Stocks and Shares

The S&P 500 is being looted by management

The biggest buyers of stocks in the S&P 500 index are the companies themselves. Prices have been driven to artificially high levels. The only winners are the management teams that are looting these companies. The losers are the companies themselves, and ultimately the other shareholders – which could mean you.

There’s a dirty little secret in the US stock market. Corporate America is paying out more cash to shareholders than it earns in profits. This means there’s nothing left to invest in business growth. It also means debt levels are going up, increasing risk.

How do I know this? Well the S&P 500 index of the largest US companies has a price-to-earnings ratio (P/E) of 22.1. Divide that into 1 and express it as a percentage and you get the earnings yield (E/P). That’s 4.5% – the earnings divided by the value of all the companies in the index.

Companies have to choose what to do with those profits. They can keep them inside the business to invest in maintenance and growth. Or they can pay them out to shareholders, as cash dividends or stock buybacks.

Stock buybacks result in fewer remaining stocks, and artificial demand for them. If the total market capitalisation of the company – the value at the current share price – stays the same, but the number of shares is reduced, then the share price goes up.

Senior managers at large companies love stock buybacks. Most of them – such as the chairmen, CEOs and CFOs – own millions of dollars worth of share options. If the share price goes up the options gain value at an even faster rate. They can then be sold for a fat profit.

So even if the company isn’t growing – in other words even if management isn’t doing its job – buybacks make the managers richer. Buybacks are a lazy shortcut to big bucks for management, even if the company isn’t doing too well.

Added together, all the companies in the S&P 500 are worth US$17.8 trillion, at current market prices. Analysis by Bloomberg, the financial news and data provider, shows that those companies are on track to spend US$590 billion a year on buybacks in 2016, at the first quarter rate.

That would be even more than the last point of peak buybacks – at the previous market top in 2007, just before the last crash. Put simply, companies are spending record amounts of cash on buybacks at precisely the wrong time (as usual): when stocks are extremely expensive.

At the same time investors have been selling out. Bank of America Merrill Lynch, which has about 8% market share of all US stock trading, tracks cumulative order flows by client type. This just means they watch who is buying and selling shares over time. Other big brokers are likely to have seen similar trends as the ones they spot.

Since 2007 private individuals and institutional investors (mainly fund managers, pension funds and insurance companies) have been big net sellers. Hedge funds have been net sellers too.

Cumulative-Flow

As these investors have sold more and more US stocks someone had to be sitting on the other side of the trade. Every seller needs a buyer. That buyer has mainly been the companies themselves, which have spent trillions of dollars in recent years.

Taking that current US$590 billion a year buyback rate, and dividing it by the market capitalisation of US$17.8 trillion, we get a buyback yield of 3.3%. Add that to the S&P 500’s dividend yield of 2.2% and the total shareholder yield is 5.5%. Sounds pretty good right?

S&P 500 companies are paying out more cash than they are generating in profits: 22% more to be precise.

Except there’s a catch. The total earnings yield is only 4.5%. This means that, taken as a whole, S&P 500 companies are paying out more cash than they are generating in profits: 22% more to be precise.

This is strange, to say the least, because average profitability is pretty good. The S&P 500 has a return on equity – which is profit as a percentage of net assets – of 12.2%. Those companies should be able to reinvest cash profits into growth and expect to make 12.2% a year on that cash reinvested, on average.

That’s much more than the long term return on US stocks since 1871, which is 9.6% including both dividends and capital gains. In other words it should be a “no brainer” to keep investing in business growth. Instead they are choosing to pay out all profits, and more, as buybacks or dividends.

One, highly charitable, interpretation is that there really are insufficient opportunities for growth. Just because today’s business, in its current form, makes a certain return doesn’t necessarily mean that new projects will do as well.

That’s unlikely. But let’s give the CEOs and CFOs the benefit of the doubt for a minute. Let’s assume it really does make sense that all profits, and more (the difference being funded with extra debt), get paid away instead of invested.

The corporate managers then have a choice. If the stock price is cheap it’s best to use buybacks. If it’s expensive then it’s best to pay dividends.

Most S&P 500 stocks are expensive, so dividends should be the clear winner. Instead America Inc. is spending US$3 on buybacks for every US$2 it spends on dividends.

The long term median P/E ratio of the S&P 500 is 14.6. Let’s assume that multiple would be “fair value”. It’s 34% below today’s index level of 2,014, which would put the S&P 500 at around 1,330.

At that level investors could expect returns consistent with past history of 9% to 10% a year (I’ve worked it out). That’s a reasonable long term return expectation – after taxes and inflation, and taking account of the risks of investing in stocks.

So if that’s what the S&P 500 is really worth, then today’s buybacks are a waste of money. The S&P 500 is trading 51% above where it should be. Put another way, American corporate management is doing the equivalent of paying US$151 to buy US$100 bills. Obviously that’s pretty stupid.

(See “The seven deadly sins of the US stock market” for the overwhelming evidence that US stocks are expensive by any measure. The market is down 3.5% since the article was written in November 2015, but the conclusion is the same.)

Are these managers mad? Unlikely. But they are incentivised to waste money in this way. Ultimately it amounts to them looting their employer to line their own pockets. Low level cogs in the corporate machinery would be fired if they were caught doing the same. But the rules are different for the bosses.

Let’s say a company has a share price of $100. And let’s say the company CEO has 100,000 share options. Each option gives him the right to buy one share for $95 at any time within the next year.

If he exercises the options right now he will spend $9.5 million to buy shares that are worth $10 million, netting a profit of $500,000.

But he’s greedy, and wants more. For that he needs the share price to go up.

The CEO can invest company cash in business expansion, but those projects may not pay off for a few years. So they won’t improve earnings or earnings per share (EPS) for a while, and won’t help the share price to rise in the short term.

So instead he takes a short cut. He spends cash that’s equivalent to $3 a share on stock buybacks, cancelling 3% of the stock and leaving 97% still trading.

Earnings haven’t grown but there are now fewer shares. If the P/E stays the same then the stock price will go up 3.1% to $103.10 ($100 divided by 97%).

Bingo!

He’s done nothing to improve the company but his stock options are suddenly worth much, much more. He can still buy $9.5 million worth of shares using the options, but now those shares are worth $10.31 million. They can be sold for a profit of $810,000, or 62% more than before doing the stock buyback.

This simple example shows why management teams that own loads of stock options will always favour buybacks over dividends, or investing in company growth. They are completely insensitive to whether the stock is expensive or cheap. They just want to drive it up so they can line their own pockets.

The rising price creates an illusion of prosperity for shareholders, even if there is none in reality and cash is being wasted. Taken as a whole, this is where the S&P 500 is today. It’s being looted by management.

That’s something to bear in mind if you still own US stocks.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.