By Wolf Richter, a San Francisco based executive, entrepreneur, start up specialist, and author, with extensive international work experience. Originally published at Wolf Street.
Magic trick turns into toxic mix.
Stocks have been on a tear to nowhere this year. Now investors are praying for a Santa rally to pull them out of the mire. They’re counting on desperate amounts of share buybacks that companies fund by loading up on debt. But the magic trick that had performed miracles over the past few years is backfiring.
And there’s a reason.
IBM has blown $125 billion on buybacks since 2005, more than the $111 billion it invested in capital expenditures and R&D. It’s staggering under its debt, while revenues have been declining for 14 quarters in a row. It cut its workforce by 55,000 people since 2012. And its stock is down 38% since March 2013.
Big-pharma icon Pfizer plowed $139 billion into buybacks and dividends in the past decade, compared to $82 billion in R&D and $18 billion in capital spending. 3M spent $48 billion on buybacks and dividends, and $30 billion on R&D and capital expenditures. They’re all doing it.
“Activist investors” – hedge funds – have been clamoring for it. An investigative report by Reuters, titled The Cannibalized Company, lined some of them up:
In March, General Motors Co acceded to a $5 billion share buyback to satisfy investor Harry Wilson. He had threatened a proxy fight if the auto maker didn’t distribute some of the $25 billion cash hoard it had built up after emerging from bankruptcy just a few years earlier.
DuPont early this year announced a $4 billion buyback program – on top of a $5 billion program announced a year earlier – to beat back activist investor Nelson Peltz’s Trian Fund Management, which was seeking four board seats to get its way.
In March, Qualcomm Inc., under pressure from hedge fund Jana Partners, agreed to boost its program to purchase $10 billion of its shares over the next 12 months; the company already had an existing $7.8 billion buyback program and a commitment to return three quarters of its free cash flow to shareholders.
And in July, Qualcomm announced 5,000 layoffs. It’s hard to innovate when you’re trying to please a hedge fund.
CEOs with a long-term outlook and a focus on innovation and investment, rather than financial engineering, come under intense pressure.
“None of it is optional; if you ignore them, you go away,” Russ Daniels, a tech executive with 15 years at Apple and 13 years at HP, told Reuters. “It’s all just resource allocation,” he said. “The situation right now is there are a lot of investors who believe that they can make a better decision about how to apply that resource than the management of the business can.”
Nearly 60% of the 3,297 publicly traded non-financial US companies Reuters analyzed have engaged in share buybacks since 2010. Last year, the money spent on buybacks and dividends exceeded net income for the first time in a non-recession period.
This year, for the 613 companies that have reported earnings for fiscal 2015, share buybacks hit a record $520 billion. They also paid $365 billion in dividends, for a total of $885 billion, against their combined net income of $847 billion.
Buybacks and dividends amount to 113% of capital spending among companies that have repurchased shares since 2010, up from 60% in 2000 and from 38% in 1990. Corporate investment is normally a big driver in a recovery. Not this time! Hence the lousy recovery.
Financial engineering takes precedence over actual engineering in the minds of CEOs and CFOs. A company buying its own shares creates additional demand for those shares. It’s supposed to drive up the share price. The hoopla surrounding buyback announcements drives up prices too. Buybacks also reduce the number of outstanding shares, thus increase the earnings per share, even when net income is declining.
“Serving customers, creating innovative new products, employing workers, taking care of the environment … are NOT the objectives of firms,” sais Itzhak Ben-David, a finance professor of Ohio State University, a buyback proponent, according to Reuters. “These are components in the process that have the goal of maximizing shareholders’ value.”
But when companies load up on debt to fund buybacks while slashing investment in productive activities and innovation, it has consequences for revenues down the road. And now that magic trick to increase shareholder value has become a toxic mix. Shares of buyback queens are getting hammered.
Citigroup credit analysts looked into the extent to which this is happening – and why. Christine Hughes, Chief Investment Strategist at OtterWood Capital, summarized the Citi report this way: “This dynamic of borrowing from bondholders to pay shareholders may be coming to an end….”
Their chart (via OtterWood Capital) shows that about half of the cumulative outperformance of these buyback queens from 2012 through 2014 has been frittered away this year, as their shares, IBM-like, have swooned:
The Citi analysts, via Bloomberg:
The three-fold increase in share buybacks in the past five years has been the key driver of corporate re-leveraging. In large part, buybacks have been the result of strong incentives provided to corporate managers by activists in particular and equity investors in general…
Companies that spent more on shareholder handouts and less on investments have tended to get higher price/earnings ratios in the market. But there are signs that this may be changing. Recent conversations that we’ve had with equity [portfolio managers] suggest that they have become far more focused on revenue growth, and are placing far less of a premium on any financially engineered EPS growth.
The fact that a basket of stocks that [has] been reducing shares outstanding is meaningfully underperforming the S&P 500 on a beta-adjusted basis suggests that this view may not be that of just the investors we talk to, but far more broad-based.
The performance of the S&P 500 has been crummy this year, in part because it has been dragged down by the buyback queens. Investors are smelling a rat. Financial engineering performs miracles, even with duds like IBM and HP – until it doesn’t.
Results of all this financial engineering? Revenues of the S&P 500 companies are falling for the fourth quarter in a row – the worst such spell since the Financial Crisis. And with the failure of financial engineering, one of the most powerful props collapses under the already wobbly but sky-high stock market.
Junk bonds, a bellwether for stocks, have been warning for a while. Investors are sitting “on large amounts of potential and realized losses,” Moody’s said. Read… Bloodletting 8 Trading Days in a Row: Junk Bonds Go to Heck .
18 comments
Comments are closed.
Me thinks Wolf is slightly barking up the wrong tree here. What needs to be looked at is how buy backs affect executive pay. “Shareholder value” is more often than not a ruse?
probably, in some or most cases, but the effect on the stock is the same.
Interesting that you mention ruse, relating to “buy-backs”…from my POV, it seems like they’ve legalized insider trading or engineered (a) loophole(s).
On a somewhat related perspective on subterfuge. The language of “affordability” has proven to be insidiously clever. Not only does it reinforce and perpetuate the myth of “deserts”, but camouflages the means of embezzling the means of distribution. Isn’t distribution, really, the only rational purpose of finance, i.e., as a means of distribution as opposed to a means of embezzlement?
The top 500 S&P companies spent $3 trillion from 2001– 2010 in stock repurchases, equal to well over 50% of profits (Lazonick 2014). Since they never resell stocks, these are essentially one-way bets that benefit insider sales. In other words, there is no benefit to the firms—it is pure value extraction by private sellers of the stocks. (One might justify stock repurchases to benefit from rising equity markets if they were sold at the peak for cash to finance investment and research and development—but that doesn’t happen.)
Mission Oriented Finance
More nuance and less dogma please. The dogmatic tone really hurts what could otherwise be a fine but more-qualified position.
“Results of all this financial engineering? Revenues of the S&P 500 companies are falling for the fourth quarter in a row – the worst such spell since the Financial Crisis.”
Eh, no. No question that buybacks *can* be asset-stripping and often are, but unless you tie capital allocation decisions closer to investment in the business such that they’re mutually exclusive, this is specious and a reach. No one invests if they can’t see the return. It would be just as easy to say that they’re buying back stock because revenue is slipping and they have no other investment opportunities.
Revenues are falling in large part because these largest companies derive an ABSOLUTELY HUGE portion of their business overseas and the dollar has been ridiculously strong in the last 12-15 months. Rates are poised to rise, and the easy Fed-inspired rate arbitrage vis a vis stocks and “risk on” trade are closing. How about a little more context instead of just dogma?
John Malone made a career out of financial engineering, something like 30% annual returns for the 25 years of his CEO tenure at TCI. Buybacks were a huge part of that.
Perhaps an analysis of the monopolistic positions of so many American businesses that allow them the wherewithal to underinvest and still buy back huge amounts of stock? If we had a more competitive economy, companies would have less ability to underinvest. Ultimately, I think buybacks are more a result than a cause of dysfunction, but certainly not always bad.
“No one invests if they can’t see the return”
Modulo CEOs engaged in accounting control fraud.
Modulo CEOs engaged in accounting control fraud.
They can see their return.
One aspect that Reuters piece mentions, but glosses over with a single paragraph buried in the middle, is the fact that for many companies there are no ( or few) reasons to spend money in other ways. If capex/r&d doesn’t give you much return, why not buy out the shareholders who are least interested in holding your stock?
Dumping cash into plants only makes sense in the places where the market is growing. For many years that has meant Asia (China). For example, Apple gets 66% (iirc) of revenue from Asia, and that is where they have continued investing in growth. If demand is slowing and costs are rising, and it looks like both are true, why would you put even more money in?
Dumping money into R&D is always risky, although different industries have different levels, and the “do it in-house” risk must be weighed against the costs of buying up companies with “proven” technologies. Thus, R&D cash is hidden inside M&A. M&A is up 2-3 years in a row.
I surmise that you speak as a financier, without hands-on knowledge of R&D. If you can’t assume the risk of R&D, you shouldn’t be in a technological business (and that includes the chemical and pharmaceutical industries.) Buying other people’s technology is a limited strategy at best– historically, the big players — e.g. DuPont, General Electric, General Motors, 3M, Apple (yes Apple)– have made money on their own stuff.
If you haven’t built a better mouse-trap, no-one will beat a path to your door. I work for a Fortune-500 company that, for several years now, has been getting its ass handed to it by a European competitor, whose management ranks are filled with Ph. D.’s.
Financialization is a curse on industry. Take it from someone who develops actual products, and then helps put them out the door.
If big shareholders have the power to force corps to buyback stox and give them higher dividends, who exactly are those shareholders; are they investment fund shareholders who demand that their investments payout even if the corporations have to borrow money to buyback stock? My guess: retirement funds. And Carl Icahn. Capitalism has devastation built in – when it fails it takes down the safety net with it. Isn’t that a hugely expensive way to pay entitlements – which help to stabilize the economy? My next guess is that Wolf is going to howl about retirement benefits and equate them with extortion. Hey Wolfie, it’s just your beloved system.
The finance parasites are draining the economy. The long term shift to short term thinking is world wide, and there will have to be one hell of a crash (on the way) to burn that cancer out.
Could not agree more.
While this statement is incorrect from the legal standpoint, as Yves has often pointed out, as well as from the psychological standpoint (i.e. firms don’t have objectives–the people in charge of running firms do have objectives, namely to maximize their personal take) it should none the less be emblazoned in every City Council chambers and State legislature and also be turned into a public service announcement for regular airing on t.v., radio, and all across the interwebs:
Before any municipality gives out a tax break to some corporate behemoth, the corpo spokes-creature should be made to answer questions like, “Given that we know your only concern is with making as much money for yourselves as possible — not creating jobs or supporting our community — why should we believe you when you say that you care about those things? Given that the goal of your firm is to maximize shareholder (and executive) value, if serving customers and community or creating jobs gets in the way of maximizing that value, which one will take precedence?”
That last one is, of course, a trick-question, as we all already know the answer. These douchebags love to go on about how their only responsibility is to maximize shareholder value. I’d love to see that thrown back in their face once in awhile.
Itzhak is talking his book. Who are his customers? Wouldn’t that be the kiddies taking on massive debt to listen to his lessons?
Those kids and those lessons are just part of a process that turns massive indebtedness into a fat paycheck and pension for the professor, plus his “administrators”. Maximizing his shareholder self.
. . . if serving customers and community or creating jobs gets in the way of maximizing that value, which one will take precedence?”
At the end of the day, if serving customers isn’t the top priority there will be no shareholder value.
cnchal… you need to understand Jenson’s trope about shareholder value is a meme and as such can not be incorporated into an argument, as well as supply side Bernays corporatism could not give a rats ass about customers…. cough citizens….
. . .supply side Bernays corporatism
Thanks for the kick in the ass. Found a funny story about Lucky Strike.
One of the ways Bernays was able to increase cigarette consumption was to use a professor’s death that hated smoking to his advantage. This professor kept the brains of deceased smart people to examine, and upon his death, his own brain was examined and found to be deficient in an area that was associated with the sense of smell.
WILDER WAS UNABLE TO SMELL TOBACCO
Study of His Brain Reveals Reason for Cornell Professor’s Anti-Smoking Crusade
Special to The New York Times
ITHICA, N.Y., May 7.-The results of a comparative study of the brain of Professor Burt M. Wilder of Cornell, who died in 1925, were made public today at the university. The brain is a part of the collection which Dr. Wilder established over forty years ago. The study was made by Dr. James Papez, the curator of the collection, whose report on the brain of Helen Gardener, a prominent suffragist, confirmed the assertion of many women, “that the brain of a woman need not be inferior to that of a man.”
Dr. Wilder’s brain, which was compared with the brains of forty eminent men and women in the Cornell collection, corresponded closely to that of other scholars. It further confirmed the belief that the size of the brain is not a measure of intellect, its weight of 1,200 grams not being large in comparison with brains of other scholars or the brains of average individuals.
In the pronounced development of certain areas of the brain which have come to be associated with scholarly attainments, that of the Cornell professor was marked. Dr. Papez found that, “the greater length and depth of the furrows in the frontal, occipital and temporal regions appears to show that these local developments favoured in a very important way the acquisition of cultural and scholastic habits.
“Dr. Wilder’s brain showed splendid development in the speech area, which is located in the lower frontal region. In the visual area, located in the back of the brain, and in the center of hearing, located in the temporal region, the brain large relative dimensions in comparison with others in the collection.”
From these facts Dr. Papez deduced “it appears reasonable to infer that his musical as well as his literary abilities were in some way dependant on this endowment. In the brain of Helen Gardener, who was not musical, the temporal measurements do not indicate a development above the average.”
The examination served to explain Dr. Wilder’s long-standing and vehement abhorrence of tobacco smoke in any form. A non-smoker, he crusaded against the smoking of others. His brain showed an atrophy of the olphactory center, devoted to the functions of smell. The atrophy was of such advanced degree that Dr. Papez infers it was of long standing and explains Dr. Wilder’s lack of appreciation of tobacco.
Right now, someone needs to be the first penguin to jump off the R&D iceberg, in many fields, including especially water technologies. That someone is going to be a private inventor. The sum total of federal R&D here is zero, state R&D more or less zero, and, corporate R&D, nothing much. Private inventors often are the ones with real ideas and skin in the game.
OK I may be missing something here – but isn’t there a difference between stock buybacks and dividends?
A stock buyback is surely financial engineering, pumping up the value of the stock without reflecting the underlying essentials (and very very toxic if done with borrowed money).
But surely dividends paid out of profits are another thing? If a company simply doesn’t see any profitable uses of its available cash, then why not return that to the stockholders and let them decide what to do with it? Like invest in a company that actually does have something useful to do with the money, or maybe buy something? (These two possibilities are of course the same thing: consumption is investment. How do most companies get money anyhow?). A business that makes a profit and pays it back to the stockholders – who OWN it in the first place – sounds like capitalism to me.
Unless of course the dividends were paid for by borrowing – now THAT is surely toxic. Isn’t it more important how dividends were paid for, than that they exist?