Stock Buybacks With Cheap Fed Money

Fewer shares = more earnings per share = lower (better) P/E ratios. There are three key ways that companies can boost earnings per share (EPS) to show earnings growth, fueling the stock market and attracting more small investors to buy and/or hold shares.

  • Grow revenue — Increasing top line revenue leads to increased earnings and increased earnings per share.
  • Engage in cost reduction measures — This allows more of their top line revenue to pass through to earnings.
  • Buy back shares — This is a popular method employed by today’s corporations, simply buying back their own shares. Fewer outstanding shares = more value per share. Good for companies and good for investors. Right? Not so fast. According to Data from TrimTabs Investment Research, corporate buybacks are at record levels today. It’s a trend that’s been in place for many years, and it may be playing a strong role in driving today’s market higher. How do you buy back shares? Use excess profits and/or borrow cheap money.

Just over the past eighteen months, American firms have bought back more than $600 billion of their own shares, close to a record amount. From Apple to Walmart to IBM to Home Depot to Exxon, the most profitable and prominent companies have big buy-back schemes. IBM spends twice as much on share repurchases as on research and development. But, it’s not just the biggest players. The current level of U.S. corporate debt, all combined, totals about $13 trillion. The Economist has recently referred to this scheme as ‘Corporate Cocaine’, especially for companies borrowing cheap money to buy back those shares. And wait, there’s more.

In many ways, the surge in buybacks is a symptom of the rich world’s feeble growth prospects. But it could also be a source of trouble, for two main reasons. First, both short-term investors and managers have incentives that could lead them to overdo buybacks and neglect long-term investment projects.

Announcing a plan to buy back shares can prompt a sudden spike in share prices and a quick buck for the short-term investor (and employees, managers and owners!) By reducing the number of shares outstanding, buyback schemes can also artificially boost a firm’s earnings per share. This helps explain why managers whose paychecks (and stock incentives?) depend on reaching specific earnings per share targets are motivated to buy back shares. So, there you go – ‘Corporate Cocaine’.

Expensive Buyback Habit

Some firms may be borrowing too much to pay for their buyback habit. In 2013, 38% of firms paid more in buybacks than their cash flows could support – an unsustainable position. Some American multinationals with apparently ‘healthy’ global balance sheets are, in fact, dangerously lopsided. They are borrowing heavily at home to pay for buybacks while keeping cash abroad to avoid America’s high corporate tax rate. How quaint! If firms are overdoing buybacks and ignoring strategic investment, artificially propped-up share prices will eventually tumble. Investors need to pay close attention. So where is all this cheap borrowed money coming from?

Is ‘QE’ at the forefront of the minds of busy middle class Americans? Hardly. If people truly understood what the federal government was doing and how it affects them, they would revolt. (How does one ‘revolt’ these days? Remember Occupy Wall Street?) Printing so much digital money is a form of theft, plain and simple. It decreases the value of every dollar you have through inflation. You’ll hear politicians say that this isn’t true, that inflation hasn’t increased. But regardless, basic arithmetic dictates that it is indeed true. If there are more ‘fiat’ dollar bills in circulation today than yesterday, then dollar bills, by necessity, must be worth less today than yesterday. Why the term ‘fiat’? In Latin ‘fiat’ means ‘it shall be so’. Sort of a god-like decree from on high, don’t you think? $80 billion per month equals $8,000 per year for every one of America’s 120 million households. That adds up to about $1 trillion per year. Where did we hear that number before? Oh yeah, college debt! It’s indeed a wicked addictive game. Think about it. Stimulate the economy in sustainable ways or overstimulate an artificially hyped stock market. Investors have earned a lot. That’s true. But will it stick?

Quantitative Easing is open ended, which means they’ll be printing $80 billion per month until ‘they’ say it’s enough. And ‘they’ are not elected officials, and ‘they’ want you to believe that ‘they’ aren’t decreasing the value of the dollar. If you don’t have the money to buy something, you do without. If the federal government doesn’t have the money to buy something, it simply prints more digital money. Where does this money go when it leaves the Fed? It goes to a handful of primary dealers.

The point? Don’t believe the stock market. To some unquantifiable degree, it’s lying to you. Uvida will offer financial coursework that appeals to both novice and experienced investors, with topics ranging from financial planning to stock market alternatives.