Why are corporate insiders buying back record amounts of stock whilst bailing out of their own holdings?

After hitting single digit levels at the nadir of the financial crisis in 2009, P/E ratios in the States, and indeed in most developed markets, have been gaining traction as share prices continue to climb. The US is now valued, according to the bullish “anal”-ysts and strategists at around 17 times earnings (normalised) – a pretty rich valuation in historical terms while in contrast, earnings are now growing at much lower rates than recent years.

If we actually use the Shiller P/E ratio however, this shows a level nearer 26x and which is a whopping 55% above its historical mean held at 16.52x. Taking out the tech bubble figure, this measure is now above the 2007 market peak and is likely to be an ominous sign for stock bulls…

Even though the US economy has been recovering from its worst levels seen during the financial crisis when industrial production collapsed, all the same, it has been difficult for corporate America to improve earnings at the same pace that equity prices have been rising. With the US consumer still depressed and global unemployment at stubbornly high levels, in particular in Europe, and which is an important source of income for US corporations, it is tough to achieve decent margin improvements and sales growth. The final result while China slows, Europe remains in a stop-start recession recovery pattern and Latin America now has new woes is that earnings growth to justify these lofty valuation is likely to prove hard to come by.

Under these circumstances, just what can company managers do to improve the bottom line and lead to substantial earnings per share improvements?

In prior blogs, we have mentioned that there are essentially two ways to accomplish that goal, and one of them depends more on “the market” than on a company executive’s will. You don’t need a PhD in maths to see that in order for the markets P/E ratios to become more realistic there are 2 ways for this to occur:

1) Managers need to boost their company’s earnings. If a company is able to produce higher earnings for shareholders, then, all else held constant, P/E ratios should improve. Or,

2)  Wait for prices to decline. That has been the case many times before and will be many times in future. Shares rise so much that at a certain point there is little in the way of fundamentals to continue the expansion. The smart money sells first and prices then top with the masses finally scrambling to preserve what gains they have (read Gulf Keystone in recent months for a prime illustration of this cycle in progress). There is also the possibility of a crash. At that point, P/E ratios finally adjusts to normal levels. This adjustment is thus in the hands of “the market” as a whole rather than in management’s.

There is actually a third way for the P/E adjustment to occur. How could we forget about that? If you can’t make a cake for everyone, just divide it up more so that there is less for everyone! That’s a really great idea that managers have been practicing extensively during the last several months. How do they do this? Simple, through buying back company shares. The cake analogy is that through buying back stock when dividing earnings by a reduced number of shares, EPS improves and hence better fits in the P/E ratio. Hey presto!

If companies collectively aren’t selling their products and services at a pace that they would wish, at least they are sitting on a pile of cash after the experiences of the GFC. Even better, if they are not sitting on cash, they can get it almost for free as interest rates remain nearer zero level. With this excess liquidity window possibly being closed this year what with the QE tapering underway, managers are thinking smart through issuing bonds and using the proceeds to buyback their company shares. That of course makes investors happy as they receive a larger fraction of the company’s earnings. Buying back shares is the same as paying an incremental dividend. As The Vampire Squid stated recently – “February was the busiest month in our buyback desk’s history”.

There is however a curious issue with this phenomenon. Who do you think is one of the most active sellers back of the equity base to company management? Why, management themselves silly! They are selling their own stock back in spades to themselves and using shareholders money to further enrich them.

The data reveals that stock buybacks are at record high prices and the argument goes that company executives collectively think the future is even brighter and that their shares are undervalued. A share buyback is thus a way of transmitting confidence to the market, a way for the CEO to say he thinks his shares are trading at very low prices and hence it is worth exchanging some equity financing for debt financing.

Then just why are insiders are selling shares at a record pace at the same time? Prof Nejat Seyhun has carried out extensive research on insider selling over many years. In the process he has developed his own index to track the relative “bullishness” or “bearishness” of corporate insiders at any given point in time. His index is currently showing a bearish level. In fact, his index is showing one of the most bearish levels ever tracked, which is similar to levels recorded in 2007 and 2011 and not much above the level that preceded the Great Depression of the 1930s.

So, when we adding both circumstances together, the final result makes us scratch our heads somewhat. Why are insiders buying back shares (a bullish sign) while selling their personal holdings at the same time (a bearish sign)? They appear at the same time to be very optimistic and very pessimistic. Curious and curiouser…

The only conclusion that we can come to us that they are acting collectively as humans and capitalists do – that is preserving their own circumstances at the expense of all others. Through buying back shares in their company it is a great way to improve their own holdings’ value. With their hands on the company purse strings they can get away with this and it is a no risk business for them. For the buyers of ever more richly valued equities the words “caveat” and “emptor” spring to mind.