In the previous century, after a company had maxed out all its private funding sources, it would tap into the large pool of public funding by listing on a stock exchange. The company then needed to summon all its strength to keep shareholders happy. There are several strategies employed to maximize shareholder happiness.
Strategy 1: Growing the Revenue of the Company
There are two ways to grow a company. The first is organically. For Whole Foods shoppers, organic means the absence of pesticides and genetically modified organisms. In finance, it means internal growth. The masters of internal growth are Steve Jobs, Elon Musk and Jeff Bezos. All three plowed their excess cash back into their businesses. Jobs invented the iPhone, iPad and all the other "i" products that millions of people around the world obsess over. Musk invented the model S, X and Model 3 cars that are redefining electric vehicles. Bezos invented Amazon, one of the biggest, best and greatest companies in the world.
The second way to grow is through acquisitions. The two are not mutually exclusive. Great entrepreneurs combine the two. Bezos bought Whole Food to take on Wal-Mart. Musk bought Solar City so customers could charge their cars off the tiles on their roofs. Some CEOs make smart acquisitions while others succumb to the bladder syndrome. They have access to too much cash or credit and embark on a strategy of pissing it away. The bladder syndrome champion was Jack Welch. Once proclaimed as a genius, Jack is now blamed for the majority of GE's problems. The stock reached its summit of $55 in September 2000 and has been sliding down ever since. GE makes everything from lightbulbs, microwaves, and washing machines to jet engines and turbines for the running of hydroelectric plants. It also dabbles in finance and insurance. Thomas Edison is turning in his grave at the indiscriminate mismatch of acquisitions executed by Welch. You can now pick up Welch's books on Amazon for next to nothing.
Strategy 2: Share Buybacks
The world is full of cheap money and banks are throwing this money at the entities that least need it. Listed companies can borrow bucket loads of cash at 2,3 or 4 percent and there is a limit to the number of photocopiers you can buy. Companies, therefore, have started to buy back their own shares. This pushes share prices up and helped to sustain the bull market in U.S. equities that started in March 2009 and ended in February 2020 with the coronavirus pandemic.
Buybacks make sense. Firstly, it reduces the number of shareholders. This means the pool of potential complainers is reduced and less cash needs to be spent on umbrellas, pens, and keychains from China at their next investor day. Secondly, it reduces the number of shares outstanding which boosts earnings per share. If a company posts net income of $10 million on 10 million shares, that is earnings per share of $1. If the company halves the number of shares outstanding, earnings per share doubles to $2.
A Deeper and Dirtier look into why Companies Buy Back their Stocks
Some companies have too much cash. This is a happy place. It is also where streets are paved with Belgian chocolate, Rolex watches grow on trees and noisy neighbors are flogged religiously at noon. To the end of October 2019, nine non-banking companies had cash and marketable securities of more than $50 billion according to data from Bloomberg. Apple leads the pack with more than $200 billion, followed by Microsoft, Google, Samsung, General Electric, China Mobile, Toyota, Alibaba, and Facebook. Of these nine companies, only five paid a dividend: Apple, Microsoft, Samsung, GE, and China Mobile. Normally, companies with excess cash return it to their shareholders in the form of dividends. Today, however, there is a growing affinity for the buyback, because it has a direct impact on the stock price.
So what are the Benefits of Buy Backs?
Companies issue shares because they need cash to grow. The downside of this is that they are inviting strangers to take a stake in their company. If a business has a managing owner and 1,000 shareholders, there are actually 1,001 shareholders. Capitalists do not like to share. So when they reach terminal velocity and are swimming in cash, they reduce the size of the shareholder pool. Fewer people in the pool means cleaner water and more space for the top-dog on his floating lounge chair. In addition to reducing the number of shareholders, buybacks boost the share price. This is especially cunning when the stock is undervalued. Shareholders are bitching about the performance of the stock. The company swoops in like a Marvel superhero, and buys up the stock at these low levels. The stock then rerates and the shareholder's wheel out the glazed pig and tankards of beer, and throw a banquet that would make Caligula's look like a preschool birthday party. Then, when the stock is higher, the company could reissue stock at a higher level and raise even more cash than they had before.
The cost of money has boosted buybacks. After the Lehman Brothers collapse, cash became cheaper than a middle-aged hooker at 4 am on a Tuesday. Even if companies do not have large stockpiles, they can go to the credit markets and borrow at 2 percent. They buy back their shares, the stock rallies 20 percent. They then issue new stock, pay back the bonds, and kill two very large predatory birds with one stone. It's a Quick Fix for the Financial Statement Buying back stock is an easy way to make a business look more attractive to investors. If you put makeup on a pig it is still a pig. This is not true in equity markets.
Most equity investors are lazy and ignorant and cannot differentiate between a fake Chinese Rolexx and a genuine Swiss Rolex. They are ignorant of how companies slap lipstick onto their ugly numbers. By reducing the number of outstanding shares, a company's earnings per share (EPS) is automatically increased. Annual earnings are now divided by a lower number of outstanding shares. For example, a company that earns $50 million in a year with 500,000 outstanding shares has an EPS of $100. If it repurchases 100,000 of those shares, reducing its total outstanding shares to 400,000, its EPS increases to $125 without any actual increase in earnings. This is a branch of finance known as cosmetic engineering proudly sponsored by Mary Kay and Estee Lauder.
Another benefit to the company is that before a share buyback, the company will do a pretty good job in publishing their intentions. They will shout from the rooftops on every business network like CNBC, CNN Money, and Bloomberg. This will cause the short term traders to jump onto the stock, drive it up and this momentum will be continued when the company enters. This higher stock price will make the company's price-earnings (PE) ratio more attractive and boost its Return on Equity. This will add eyeliner and lipstick to the little porker.
What is really happening?
Everything seems hunky-dory. If however, you look below the surface, you will see that the market is suffering from a nervous disorder, chronic irritability, and moderate depression. The average investor does not see this because they are too infatuated with the sexy pigs in the miniskirts and pumps. Let's look at the Dow Jones Industrial Average. It is an archaic price-weighted index but only has thirty stocks and therefore easier to work with. I did some behind-the-matchbook calculations.
Step 1: I calculated how the number of shares outstanding had changed in these companies over the ten years from the time of the financial crash in 2008/2009. I assumed if the number of shares declined, the company had bought back stock and if the number of shares had increased, they had issued stock. Of the thirty companies, only two (Verizon and Merck) had issued shares. The other 28 had embarked on massive share buybacks. The most aggressive on a percentage basis was Travelers who registered a 55 percent decline in their shares outstanding, followed by Visa with 42 percent and Home Depot with 35 percent. Apple, IBM, and Costco had all bought back one-third of their own shares.
Step 2: To get an idea of the size of these buybacks, I then calculated the average market capitalization of each stock over that period. The dollar value of these buybacks was slightly south of 1 trillion dollars. That is one with twelve zeros. Where did this obscene amount of money come from? Everyone knows that Apple is sitting on a brick shithouse full of cash. The only problem is that most of this cash is in Dublin - waking up late and spending its time drinking Guinness at the Temple Bar and hitting on girls who look like Courtney Cox. My agricultural calculations indicate Apple bought back around $160 billion in stock. I then charted the evolution of its debt over that period. In 2008, it had $15 billion in total liabilities. By 2019, this number had mushroomed to $250 billion. Of that $250 billion, a total of $101 billion was borrowed in the bond market via 70 issuances with a weighted average maturity of 9 years and an average coupon of 2.7 percent.
Why should you care about Buybacks?
Granny used to teach you that money does not grow on trees. With low and negative interest rates in the U.S., the Eurozone, and Japan, it looks like granny could have been mistaken. Imagine a world in which money is free. Banks and investors are throwing cheap money at corporations. Siemens, the German engineering and manufacturing giant, had borrowings of 7.6 billion euros with a weighted average coupon of 0.38 percent and a weighted average maturity of 4.25 years. This is according to data from Bloomberg as of November 2019. Siemens would need to pay 29 million euros per year in interest to service this debt. In 2018, Siemens generated revenue of 83 billion euros. Assuming 250 business days in a year, that works out to 332 million euros per day. Assume, like most efficient Germans, they work 8 hours a day. That means they make approximately 41.5 million per hour. They can cover the annual cost of this money in 42 minutes. That, granny, is tree-money. So what are companies doing with all this dinero? A large chunk is being used by companies to buy back their own shares. The obvious question is whether this is dumb money? Not exactly, because who knows a company better than that very same company? That, however, is not the point. This massive flood of corporate money into the market creates a bull market that is not based on fundamentals. Stock buybacks boost stock prices, lifts the stock market and sucks more dumb money into the market. This helps to distort valuations. At Rebel Finance, we love market distortions.
Conclusion
You either love it or hate it. It is impossible to ignore it. It was romanticized in movies like "Wall Street" and "Barbarians at the Gate". It was vilified in the "Wolf of Wall Street" and "Rogue Trader". It is the conflux of animal spirits. It is the embodiment of capitalism. It brings out the best and worst human emotions. It is the stock market and for many, it is one giant casino. Studies have shown that the average human spends more time researching the purchase of a washing machine than a stock. For these "investors", there is no difference between buying Amazon stock and shooting craps. Also, humans are horrible investors - they are led by their emotions and are easily influenced.
The potential to make and lose large quantities of money causes greed, fear, panic, and anxiety to bubble to the surface in a stressful cauldron. Add to this the fact that most investors are like sheep and easily lead astray, and you create a fertile breeding ground for exploitation. In 2016, one of the greatest traders ever, the Hungarian George Soros, was interviewed on CNBC. He was strongly advising the audience to buy gold. Two weeks later, it was revealed in a regulatory filing, that Soros's flagship fund was selling gold. Was this a case of dishonesty or foxlike cunning? Economics 101 teaches that a market is a place where buyers and sellers interact. If you are a seller, you need to find a buyer. Soros was doing exactly that – he was a seller and was inviting the world to take the other side of his trade. So how do we approach this market? Dominating the stock market is not difficult. All you need to do is disconnect your emotions and follow the stupid money. Everyone tells you to follow the “smart money.” That is horrible advice. You should follow the dumb money. Why compete with the smart guys when you can compete with the dumb asses? The equity market is the dumbest market in town.
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