Company stock purchasing Signals potential Turbulence Ahead…

At a time when the Federal Reserve has already tapered asset purchases from $85 billion per month to $45 billion, momentum effects are fading out and investors are seeking the safety offered by bonds. The stock market has avoided the worst so far, with the Dow still up 0.6% YTD, but it is undeniable that the big momentum effects emanating from the multi-trillion package the Federal Reserve threw at the market are now gone and we are approaching a turning point.

The massive quantitative easing package combined with the herd mentality that retail investors (and institutional ones to some extent) generally always display has helped shares rise for over 5 years now and resulted in the strong momentum effects we have been witnessing too. But, as time goes on, share valuations depart from intrinsic value and the buying appetite eventually dimishes… At such a point, contrarian strategies become fruitful as the market gets reacquainted with gravity and traditional valuation metrics are restored.

At a time when US shares are trading much higher than before the 2007 crisis began and with trading volumes decreasing, one could ask: why are shares still holding tight? Who is still buying? Is it the retail investors?

One of the biggest distortions caused by quantitative easing relates to wealth redistribution. Instead of creating wealth – or at least the conditions for it to be created – it has just redistributed it. Those who think low interest rates and free money lead to more investment and full employment could not be further from the truth. As we have mentioned before here at SBM, corporate America is not using the “free money” for investment purposes. CEOs are not investing in new projects or expanding the existing ones, but rather using the money to pay massive dividends to investors, in the form of share repurchases. With almost all cash rich US companies doing the same, the buying pressure has been high and has contributed in large part to sustained high equity prices. Companies in the S&P 500 index have been the biggest buyers of shares during the last few quarters, in particular the last quarter. If the trend continues, this year will be a record one. During the first quarter companies in the S&P 500 index in fact purchased a cumulative $160 billion of their own stock.

While ostensibly there’s nothing bad with share repurchases, when it is done on a large scale, at growing rates, and during a prolonged period, the alarm bells should start to ring. Companies are here to make profits. They make profits when they invest and produce. They sometimes buy shares to signal to the market that the stock is undervalued.  However, when they begin to labour the point, this must be because they don’t have anything better to do with their money and that is because they don’t believe demand will be strong enough in the future to justify investment to expand capacity. Ergo, CEOs are predicting a slow-growth economy for the foreseeable future.

Unfortunately, elevated buyback levels are not only an alarm bell regarding future prospects but also for CEO malpractices. Repurchases are a way of misguiding investors about company profitability. At a time when companies aren’t able to organically expand their earnings, they buyback shares to reduce the number of shares outstanding. This way, there’s less earnings to distribute among investors but fewer investors among whom to distribute the earnings. That is the main reason why many companies can still surprise and beat earnings estimates.

Of course, as a result of so much money being spent on buybacks, cash reserves are decreasing and debt is increasing. Companies are replacing shares by debt and increasing leverage once again.

The implication of all this is that we must be cautious of the future, and in particular of companies that are aggressive “repurchasers”. These are the ones that aren’t expecting good opportunities for the immediate future and will face flagging demand (at least as foreseen by their CEOs). These companies don’t expect any significant demand increase for their products, they don’t have any good investment ideas in their pipeline, and they are trying hard to keep EPS above “normal” levels. Can you guess what the top of the list is? Yes, that isn’t a tough question! Of course Apple is leading it.

Since the death of Steve Jobs, Apple has been struggling to develop anything new, as it seems the ideas sadly died with him. Apple spent a total of $16 billion repurchasing its own shares during the first quarter, which is 10% of total S&P 500 repurchases. IBM holds the second spot with $8 billion. Exxon Mobil is third with $4 billion and FedEx is fourth with around $2.5 billion. If these CEO’s expect a weak future, why would we bet on anything better?