 years.
I tell this story because I have always been wary of common stock buy-back plans. Not because they are all bad. Many companies have a disciplined approach of returning capital through this process rather than paying dividends. However, when the buy-backs are not backed up by fundamental growth in the company, they turn into little more than the company entering the debt market to finance dividends, or worse, robbing from needed capital investment to maintain future cash flow.
With this perspective in mind, I have been keeping a watchful eye on the buy-back activity of large cap companies with a level of fascination, particularly since the beginning of 2012. Since the end of 2012, using the DOW (NYSEARCA:DIA) companies as a large cap company market proxy, share buybacks in dollar volume have exceeded the actual level of after tax profits recorded by the 30 companies in the index. What this means is that somewhere in the DOW there must be more than a handful of companies, which are either borrowing money or deferring capital expenditures in a potentially harmful manner for the sole purpose of buying their shares back in the market to boost share price. And, in many cases thanks to a Fed driven liquidity free-for-all, the shares being purchased are not cheap.
Warren Buffett in a discussion about IBM's (NYSE:IBM) share re-purchase program in his shareholder letter reflects a perspective on buy-backs that may explain why so many large companies get addicted to the process. His view, in effect, is that share re-purchases are great, particularly if the company is intrinsically undervalued, because it increases Berkshire's (NYSE:BRK.A) (NYSE:BRK.B) percentage ownership of a company through time without further investment. Ownership and control can be intoxicating. But if you wake up when the stock buy-back program "tapers" and find that what you own has dwindled into a liability rather than an asset, your perspective as an investor will quickly change.
Based on the data I have pulled together for this article, you may be surprised by the companies, which make the bad company list when it comes to share buy-backs at the present time. IBM is one of many.
Blue Chip Revenue Growth and Profitability Not Stellar
Probably not a surprise to many readers, the composite data of the 30 companies in the DOW show that both revenue and earnings have been growing at a rate best described as an anemic pace. The data is interesting on an aggregate basis. In 2008, the DOW companies did a little over $2.6T in revenue. Now, almost 6 years removed from "the Greatest Recession since the Great Depression," revenues on a trailing 12-month basis as of Q1 2014 were just under $2.8T. Adjusted for government recorded inflation (10.27% over the time period), the revenue is actually worth less today than it was in the depths of the recession.
When I realized this about the data, it struck me that despite all the rancor about stock market all-time highs, a good case can be made for a stock market valuation closer to the lows reached in early 2009, than the peak levels we are at today.
Then I took a look at the actual after tax profitability of the DOW companies today versus the end of 2008. In this regard, company profitability has improved, justifying on an economic basis some increase in the DOW index since 2008. But how much of an increase is justified? The answer to this question should depend on the "quality" of the earnings growth.
One aspect of the data conspicuously stands out in the change in the composite DOW company profitability from 2008 through today. In the research, I was interested in finding out how much impact the "trickle down" impact of Federal Reserve holding interest rates at the zero bound throughout the entire time period had on corporate earnings. Based on the DOW as a proxy, one could argue that it has accounted for a very high % of the entire aggregate profit growth. Before taxes, the net change in the interest expense line on an annual basis was $65.6B. The after tax benefit is estimated in a range of about $50B per year.
Is it a coincidence that the estimated net tax benefit almost directly equates to the annual profit growth experienced in the DOW companies since 2008? Given a closer examination of the sources and uses of funds through time, "probably not" is the likely answer.
Given the anemic revenue and earnings growth, just how have the Wall Street masters managed to engineer share price increases, which across the DOW in aggregate average almost 100% since the end of 2008, and more recently in 2013 went up 21.5% and currently moving higher in 2014? Much has been written about the Federal Reserve quantitative easing programs, which have flooded the financial markets with liquidity. The correlation of the Fed asset purchase program and the stock market increase is over 90%. However, it is only a part of the puzzle.
Capital Formation Flat as More Cash Focused on Buybacks
To get a better understanding of how corporate America is reacting to the economic and regulatory changes since 2008, the change in the balance sheet of the DOW companies provides some useful insights. The financial data contained in the table below has been segregated at the end of 2012, 2013 and Q1 2014, as well as dates back to the end of 2008. The end of 2012 is when the infamous $1T+ Federal Reserve QE3 purchase program began, and it is still proceeding today (Q2'14), but forecasted to "taper" by the end of 2014, "subject to the economic data."
As the data for the 30 DOW companies show, after the 2008 recession, cash on the balance sheet of large corporations increased. However, the overall cash liquidity is not extraordinarily high, and the big balances are concentrated primarily in technology companies like Microsoft (NASDAQ:MSFT) and Cisco (NASDAQ:CSCO). In fact, since the beginning of 2014, cash balances have been drawn down. The question is, where is the cash going?
Unfortunately, at least for large cap companies, the answer is that cash flow is not going into overall capital formation. Apparently, because of the general lack of "aggregate demand" growth, corporate CFOs are winning the boardroom debate, clamping down on programs to expand production or product lines, or making new loans in the case of financial companies. The aggregate total assets of the 30 DOW companies are at the same $7.2T mark at the end of Q1 2014 as at the end of 2012.
As cash is going down, and total assets are static, corporate debt is edging up, increasing $300B since the end of 2012. Overall, leverage for most DOW companies is not a concern. The vast majority of the non-financial companies in the index have very low debt to equity ratios. Verizon (NYSE:VZ), with its heavily debt financed buy-out of the Vodafone wireless stake, is now an outlier from a leverage standpoint. The debt to equity ratio of the DOW composite stood at 2.22 as of the end of Q1 2014, only slightly more than the 2.17 at the end of 2012, and well below the 2.76 at the end of 2008. The big change after 2008 was the deleveraging of the major financial companies in the DOW.
However, the current trend is now an increase in corporate debt in the DOW companies on an aggregate basis. If the present trend in M&A activity continues, like the AT&T (NYSE:T) deal for DirecTV (NASDAQ:DTV), and the currently on hold bid from Pfizer (NYSE:PFE) for AstraZeneca (NYSE:AZN), then look for the leverage ratio to expand more quickly in the coming year. An M&A frenzy of activity is very likely over the near term as many large cap company corporate executives realize they have an unsustainable share price unless they use their shares as a currency to buy growth.
When you look at the balance sheet of the DOW in aggregate, the one counter-correlating variable that stands out as the most likely share price stimulant in the past 15 months, and to some extent dating back to 2008, is the decision from a corporate finance standpoint to shrink the shares available in the open market. During 2013, the fully diluted shares outstanding for the 30 DOW companies decreased by 4.1M, or about 5%
The year 2013 was an opportune time to reduce the shares available for trading. The Federal Reserve asset purchase program was simultaneously flooding the market with cash at unprecedented rates. Corporate executives were given a golden opportunity to pump up demand for their company shares through a steady buy-back program. At the same time, many investors were being forced to buy riskier assets in order to maintain the purchasing power of their investments. In the short term, this combination of events was a perfect recipe for good old fashioned asset inflation. Where is the flaw in this financial engineering? There really is not as long as the company is able to maintain the investment level in its business required to produce the returns implied in the ever increasing valuations sparked by the combined Fed sugar and the buy-back kicker. But the numbers don't lie. Some companies are sacrificing investment in the future to get the boost in share price today. And many will not be able to buy growth in the upcoming M&A rally as they are outmaneuvered by incoming foreign investment, particularly from Japan.
The question investors need to answer, particularly those who use indexes as a means of investing, is "has the buy-back craze created a systemic risk that once removed will cause a breakdown in the market?"
Devil in the Details - Recent Buyback Activity by Company
To review this question, I took a look at the buy-back activity of each company in the DOW index to get an understanding of whether their program was sustainable or possibly masking growing problems. These problems may be self inflicted due to lack of investment in growth, or related to the overall state of the economy induced by government policies. Regardless of the cause, the weak links should begin to stand out in the bunch after such a prolonged period of buy-backs across the market.
The first aspect of the share buy-back data, which is striking, is just how pervasive the programs have been over the last 15 months. In total, 27 out of 30 DOW companies reduced the level of fully diluted shares outstanding over the time period from 2013 into early 2014. The total share count of the DOW companies in the time period fell 3.4%. Netting out the Verizon acquisition of the 45% stake in its wireless business held by Vodafone, which added 1.28M shares to its base with owners who were already technically shareholders in a minority owned off-balance sheet business, the total shares outstanding fell almost 5%.
Digging deeper into the data, there is a sub-set of companies that fit the risk profile of using share buy-backs to inflate their stock because the prospects for their business are currently limited. These companies are highlighted in red, or yellow to denote a slightly lower degree of concern. The definition used to cull the data is negative revenue growth and negative total profit growth over the last 15 months as the stock buybacks were being executed. The cross section of companies which stand-out when looked at in this fashion is broad and deep, 9 out of 30 companies. Some of the biggest offenders include tech giants IBM and Cisco, construction equipment company Caterpillar (NYSE:CAT), pharmaceutical drug maker Merck (NYSE:MRK), beverage maker Coca-Cola (NYSE:KO), energy companies Chevron (NYSE:CVX) and Exxon (NYSE:XOM), and Wal-Mart (NYSE:WMT).
Within this sub-set of no growth companies, there are 4 that even exceed the average 16.1 P/E ratio of the entire DOW. These are noted on the graph and include CAT, MRK, KO and CSCO.
Investment Strategy as the Buy-Backs Taper
My current forecast is that the next major market move is rates up, shares prices down. This is directly at odds with both the current Fed and retired Chair Ben Bernanke who are still forecasting low rates for a "considerable" time period; as well as many on Wall Street who are convinced that economic growth will lead stocks higher.
It may take the remainder of this year before the reality begins to take hold, or even to the 2016 election time frame, but the groundwork has been laid for a completely different route for stocks and Treasury bonds in the next several years. When you look at the Boardroom decisions that have been made over the last 15 months, clearly supply-side investment has been at the bottom of the list. Meanwhile, the Federal Reserve has been screaming that they want inflation, pumping more and more liquidity into the financial system. As the M&A rally takes hold, loan demand is going to rise in order to fund the need to buy growth by the large cap companies, putting market pressure up on interest rates. In reality, the growth will not be growth, but rather just a constraining force on market supply and an increasing ability of large firms to control prices moving forward. The pent-up pressure for price increases in the supply chain that are currently showing up will increasingly be unleashed on the market. What is the most likely Fed response? The obvious answer is probably not going to happen quickly. The current regime will wait until they are even further behind the inflation curve because their goal is not containing inflation or increasing economic growth. The Fed's current primary goal is low rate government debt financing.
On the desire to "get inflation up," be careful what you wish for Chair Yellen, Wall Street is working hard to give it to you. Only this time it will be a production constrained 70s style inflation, not a demand driven inflation based on supply-side economics. Raising interest rates won't kill it; increasing rates will chase inflation up as it spreads.
In this financial environment, it is still early to short weak over valued stocks. Liquidity fueled momentum is still too high, and can easily continue through the rest of this year. But when the Fed taper is finally concluding later this year, and I suspect simultaneously so will stock buy-backs, the 9 stocks above, with the exception of the energy names, should head to the top of the short list, particularly those that have high P/E ratios at that point in time. Until the signals strengthen that the market is rolling over, I recommend focusing on the more fundamentally sound companies in the DOW or other indexes like the S&P 500 (NYSEARCA:SPY), and begin to avoid ones heavily dependent on buy-backs to boost share value. Additionally, look for M&A to continue. Holding a group of companies likely to become targets over the next year is likely to provide above average returns. The tech, pharmaceutical and food sector appear to be the most likely targets.