It has been one heck of a market rally for major indices - five-and-a-half years long thus far. Yet, miraculously, the global economy is still fragile, unemployment is well above historical norms and sovereign debt levels, particularly in the Western World, are raging out of control. And, despite the record highs for stock prices, much of Main Street has completely missed out on the rally. As a consequence, the income gap continues to grow.
 | | 5 Year Chart for Dow Jones |
Today we are going to explain one of the main drivers behind record high equity prices, which is fueled by the Fed's cheap money policies. But be warned, learning about what's been going on may make you rather uncomfortable about the future of the overall economy.
Two questions before we start:
Do you think borrowing money to buy stocks increases risk?
Do you think borrowing money to buy stocks near all-time highs increases risk even further?
According to Paradarch Advisors, nearly 87% of the $3.4 trillion in debt taken on by non financial corporations since 2009 has been used by companies to pay dividends or buyback stock.
source: washingtonpost.com
Most retail investors assume that dividend payouts are a way for corporations to profit share with shareholders. Makes sense and seems the responsible and logical thing to do. However, it is common nowadays for companies to borrow money to pay dividends. That on its own seems backwards, doesn't it? And most investors are unaware of the fact that when some companies engage in a share repurchase program (buy back their own stock) they are often doing so with borrowed money... this behavior, by some of the largest companies in America, has helped drive the stock market to all-time highs; but in the process it has created systemic risk.
"In the third quarter of 2013, share repurchases totaled $128.2 billion, the highest level since Q4 2007. For the twelve months ended in September 2013, aggregate share repurchases were an astounding $445.3 billion; the only twelve-month period greater than that total was the calendar year of 2007 and its $589 billion."
source: counterpunch.org
2014 has seen the trend continue, and could be an all-time record year for share repurchases. In Q1 of 2014, $138.5 billion in share buybacks took place, the second highest quarter ever, according to Fox Business. Keep in mind, the Dow is at an all-time high. And we know for a fact that many S&P 500 firms participating in these share repurchase programs are doing so, at least in part, with borrowed money. This is a direct example of how low interest rates are propping up equity prices. If credit was expensive, this most certainly would not be happening at such a feverish pace.
Excessive leverage and a herd mentality by corporations has always been, and will continue to be, a bellwether to market corrections, and even crashes if debt loads are out of control as they were in 2008.
There's an interesting correlation between share repurchase programs hitting record levels and the previous two major stock market crashes as well.
In 1998, US corporations announced a record-setting (at the time) $220 billion in share buyback programs, according to Securities Data Co., Newark, New Jersey. Less than two years later, the dot-com bubble burst in March, 2000. The Nasdaq has yet to recover to pre-bubble levels. In 2007, share buybacks by corporations hit an all-time record of roughly $589 billion. Less than one year later, the market imploded. Once again, we are inching closer to a new all-time record for share buybacks...
Stock market crashes are virtually always connected to massive leverage and/or exuberance...
Corporate share repurchase programs have only been allowed in the US since 1982. And since that time, the use of such programs by S&P 500 companies has steadily increased.
Now, we're not saying share buyback programs are bad - not by any stretch. They can serve an important purpose in minimizing dilution. However, when repurchasing shares, near all-time highs for that matter, with borrowed money, the risk is heightened tremendously. It's an unnecessary risk. And when one market leader announces a significant share buyback program, others will follow; monkey see, monkey do. This creates major systemic risk if interest rates were to rise as little as 2%, or if a significant stock market correction were to occur.
The Lemming Mentality
Since share price performance seems to be the only metric investors, fund managers and boards care about these days, there is tremendous pressure on executives to outperform; or at the very least, meet their competitor's performance. So when one of the largest companies in the world decides to borrow money to buy back its own stock, the competitors underneath it often receive pressure to follow suit. If they don't, then they risk a falling stock price, a general loss of interest from funds and strategic investors; and executives could, and likely will, be fired.
When a company like Apple borrows roughly $30 billion to increase dividends and buyback its own stock, what will its competitors do? The answer is obvious.
If a company buys back its own stock it decreases the amount of shares outstanding. And when the float decreases, earnings per share (EPS) increases (the all mighty and most respected stat on Wall Street). This adds value for current shareholders, and propels investor interest in the company, often resulting in higher stock prices. The same goes for dividends. The higher the yield, the more attractive the company is to own. However, risk to the company's longevity and growth can increase if it uses borrowed funds to pay dividends or buyback stock.
Even more important, systemic risk increases because of all the copycats who try and compete. The culture that this type of activity creates is a dangerous one. And it would not be possible if not for the cheap money environment the Fed has created...
An Example
Given Apple's current share buyback and dividend program, which has increased in value to roughly $130 billion since 2012, Samsung, its biggest rival, is under tremendous pressure from funds and shareholders to partake in a buyback program of its own.
The Wall Street Journal reported last month that investors "have been pushing Samsung executives to increase dividends and restart share buybacks in private meetings."
The article continued "Returning capital to shareholders will result in a better valuation," David Russekoff, Perry Capital's chief investment officer said, declining to disclose the company's holdings. "That's what we're trying to communicate to them."
"As activist investors including David Einhorn and Carl Icahn mounted a public campaign last year, Apple raised its dividend and buyback and later executed a seven-for-one stock split.
Its stock has soared 66% in the past year even amid unchanged Apple earnings expectations, while Samsung's shares have remained flat."
source: online.wsj.com
Samsung's CEO raised valid concerns about such activity and advised caution against rushing into buyback programs and dividend hikes. Borrowed money or not, spending capital on buybacks and dividends can compromise sustainability in growth and result in missed opportunity and lack of innovation. While it may be great for short-term investors, these programs can be detrimental to long-term growth, and even put some companies in dire financial positions if the economy slows or interest rates rise.
Why Borrow?
You may be wondering why a company with mountains of cash, such as Apple, would borrow money to, at least in part, help finance its massive dividend and share buyback programs. It does this for two reasons. One, credit is cheap and two, much of Apple's cash on hand is offshore. It is estimated by analysts that Apple only has about $40 to $50 billion of its approximate $130 billion in cash on American soil.
If the company was to use its treasury to pay dividends and buy back stock it would have to repatriate much of the capital needed, which would then be subject to a higher corporate tax rate. Instead, the company borrows billions to finance much of the plan. It's not some shady agenda on Apple's part, but merely the most cost efficient way of keeping its powerful investors happy. However, unintentionally, it creates systemic risk given the pressure it puts on Apple's competitors.
After all, aside from the Samsungs and Googles of the world, most companies don't have a hundred billion dollars sitting in their treasuries. As such, in order to remain competitive and attractive to investors, other companies of lesser stature are inclined to borrow money to pay dividends and conduct share buybacks of their own.
This activity is fueling two bubbles at once: A credit bubble and a stock market bubble.
Steven Pearlstein of the Washington Post reported that,
"And make no mistake: In the short term, the buyback strategy works. Stock buybacks in the S&P 500 transformed what would have been an 80 percent rebound from the lows of 2009 into a 178 percent increase, according to a study by Fortuna Advisors."
source: washingtonpost.com
Zero Hedge reported that the most aggressive companies buying back their own stock are Boeing, Caterpillar, Cisco, 3M, Microsoft, Safeway and Travelers. These companies all bought back near 10% of their entire float.
Just this past week it was announced that Cisco will be laying off roughly 5% of its workforce. However, "CSCO also announced it had just spent $1.5 billion in the quarter to repurchase 61 million shares of its stock, bringing the total for 2014 to $9.5 billion (including $3.8 billion in dividends)" according to Zero Hedge.
source: zerohedge.com
Cisco has spent roughly $79 billion on share buybacks since 1999, according to Mark Rogowsky, a contributor at Forbes.
In Q1 of this year, IBM bought back roughly $8 billion of its own stock. Most of the funds used to pay for the buyback were borrowed. Steven Pearlstein of the Washington Post stated that the company now has the highest debt-to-equity ratio in its history. Zero Hedge commented that IBM will "postpone the day of income statement reckoning by unleashing record amounts of debt on what was once upon a time a pristine balance sheet."
source: washingtonpost.com
IBM is one of the greatest serial share buyback companies in America. According to the Wall Street Journal, *since 1993 IBM has cut its outstanding shares roughly in half through buybacks. Obviously, this activity has the potential to have a profound impact on the company's EPS...
*source: online.wsj.com
In respect to IBM, Bloomberg reported that, "With sales dropping, the company is counting on the buyback to help reach its goal of $20 in adjusted earnings a share by 2015, up from $15.25 last year."
source: bloomberg.com
In respect to Costco, the massive retailer, Fortune reported near the beginning of last year that,
"...the warehouse merchant said that it was paying out a special dividend of roughly $3 billion to shareholders, or $7 per share..."
"To pay for the dividend, Costco is going to sell $3.5 billion in debt. It will buy back some shares as well."
The article continued "The deal will more than triple Costco's long-term debt."
source: fortune.com/2012/12/03/costcos-odd-fiscal-cliff-dividend-deal/
"Buying back shares is so in vogue that 80 percent of the S&P 500 did it over the past year [2013], according to Kiplinger."
source: washingtonpost.com
Systemic Risk
We've highlighted some of the major American companies borrowing to pay dividends and buyback stock. If things got volatile in the economy, many of these firms would be forced to lay off thousands of workers, but they likely could survive even a severe recession. However, these large firms have created a culture that forces mid-tier companies into heavy borrowing in order to buyback stock or pay dividends. It's the only way they can compete for investors' money. As such, if the economy hit a severe recession, many mid-tiers or those deemed not 'too big to fail' would cease to exist - thanks in large part to the leverage taken on to compete in the public markets.
Example of a Casualty
KB Toys was founded in 1922 and was, at one point, the second largest toy manufacturer in North America. It had more than 600 stores in the US at one point. In 2002, KB Toys issued roughly a $120 million dividend payout, largely on borrowed funds and at the behest of pressure from some of its investors. By 2005, KB Toys filed for bankruptcy...
Bloomberg reported "Companies owned by private-equity firms are borrowing money to pay dividends like it's 2007, adding to concern among regulators that excesses are emerging in the riskier parts of the debt markets."
source: bloomberg.com
 Because a corporation is not an individual, when it borrows and can't pay the money back, no person is on the hook for the cash. Therein lies the moral hazard. Executives are pressured into buyback programs, to increase EPS, or to pay out dividends, often times with borrowed money involved. It's the culture on Wall Street right now, and it's dangerous. Couple that pressure from the distorted culture on Wall Street with the ridiculously cheap credit available and we could be on the precipice of a disaster for the equity markets and global economy. At the very least, these revelations shine light on what a real asset is...
The inflated equity prices are inevitably going to turn investors attention back to hard assets in the near future.
Side note: Given how much buyback programs have contributed to volume and the rebound in stock prices since 2009, coupled with the fact that high frequency trading has been estimated to account for between 60% and 80% of total daily volume in US markets, it's clear how the retail investor has, for the most part, missed out on this five-and-a-half year bull market.
All the best with your investments,
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