Buybacks Boost Silicon Valley

by: Elite Wealth Management

Summary

2016 dividend and buyback expenditure is expected to grow faster than "growth" related expenditures.

Icahn: Be aware of the current "earnings mirage."

Public firms are focusing on executing more conservative cash strategies - a pro and a con for equity investors.

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The Bay Area knows its way around an expansion cycle. Few have experienced equity volatility like Silicon Valley, for both public and private entities. Low interest rates and a general appetite for risk have seemingly pushed tech multiples to the moon, but this underlying trend has bolstered The Valley more than many give it credit.

Corporate America has been pushing cash back to shareholders for some time now. The trend has been to increase dividend yields and engineer higher earnings per share with buybacks. While many companies have been doing this since their inception, a number of firms have just jumped on this trend. Boards attract investors with these measures, which is especially important in a near-zero interest rate environment with seemingly slow economic growth.

Executing a shareholder-friendly policy of returning a material amount of earnings back to owners can be good for the short term, but this policy might not be best in the long run.

Innovation is the trade off here.

Goldman expects "growth" related spending - which includes capex, mergers, acquisitions, and research and development expenses - to grow 3% this year. On the other end of the risk spectrum, buybacks and dividends are expected to grow 7% vs. 2015 levels. This underscores the thesis that the majority of U.S. public firms are focusing more on executing more conservative cash strategies vs. growing their businesses... with the marginal dollar going back to shareholders.

In a recent note, FactSet indicated buybacks grew 5.2% in 2015 vs. aggregated 2014 levels. To that point, capex for the S&P 500 (excluding financial stocks) decreased 9.8% year over year.

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Major Wall Street players are concerned about this trend. Carl Icahn is one of them. Mr. Icahn has been especially critical of these maneuvers, which he calls an "earnings mirage." The numbers confirm his concerns. "What they're doing with money is almost perverse," according to Icahn on the topic of buybacks and other financial engineering strategies to boost share prices.

Icahn notes that low interest rates have only boosted this type of activity as opposed to actually investing in the business. U.S. firms announced a total of $182B in buybacks for Q1 2016, according to Birinyi Associates' research. Some of this capital could have been invested in R&D for next generation innovation, but shareholders' satisfaction seems to trump other projects at the moment.

To combat this trend, a few more aggressive companies have started their own "ventures" arm. Firms from Google (NASDAQ:GOOG) (NASDAQ:GOOGL) to BBVA (NYSE:BBVA) have venture capital/private equity orientated entities, many located in the Bay Area. Their role is to find, invest and help execute disruptive business models...perhaps the very businesses of the sponsoring firm behind the fund. While these are high-risk entities with steep adoption curves, drastic innovation seems to be cheaper to buy than develop internally. More or less, these ventures are a hedge for the parent company, but a necessary trade considering their net exposure. These efforts also keep the parent company on the cutting edge of technology and new ways of thinking. An outsider's point of view is especially valuable to large firms; fresh perspective on a problem or different user base can help diversify the firm.

It is no wonder public entities and venture capitalists are chasing startups. Numerous have turned modest seed capital into multi-billion-dollar businesses.

Silicon Valley has witnessed a record number of unicorns of late - those privately valued at over one billion dollars. In many cases, these cash-burning machines have pushed their investors' capital to the limit, but have been handsomely rewarded valuation-wise. CB Insights, a venture capital database and analytics firm, currently estimates there are 161 unicorns in the world, with a combine value at over $567B. Google Ventures, for example, is involved in eight of these unicorns and 58% of those firms are indigenous to the U.S.

Startup founders have been getting rewarded for the risk they are taking. According to angel.co, another startup database, the average startup valuation in Q1 2015 was $4.6M. Data for Q1 2016 has average valuations at $5.0M, or about 8.7% higher year over year.

Angel.co Valuation Data

Data from Angel.co includes a variety of startups across sectors and geographies, but excludes valuations over $10M (due to its emphasis on earlier round raises and younger companies).

It's common for startups to "burn cash" on R&D and headcount to generate interest in their product or service. So much so, that a "burn rate" is a common metric investors look at. Public companies should take note of this strategy, as there is a statistically significant relationship between return on equity and R&D spend.

Goldman Sachs discovered the startup mathematical edge. Its heavy spending mantra, of which many live by, works well. Specifically, in tech and biotech names, the firm found a strong correlation between research and development spending and sales growth. The two had an R 2 = 0.75 over an eight-year period. R 2 quantifies the strength of the relationship. For example, an R 2 of one (1.00) would mean there is a perfectly positive relationship between the two variables.

They also tested sales growth and stock performance, which had an R 2 of 0.71. In summary, the study noted that:

"Companies with strong R&D spending also see the best stock returns. The relationship between sales growth and stock price gains may already be intuitive. But it's interesting to see the connection made to R&D, which is an expense."

Growing interest in startups in Silicon Valley and around the world is a trend to watch. These investors are some of the most revered in their industry and naturally assume tremendous risk (given that the majority of small businesses fail and are rather illiquid). These underlying trends have facilitated the explosion in private startups. Public firms have participated in the upside, especially technology geared firms, but not nearly as much as venture capital firms and founders. Moreover, on average, public firms seem to have shifted their attention to more conservative cash strategies. While they are not ignoring this boom, they are not exposed enough to move the needle, for now.

Fariba Ronnasi

CEO, Elite Wealth Management

Full disclosures here

This article is not intended as investment advice. Elite Wealth Management or its subsidiaries may hold long or short positions in the companies mentioned through stocks, options or other securities.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.