Fiddling the Figures

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 emptorBy 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.

Enjoy reading WOLF STREET and want to support it? You can donate. I appreciate it immensely. Click on the beer and iced-tea mug to find out how:

Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.

  5 comments for “Fiddling the Figures

  1. matt says:

    Wolf. I have no business degree. I do have common sense. Here is what I do not get. eps have been diving the past 2 years , msm ignores the facts. The only thing driving the market right now is stock buy backs.. Things are so bad in the coal Industry that Glencore is shutting its mines in Australia in December for 3 weeks with all employees getting paid. . Then you have Caesar’s Entertainment filing for Bankruptcy by January 14 that has been totally ignored by the msm. Iron Ore and coal prices have collapsed by half the past 18 months. We are having a stealth collapse of the economy around the world and yet everyone thinks we are doing fine? Commodaties excuse the spelling, are collapsing yet the market is over priced 100 pct? Anyone see the disconnect here people?

    • Petunia says:

      The stock market has been disconnected from the real economy for decades. It is only now that earnings have really dried up that it is becoming visible. The price of a share of stock in the market is based on the demand for the share, as a commodity, not the fundamentals of the company. The article is correct that these companies are now liquidating in order to pay dividends and high compensation. There should be some big defaults coming soon, after the holidays.

    • Richard Lamb says:

      Glencore executives (i.e the ones in the know) proved how smart they were with their IPO which nicely called the top of the commodities market. Financial engineering has been the main driver for many company’s share price performance and for some time. Whether that is in the direct form of a share buy-back scheme or the reduction in tax liabilities by re-locating their brass plates or their earnings to some more amenable tax regime.

      Thus a firm’s “performance” has become disconnected with that of the underlying business.

  2. Julian the Apostate says:

    “Nothing so focuses the Attention as the Sound of a Purse snapping shut.”
    Poor Richard’s Almanack

  3. Peter Smith says:

    It is imperative for the Government , the FED, and their mouthpieces,
    The MSM ,to collectively continue the phony narrative of a recovery,
    Which has been artificially created with printing money, which is holding the economy together.
    If you keep repeating the narrative year after year it becomes truth,
    According to Shrub GWBush.
    The status quo know once said narrative is sold to the masses, said
    Masses will go back to the Kardashian’s and NFL football

Comments are closed.