Why Did Corporations “Waste their Capital”?

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Hi Roger,
I’ve got a basic question about how the post-2008 “economic fragility” you mention in your May 13 briefing relates to the “wasted” leveraged buybacks Raoul Pal talks about in the May 15th briefing:
QUESTION:
Was the consumer too weak to support robust growth post-2008 and is that why corporations “wasted” their capital by buying back shares with borrowed money?
Background:
———————————————————————————————
 
(21:06) RAOUL PAL: So I’ve talked about this in the doom loop on Real Vision before as part of a whole thesis of mine, which is based around the maximum amounts of corporate debt in US histories now. That debt was driven by corporations basically wasting their own capital to buy back their shares, without putting it to more effective use and efficient and productive use. 
MY QUESTION:
What accounts for the use of buybacks rather than productive investments?
Why didn’t corporations use their capital for productive purposes?
(My suspicion is that consumers were too maxed out to afford substantially more consumption, so why invest in increased capacity?)
——————————————————————————————–
Here’s what you said about two days earlier about “economic fragility”:
06:57
ROGER HIRST: … That’s going to be what’s happening, and so it becomes all about balance sheets. It’s corporate balance sheets, it’s household balance sheets and it’s government balance sheets. Have they been impaired?07:16
I think the key to all of this is that there was the underlying fragility of the global economy prior to this. This was not a strong economy, and I’m not just talking about the last year where we saw some numbers deteriorate. I’m talking about the world post-crisis 2008 where there’s never proper recovery. We had anemic growth. We had the illusion of health because the equity market in particular and in particular in the US, rose to these astonishing heights, but overall, a lot of people, median wages took a long time– real median wages in the US took a long time to get back to the 2007 levels. I think it was ’15, ’16– 2015 and ‘16.07:52
The man on the street, the woman on the street didn’t see a pickup in wages for a long time. A lot of people are living paycheck to paycheck, 46% of Americans have less than $1000 of cash in their savings account.
——————————————————————————————–
MY QUESTION:
Did corporations think that their consumers were too maxed out to generate further growth in 2009 – 2020?
In other words, did they view their customer’s balance sheets and income growth potential so dimly post-2008 that they decided productive investments in additional capacity, etc were too risky and that it would be safer to take advantage of low-interest rates to use debt to buy back their own stock?
I understand interest rates were low and executives were looking to meet their bonus targets, but why did that entail so many share buybacks rather than productive investments?
 
SPELLING OUT THE IMPLICATIONS:
I figure the pros may already understand that this has taken place, but as a “citizen investor” I’d appreciate hearing this spelled out more explicitly.
If corporations were reluctant to invest before, what does that say going forward?

Why did corporations borrow to buy back their stock rather than invest it for productive purposes?

by

Investment

Question:

Why do you think many large corporations chose to borrow money to buy back their stocks rather than invest it for productive purposes between 2012 and 2020? (pre-Covid-19)1 2 3

* (this is US-centric, but I’d be interested in a global perspective too)

 

Some Possibilities:

    1. Too much regulation to make investment profitable?
    2. Too high taxes?
    3. Too much political uncertainty? (2012-2020)
    4. Customers already have what they need?  Customers don’t want to buy more?
    5. Customers too maxed out.  Customers can’t afford to buy more?4
    6. Company has a mature market position- there is little room to grow. 5 Better to “mortgage their credit rating”67 and redirect the money to other companies with better opportunities?
    7. Outsourcing to foreign firms removes need to build own manufacturing capacity?89
    8. Executives don’t want to take a risk on innovation and growth when low-interest rates make significant debt-driven share price increase a low-risk choice?
      • Low interest rates tell you why borrowing is attractive but not why innovation and growth are less attractive than stock buybacks.

 

Vote in a Twitter Poll

Twitter  has a maximum of 4 options:

I’m interested in other possibilities too.  You can reply to this on twitter /reddit.

Obviously, the low interest rates were key in enticing companies to borrow. The question is why they didn’t invest more for productive purposes rather than buying back their stock.  I obviously haven’t investigated this fully, that’s part of the reason why I ask the question.

My hypothesis is that the biggest factor behind buybacks was that companies didn’t believe that consumers in the US could afford to increase their consumption level.

US Wages have been stagnant for decades and 40% of American’s can’t afford a $400 emergency, so who would want to invest heavily into selling to such a customer.

That doesn’t answer the question of global demand.  Further work will have to be done to research consumption potential and indebtedness in other countries.

Post your comments on twitter/reddit.

Read Background Info:

 

1) The Story of the Seven Dwarfs Mining Inc:

How the Coronavirus Masked the Corporate Debt Bubble

Seven Dwarfs at Table

Disney’s Seven Dwarfs team up to tell the story of corporate America (2012-2020)

 

2) Was Pre-Coronavirus Stock Market a Bubble Inflated by “Financial Engineering”? (2014-2020)

Wall Street Bubbles Cartoon, 1901
Read More

 

Follow-up:

If corporations were unwilling to invest then, what make you think that they will be willing to invest post-Covid?

 

by Tim Langeman

 

Footnotes:

  1. From 2014 through the start of 2018, corporate profits declined. The one-time spike in profits after 2018 was due to the corporate tax cut. Essentially, without the corporate tax cut, the corporate sector has seen virtually no profit growth since 2014.↩

  2. “It’s a fair critique of corporate earnings to say that earnings “growth” in 2019 is a bit deceptive as the value is being financially engineered by corporate finance departments, not organic, core-business growth,” wrote Tom Essaye, president of the Sevens Report, in a Wednesday note to clients. “Companies aren’t making any more money than in 2018—they just have a smaller share count to spread the money over, so EPS are rising.”↩

  3. Indeed, more than half of all buybacks are now funded by debt. And while there’s an argument that repurchases benefit share prices and investors, at least in the short run, it’s questionable whether highly indebted companies should be doing this. Sort of like mortgaging your house to the hilt, then using it to throw a lavish party.↩

  4. 40% of Americans can not afford a $400 emergency.↩

  5. Coca-cola has a harder time expanding market share than a startup company.↩

  6. NPR’s “Planet Money” show had an excellent episode explaining Why so Few Companies have a Triple-A rating.↩

  7. Many companies have had their credit rating downgraded to BBB – the lowest investment grade above “junk”.  50% of all Investment-grade debt is rated BBB.↩

  8. Why build manufacturing capacity yourself when you can contract with Foxconn/etc and have them build manufacturing capacity?↩

  9. This may relate to why they don’t invest, but it doesn’t answer why they choose to borrow to buy back their stock.↩

The Story of the Seven Dwarfs Mining Inc:
How the Coronavirus Masked the Corporate Debt Bubble

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Seven Dwarfs at Table
Disney’s Seven Dwarfs team up to tell the story of corporate America (2012-2020)

by Tim Langeman 2233 words (17 min read)

Introduction

Before the coronavirus, a false narrative arose that the economy was healthy, as measured by:

  • growth in the stock market and a
  • reduction in the unemployment rate 

when in fact the recovery from the 2008 financial crisis was weak and the facade of strength was masked by low-interest rates which enabled governments, corporations, and individuals to achieve the illusion of prosperity through increased borrowing.1

Wall Street Bubbles Cartoon, 1901
1901 Cartoon depicting JP Morgan as Bull

But there is more to the economy than the stock market and unemployment rate. The bond market is larger and “smarter” than the stock market. When assessing the pre-coronavirus economy, one must also take into account the stagnant profits2 corporations disguised by borrowing in the bond market to fund purchases of their own stock, artificially inflating the stock market.

Like an Injured Athlete taking Pain Killers

The US economy was like a professional football player who had been “playing hurt” for many years.

Brandon Scherff Injury: Falcons at Redskins 11/04/18
Brandon Scherff Injury, Nov 4, 2018
Keith Allison Sports Photos (CC BY-SA 2.0)

The economy used debt like the football player uses pain killers.  The debt masked the economy’s problems3 and allow it to perform at a higher level than otherwise would have been possible had pain-killers not dampened the brain’s ability to perceive reality.  But unfortunately, an economy is not like an athlete in that it can’t retire at the end of a 15-year career.

Featuring: The Seven Dwarfs

The story I’m about to tell is intended to illustrate how corporations borrowed money and then used that money to buy their own stock, inflating the stock price.4  In finance jargon, this is called “leveraged stock buybacks”.5  Corporations have used stock buybacks as a major strategy to boost their share price but many corporations didn’t have enough profits to buy back their stock because the overall level of (pre-tax) corporate profits has been flat since 2012.6.  While some companies may have been able to legitimately afford to buy their own stock with real profits, over 50% of those buybacks were done using borrowed money.

In fact, if you look at who had been the buyer of most of the stock purchases in 2018 and 2019, it had mostly been the companies themselves purchasing their own stock, not pension funds, individuals, or hedge funds.

I illustrate how this market manipulation works using a fairy tale featuring the seven dwarfs and their mining company “7 Dwarfs Mining, Inc.” Early in the story, the dwarfs seemed to have discovered an easy way of making money until an unforeseen emergency struck and disrupted their carefully laid plans.

It is commonly known that emergencies reveal.

This story illustrates what emergencies can conceal.

The Founding Members:

Grumpy Dwarf
Grumpy Dwarf

Once upon a time, the 7 Dwarfs Mining company was founded in a small Forest Kingdom town by Seven dwarfs:7

  1. Dopey,
  2. Doc,
  3. Bashful,
  4. Happy,
  5. Grumpy,
  6. Sleepy, and
  7. Sneezy

After a number of years in business together, the mining company was valued at $7 million8 and generated $700,000 in profit per year, which they split 7 ways.9

Assets # of Shares Yearly Profit Profit per Share Debt
$7 million 7 $700,000 $100,000 $0

[Read more…]

  1. Finance-types refer to borrowing as “leverage” because, like a ‘lever’, it amplifies your effort.↩

  2. You might wonder why this Federal Reserve chart looks different than upward sloping graphs you are used to.  The first reason is that this graph uses pre-tax figures that do not include the boost that corporate tax cuts gave to the stock market.  The other reason is that this graph is based on total profits, rather than earnings per share.  In the rest of this article, you will learn how corporate debt artificially inflated earnings per share.↩

  3. The fallout from the prior 2008 financial crisis was not dealt with.  The government bailed out the system and assumed the debt.  Most Americans’ wages had stagnated and healthcare and education expenses have gone up dramatically.  In order to compensate for week customer demand, companies had begun to borrow money and buy back their own stock.  Even with a deficit of $1 trillion/year, pre-coronavirus, the economy grew at a rate of 2.1% and was projected to fall to 1.6% by 2024.↩

  4. Now with the coronavirus crisis, the federal reserve is buying some of that debt, as well as allowing corporations to issue additional debt at artificial prices.↩

  5. “Leveraged” is just a fancy term used to indicate that financial activity is amplified by borrowing.↩

  6. Pre-tax Corporate profits peaked in 2014 and have been roughly flat since 2012.  The perception of growth is mostly due to the additional debt (share buybacks) and the  2017 tax cuts (federal government debt).↩

  7. There are many variations of the Seven Dwarfs’ Names. I’m going with the 1937 Snow White and the Seven Dwarfs animated musical fantasy film produced by Walt Disney Productions↩

  8. The value of all the stock is equal to the value of all the company’s assets minus its liabilities.

    ( total stock shares = number of shares x share price) ↩

  9. I picked round numbers for this. If you want to help me improve the numbers, see the excel doc in the footer and edit it.↩

Was Pre-Coronavirus Stock Market a Bubble Inflated by “Financial Engineering”? (2014-2020)

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Wall Street Bubbles Cartoon, 1901

1901 Cartoon: “Wall Street bubbles – Always the same“

American financier J. P. Morgan is depicted as a bull, blowing soap bubbles for eager investors

 

What Will the “Corona Virus Correction” Reveal?

It’s only when the tide goes out that you learn who’s been swimming naked.

-Warren Buffett (1992) 1 2

 

Hypothesis:

What if Corporate Profit Growth from 2014 to 2020 was “anemic“, rather than strong?  What if many companies who had very little profit growth obscured this fact by borrowing in the bond market and using the proceeds to buy back their own stock.  Their stock prices went up, not because they had greater earnings, but because they had reduced the total number of shares.  In one dimension — earnings per share — these companies looked more attractive, but the borrowing corporations used to achieve this metric masked profit growth weakness and caused the companies’ credit ratings to decline, with many corporations falling to near “junk” status (BBB).  On the Eve of the Coronavirus Correction, corporate debt was $10 Trillion, leaving many corporations vulnerable to an unexpected stress, and ensuring that once a “match was struck”, the dry “tinder” would burn quickly.

Now that the recession has begin, governments will be faced with reduced tax revenue and, as a result, will reduce their pensions’ purchases of bonds.  Corporations have used money borrowed from these pension funds to buy back their own stock.  Now that the pension systems have (indirectly) stopped lending them this money, corporations will have to reduce the amount of their stock buybacks.  As stock buybacks decline,  the ratio of sellers to buyers will rise and the price of these stocks will come under pressure.

It is too early to say where the bottom is to this recession, but we have reason to believe the Millennials and Generation X do not have the resources to purchase the stock that Baby Boomers want to sell at prior market highs.  With Corporate profit growth unmasked and the Baby Boomer’s transition into retirement, it seems unlikely that stocks will make a quick return to their prior levels unless governments engage in massive asset inflation.

Here are my top 9 questions: #

  1. Is it true that Corporate Profits have been “Anemic” since 2014 and this has been obscured by “Financial Engineering”? 3 4

      • Eric Basmajian writes on Seeking Alpha (Feb 28, 2020):
        (click blue CiteIt.net arrows above and below quote to expand)

        Corporate America has been plagued by anemic economic growth in this economic cycle. Masked by the rising share price of roughly 500 companies, thousands of corporations that aren’t publicly traded have been forced to operate in a low-profit growth regime.

        Financial engineering has allowed publicly-traded companies to report strong earnings growth. Total corporate profits reported in the GDP report is a far more accurate, albeit delayed, data source on the real (non-adjusted) profits generated by the corporate sector.

        From 2014 through the start of 2018, corporate profits declined. The one-time spike in profits after 2018 was due to the corporate tax cut. Essentially, without the corporate tax cut, the corporate sector has seen virtually no profit growth since 2014.

        This assessment might seem “off” if you’re used to charts like this:
        Chart 1: from JPMorgan (page 7):
        S&P Earnings per share (JPMorgan)

    But note that the S&P Earnings per share are heavily influenced by the share count reduction caused by buybacks.

  2. Is it true that Corporations have been the dominant buyer of their own stocks in 2018 and 2019?

[Read more…]

  1. New York Times columnist James B. Stewart cited Buffett’s quote from a 1992 letter to shareholders. Stewart describes leveraged loans as a potential problem areas to watch: (March 10, 2020)

    Leveraged loans, which are private loans to already heavily indebted borrowers, could now emerge as the mortgage-backed securities and collateralized debt obligations of the financial crisis.

    ↩

  2. Warren Buffet repeated this “swimming naked” quote in his Feb 2008 letter to shareholders. ↩

  3. I recognize there are other factors.  Performance has been obscured largely by a combination of:

    1. Financial Engineering,
    2. Corporate Tax Cuts, and
    3. Loose Federal Reserve Monetary Policy
    ↩

  4. It is also possible that tax avoidance could result in under-reporting of profits. (Source: Wall Street Journal: Dec 19 2019)↩

  5. Note: this is not to say that there are not companies that have shown growth, but that the overall trend is towards stagnation (or a “plateau” in profits), while the S&P 500 rose from 1259 on Jan 1 2012 to 3230 on Jan 1 2020, an increase of 156%!↩