Corporate Focus on the Share Price or the Business?

By Ted Baumann, Offshore and Asset Protection Editor, The Sovereign Investor:

We’ve been hearing a lot lately about the future of the U.S. stock market. With business-friendly Republicans in charge of both the Senate and the House, the story goes, we should expect to see good returns across the board as American capitalists flex their muscles and the economy rebounds.

Perhaps. But as my colleague Jeff Opdyke has pointed out, this is by no means a given. Savvy investors still need to look carefully at specific industries and firms rather than adopt a general attitude toward all U.S. stocks, bull or bear.

I wholeheartedly agree with Jeff. My specific angle on this, however, is informed by my careful monitoring of the “political economy” side of U.S. markets. That side reveals some interesting facts … facts that you’ll want to take into account when making your own investment decisions.

The Big “If”: Focus on the Business or the Share Price

In the long-term, the price of any given stock should reflect the time value of its expected future earnings. But in the short term, stock prices go up and down for a variety of reasons, and are often more expensive than you might expect given the company’s actual performance in the real economy.

In fact, the shorter a stock investor’s time horizon, the less actual real-economy performance — making and selling stuff people want, at a profit — really matters. If you’re in and out fast, you can make money just by stock arbitrage.

Smart stock market players know that, and corporations that work to please them know it, too.

Now, one would expect that the operators of a publicly-held corporation would be interested in more than just arbitrage and focus more on, say, the operational health of their business and its position in its market. Is it making stuff people want to buy? Is it doing so efficiently? Is it on track to expand market share and earnings per share over the long term?

The problem is, one would be expecting incorrectly in the case of many American firms.

Fiddling the Figures: Stock Market Manipulation

Take IBM, for example. For years now, its earnings per share have increased steadily, even though its revenues have remained flat since 2008. It achieved this magical result by buying boatloads of its own shares to drive up the price. For example, in the first six months of 2014, IBM spent $12 billion on its own shares. It has spent $108 billion on share buybacks since 2000.

This made shareholders happy, the more so because IBM also paid them hefty dividends during the same period. It also made IBM executives like CEO Virginia M. Rometty very happy, since a large part of their compensation is in the form of stock options: The higher the share price, the more they make.

At one level, so what? After all, reducing the pool of outstanding shares should drive up the intrinsic value of the remainder. The problem is that IBM, like many American firms, financed its share buybacks not out of retained earnings, but with debt — the cheap money sloshing around the U.S. economy courtesy of the Federal Reserve’s QE programs.

In effect, what IBM has been doing is liquidating itself — distributing the actual underlying value of the firm to shareholders (via dividends) and to executives (via options), and replacing it with debt. It’s precisely what many American households did prior to the 2008 crash, by borrowing against the value of their homes and using it to splurge on vacations, boats and RVs.

And just as many observers have taken American households to task for failing to convert their household equity into increased earnings capacity — say by investing home equity loans into education or small business — so IBM and other U.S. firms stand accused of selling the family silver and failing to invest it in growing market share, developing new products, or improving production efficiency for existing ones … the “fundamentals” that drive future performance, and thus share price performance.

Take the Money and Run

You’re going to be hearing a lot about U.S. investment opportunities in the coming weeks and months. As always, you should invest where you think you will get the best return given your time frames.

But I would advise you to stop and look carefully at what’s driving the value of any given stock before you buy. Is it fundamentals, or financial engineering? After all, Warren Buffett, who bet big on IBM, lost a boatload when IBM’s third quarter results came out in October, driving down the share price to below what he’d paid for it on average, over the previous 10 years.

There are many good U.S. firms worth owning. There are many more overseas, in markets driven by fundamentals, like China, Burma and Panama. Be smart — and above all, caveat emptor. By Ted Baumann, The Sovereign Investor

And IBM’s problems are not unique among America’s big old tech companies, where job cut announcements have doubled from a year ago to reach the worst level since crisis-year 2009. Read… Layoffs Explode In America’s Big Old Tech Companies.

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