Goldman Sachs just completed an analysis of corporate payouts and found that dividend and stock buybacks were 103.8% of their free cash flow. Meaning that they were paying more out in cash than they had on hand! Free cash flow has dropped to – 15 %, while debt is up 8 %.
This squeeze is unprecedented, it is the worst cash flow crisis since 1980, and is unsustainable. Corporate executives have turned to extremely high borrowing levels to keep this financial merry-go-round going. While, turning to stock buybacks to hype the price of their stock and keep earnings per share high to the tune of $1.5 trillion by S & P 500 companies in the last year.
If sales and profits drop due to the trade war and consumer spending declines as it has in the last four months, corporations will default on their debt. A downward economic spiral will be triggered.
Maybe this is another reason the Fed announced a cut in interest rates and shift to an ‘inflation averaging framework’. JPMorgan recently commented to Marketwatch they believe Fed economists are shifting to a position of not worrying about inflation but instead on keeping money flowing to corporations at low interest rates possibly to zero. By keeping rates super low the Fed is enabling executives to waste profits on stock buybacks to hype their pay and stock price. We need strong companies making investments in research, development, innovation, productivity improvements and raising wages for workers. When the economy works for all then democracy is strengthened.
The financial music will stop when sales and profits decline, an already desperate cash flow position becomes untenable putting company viability in doubt. Looking out a year or two, we expect the Fed to come to the rescue after possible zero interest rates have panned out. Last March, former Fed Chair, Janet Yellen recommended that the Fed be authorized to purchase corporate stock and bonds to keep the economy going if a recession hits.
After the recent NY Times op-ed by Senators Bernie Sanders
and Chuck Schumer to require corporations share profits with workers before
stock repurchases, there has been a lot of confusion about how stock buybacks
work and their impact on the economy.
Let’s clarify how share buy backs work first.
Corporate stock is bought and sold in open markets between a buyer and seller. On any one day the share price moves up or down depending on the demand for shares between a buyer and seller. Corporate executives can manipulate the price of shares by reducing the pool of shares on any trading day, according to SEC rules up to 25 % of the daily volume and not executing a repurchase within the first 30 minutes of the open or the close. If shares are taken off the market on any one trading day, posted to the books of the company those shares are effectively taken out of the market and if demand stays the same the price goes up. Of course, the share price can go down as well, if demand drops on the repurchase day.
Stock buybacks cause misleading reports on earnings per
share. A simple example, if Gigantic HiTech
has profits of $1 million for the quarter and 1 million shares are outstanding
in the market, then the EPS is $1.00.
However, if the firm purchases 100,000 shares during the quarter and
takes them off the open market the total number of outstanding shares is
reduced to 900,000 artificially boosting EPS to $1.11 or 11 %. The company has not increased profits during
the period they have just reduced the number of shares outstanding and report
the EPS figure in non GAAP reports. GAAP
reporting requires EPS be calculated on the number of outstanding shares before
repurchase.
So, the dollars spent on stock share repurchases do not go into ‘jobs, the economy or re-invested’ the money is spent on goosing stock prices. The SEC in 1982 prior to the Safe Harbor policy that allows for stock repurchases called corporate stock repurchasing ‘stock price manipulation’. From 1982 to today the policy allowed corporations to execute market stock purchases and not be held liable in shareholder lawsuits for price manipulation. Plus, companies only had to report open market purchases each quarter voluntarily. Effectively, the SEC gave companies the green light to drive stock prices anyway they wanted. Just because time has gone buy that does not change the manipulative character of the stock repurchase practice.
How big a problem is it?
Goldman Sachs estimates that $940 billion stock repurchases were made in
2018, and they continue to forecast a similar figure for 2019. Major players in FAANG stocks repurchase
billions of dollars of shares supporting stock prices. Forbes estimates that Apple spent $100
billion in share repurchases in 2018.
CNBC calculated a year ago that Apple share prices were inflated by as
much as 20 %. Between 2015 through 2017 S & P companies spent 60 % of all
profits on stock buybacks, according to Forbes.
So, where else could they be spending the money instead of driving stock prices up and increasing the compensation of executives? On employee wages, but wage increases are not happening, interestingly since 1982 when the SEC Safe Harbor provision went into effect real wages have declined.
Source: Global Technical Analysis – 2/5/19
Real wages after inflation have continued to decline when
allocated across all persons employed. Bankrate
surveyed 1,000 workers at all income levels last year finding only 27 %
received raises. Corporations are not increasing wages even to keep up with
inflation.
What about capital expenditures are they up? No. With all the pronouncements of executives that they are investing in their companies to increase innovation and productivity they are in fact not performing, here is the analysis of business investment as percent of GDP since 1998:
Sources: The Wall Street Journal, The Daily Shot – 11/9/18
Note the declining business investment line in the chart
from 4.5 % of GDP in 1998 to 2.5 % in 2018, a 44 % reduction.
Maybe corporations are still increasing productivity anyway so they can afford to do stock repurchases? No. Productivity continues to stall. The following chart shows total factor productivity (TFP) since 1948, the long term average is the green line from 1948 to 1971 versus 1972 to today red line today, plus growth in productivity is close to zero:
Sources: San Francisco Federal Reserve, Real Investment Advice – 1/16/19
Executives have made decisions about how to allocate profits that are not increasing productivity, raising wages, hiring workers or reducing prices. Our economy and our workers are the losers while executives and the wealthy elite who own stocks profit from these short term decisions.
Next Steps:
Do executive decisions on profit allocation really affect
workers and consumers? Yes.
GM last year announced the closing of their Lordstown plant
and the layoff of 15,000 workers due to a shift in consumer buying to trucks
and misallocated investments in poor selling product lines. Yet, since 2014 GM spent $13.9 billion in
stock repurchases according to the Wolf Report.
GM could have spent that money on employee training, shifts in product development,
the phased closing of plants and phased in building of new plants and likely
would not have had to resort to massive employee layoffs.
Mylan announced 18 months ago a 584 % increase in the price
of EpiPen’s used in life – death situations to counter act food allergy
shock. At the same time Mylan executives
took care of themselves first with over $1 billion in stock repurchases to
drive stock prices up. Analysts evaluated the product cost of goods and
assembly for EpiPens and estimated it cost Mylan about $2 billion to
manufacture, so the $1 billion could have gone toward reducing the cost of the EpiPen by 50 %.
In both examples corporate executives took care of themselves first, and their employees or patients second. This profligate management of profits from customers and patients was not allowed prior to 1982. Corporate executives have a social and ethical responsibility to allocate funds in the balanced interests of the company, employees and the community
Executives are executing stock buybacks at the cost of sound financial management as well. The debt to cash ration of S & P 500 corporations is at 18 %, a lower level than at the 2008 recession. When the economy slows corporations will be squeezed between debt loads, operating costs and low cash reserves.
Sources: Wells Fargo Investment Institute, Factset – 2/14/19
Our economy continues to decline as GDP shrinks year over year, in part by trillions of dollars being wasted on stock repurchases instead of being invested in worker training, wages, capital equipment and research and development. A trillion dollars is 5.26 % of the U.S. economy shifting buy back dollars could have a huge impact. Corporate executives have magnified the problem by borrowing money at low interest rates to keep stock repurchases going even when profits lag. Today, corporate debt is 45 % of GDP at all time high inflating the economic bubble.
Sources: St. Louis Federal Reserve, Real Investment Advice – 2/21/18 (recessions in gray)
A reduction in corporate borrowing to inflate stock prices
would go a long way toward putting the economy on a more solid business
foundation. A major SEC policy shift ending stock buy backs would need to be
phased in as a percentage over several years to allow markets to adjust, yet if
we are to build an economy that works for all we need to end this misleading,
damaging and costly practice.
(Editor Note: Insight Bytes focus on key economic issues and solutions for all of us. Please right click on images to see them larger in a separate tab. Click on the Index Topic Name at the beginning of each post to see more posts on that topic on PC or Laptop.)
Image: knowledge.wharton.upenn.edu
S & P 500 corporations have been borrowing money to buyback stock and increase dividends to investors. Increasing their debt bubble could increase the probability of defaults. Research shows that defaults spike when the corporate debt to GDP ratio exceeds 44 %.
Sources: Bloomberg, S & P, The Wall Street Journal, The Daily Shot – 1/9/19
When companies take on so much debt defaults become a real possibility when sales fall, or profits are squeezed as debt payments become due. Apple recently announced that iPhone sales were falling in China and has decided to cut production of all iPhones by 10 %. Apple has plenty of cash, but their suppliers may not. Fedex in December announced plans to offer domestic employees buyouts because ‘global trade has slowed in recent months and the company expects trade to slow further.’ We can expect more reduced earnings and sales guidance beginning next week when 4th quarter reports begin coming in.
Sources: Gavekal Data/Macrobond, The Wall Street Journal, The Daily Shot – 1/9/19
When corporate debt to GDP ratios close in on 44 % or exceed that level recessions are likely to follow as the chart above shows. There is much discussion in the financial press about whether there will be a recession or not. It seems quite possible that record corporate debt combined with a likely fall off of sales in the 1st quarter of 2019 due to pull up buying by companies in the 4th quarter of 2018, will cause an economic slowdown or recession. The slowdown is made much worse by corporations overindulging in debt to finance stock buybacks and dividend distributions. Plus, turning around these companies will be more difficult as defaults spiral downward, more companies are forced to close or layoff workers. As workers are laid off they reduce spending, then reduced spending causes broad sectors of the economy to experience sales and profit declines.
Next Steps:
Where is the oversight of spendthrift management policies? Directors are likely on stock bonus plans too, so they enjoy seeing the stock price goosed by share buybacks. Where is a voice of moderation looking out for the long term viability of the company for customers, employees, shareholders and communities going to come from? We need a national dialog on how to improve corporate governance taking into account the needs of all parties represented to reign in profligate borrowing . Certainly, corporate executives did not start the trade war but they have borrowed way too much placing their firms in peril. It is management’s responsibility to look out for the interests of all effected by company success or failure.
(Editor Note: Insight Bytes focus on key economic issues and solutions for all of us, on Thursdays we spotlight in more depth Solutions to issues we have identified. Fridays we focus on how to build the Common Good. Please right click on images to see them larger in a separate tab. Click on the Index Topic Name at the beginning of each post to see more posts on that topic on PC or Laptop.)
Photo: wikipedia.org
To: CEOs – S & P – 500
From: The Progressive Ensign
Subject: Stock Buybacks Are Out of Control
Date: November 5, 2018
Congratulations, this past quarter you knocked earnings out of the park, profits were higher in particular, though revenues lower and you did well by raising stock prices to new highs in September via stock buybacks.
Source: Standard & Poors – 11/4/18
Ok, you did well on stock compensation too with soaring stock prices. You can take that trip to Cancun, buy a boat and a villa for extended stays. You have worked hard, your team has gone all out to make your companies successful, and worked harder. Remember, while you were traveling and making decisions on sales, financing, product development and marketing they are actually designing, building, shipping, selling and supporting your products and services.
Sources: The Labor Department, The Wall Street Journal, The Daily Shot – 11/5/18
Next, you have not been making the investments in capital equipment , R & D and innovation to move companies along and be prepared for more overseas competition or increase productivity. Thanks for moving wages higher for less than high school educated workers recently they still aren’t enough to keep up with inflation though. If you can increase productivity we can give workers raises without it hitting the bottom line an increasing cost, and earning would be stabilized or even get better. You wouldn’t need to use financial gimmicks like stock buy backs to take stock off the market, and goose the price so earnings look better on a per share basis. Between 2010 and 2017 S & P companies spent 51 % of their operating earnings on stock buy backs. That’s money just hyping stock nothing else. Note that business investment is continuing to decline with lower highs and investments flat since 1998.
Sources: The Wall Street Journal, The Daily Shot – 11/5/18
Your joy ride on $1 trillion of stock buybacks needs to end. We want to see a plan by the end of the month on how you will use that $1 trillion dollars in meaningful long term ways such as raising wages, job training, purchasing new equipment and systems, and innovating new products. You are basically taking away the future of your workers and the country for your short term gain. Show by quarter how you will implement the plan and get your businesses actually growing again (in real dollars not financial gimmicks), workers supporting their families in sustainable lifestyle and making America stronger.
P.S. By the way, it is time to end your constant borrowing, rates are going up, and you spent most of the money on stock buybacks or other goodies not investing in the company. You are mortgaging the future of the business by taking on a record amount of debt. Please submit a plan for retiring this debt as part of your financial plan for investing in the company by the end of the month.
P.P.S. For those of you ( a minority) who are not doing stock buybacks, thank you, and you who are spending on capex and raising wages thanks a lot! Just submit a set of graphs showing your investments so we can show the other CEOs how it is done – as a best practice.
