- Earnings haven’t grown in the last 10 years. What is corporate management doing?
- A temporarily higher stock price isn’t good for the majority of investors, especially those investing for the long term and retirement.
- Buybacks are idiotic, management pays $ 3million for a home they can build for $1 million.
- There is only one company that does smart buybacks.
There’s a huge problem affecting corporate America that nobody is seeing because most people think in positives and negatives, and can’t think on an relative scale. What do I mean by this? Well, when shareholders judge management, they look at whether the bottom line is positive and in line with what the competition is doing. Nobody is assessing whether it could have been much better.
We expect only the best from our favorite athletes and we hope our children develop to their full potential but when it comes to corporate management, we remain mostly silent and accept whatever they throw at us.
Earnings Have Gone Nowhere In The Last 10 Years
Complacency isn’t good, and certainly isn’t in the spirit of being the best at something. For me, yes, it’s important that the earnings number is 90 and not -10, but it’s equally important that the earnings number could have been 190, and not just 90.
A look at the S&P 500 earnings chart from the last 10 years will show exactly what I mean.
Figure 1: Inflation adjusted S&P 500 earnings (constant April 2017 dollars). Source: Multpl.
In the last ten years, corporate America didn’t manage to grow corporate earnings at all despite historically low interest rates and global economic growth.
In addition, the S&P 500 constantly changes in relation to market capitalizations. As we know that market capitalization is strongly related to earnings, companies operating positively get included in the index and those operating poorly get excluded. By keeping the same companies in the index for 10 years, the above chart would be even worse.
The latest index changes have seen the inclusion of Advanced Micro Devices Inc. (NASDAQ: AMD), Raymond James Financial Inc. (NYSE: RJF), and Alexandria Real Estate Equities Inc. (NYSE: ARE) which have replaced Urban Outfitters Inc. (NASDAQ: URBN), Frontier Communications Corp. (NASDAQ: FTR), and First Solar Inc. (NASDAQ: FSLR). By excluding declining companies and including growth companies, the index is skewed toward showing a rosier picture, i.e. higher earnings.
Going back to value destruction. If we know that the U.S. economy has grown 17% in the last 9 years and the global economy even more, interest rates have been and still are at historical lows, how come corporate America hasn’t grown? Well, they’ve been focused on only one thing, the stock price.
The Focus On Stock Price
You might think that a higher stock price is good. This is correct only if you are a seller. As the S&P 500 is just going up and up, the majority of investors aren’t sellers but accumulators.
Think of your pension fund, a higher stock price isn’t at all positive for you because new contributions mean you own a smaller part of whatever the fund is buying. As an example, let’s say you contribute $1,000 per month to your retirement fund. With that, you could buy three shares of Tesla (NASDAQ: TSLA) at the pumped up price it’s at today, but if TSLA’s stock price was at a more realistic $100, you could buy ten shares. In twenty or thirty year when you retire, should Tesla realize its long term company vision, those 10 shares purchased at $100 could be worth much more than the current pumped up value of your entire portfolio.
The way corporate management pushes stock prices up is through dividends and buybacks. I’ve already described why you shouldn’t love your dividends so much here and now I’ll describe how buybacks destroy your long-term value.
Firstly, corporations spend more on buybacks and dividends than what they earn. This means that management willingly takes on debt to pay dividends and do buybacks. Both activities lower shareholders’ value.
Figure 2: S&P 500 management spends more on dividends and buybacks that what is earned. Source: S&P Indices.
In the last 10 years, S&P 500 corporations have spent $7.16 trillion on buybacks and dividends while total earnings were $6.8 trillion. This means companies are taking on debt to invest in growth and to keep dividends and buybacks higher than earnings. As we all know, debt provides instant gratification but is detrimental in the long term as you have to pay interest on it.
Secondly, the biggest sin is that buybacks are made no matter the book value of the repurchased stock. Buybacks are extremely positive if you are buying back stocks that trade below their intrinsic book value. For example, let’s say to buy land, find a contractor, and build a house, you need $1 million. Let’s say the house next door was just built and is selling for $600,000. You would probably rush to buy it and not build your own. Now, if the same house next door is selling for $3 million, you wouldn’t buy it. You would build your own house for a million and, when its built, you’d have a house with a market value of $3 million. This is logical, right?
The above example is the exact opposite of what corporate management has been doing. They are buying the $3 million house with shareholders’ money instead of building new houses. As you can see in figure 2, buybacks in 2016 were $536 billion while they were $398 billion in 2012. You would imagine that the value of stocks is much lower than their book value as management is increasing buying instead of building new business. The opposite is the truth.
Figure 3: The S&P 500 price to book value is just going up. Source: Multpl.
The current price to book value of the S&P 500 is 3.12 while in 2012 it was around 2, so as it becomes more insane to buy back shares, managements has increased the buybacks.
The way corporate management behaves isn’t in the long-term best interest of shareholders. This means that many future retirees will have a much lower quality of life than what they could have had.
What makes me angry and sad is that we aren’t talking just about investment returns here, we’re talking about people, their health, their dreams, and in general, the emotional and social state of a nation. By destroying the value of the businesses we own—‘we’ as mutual fund holders or long term investors,—corporate management is doing a huge disservice to our future selves. It’s time for their focus to shift from short term rewards in the form of higher stock prices to real value creation, i.e. higher book values and higher earnings.
If you don’t want to own companies that are destroying your value by not investing and only pushing their stock prices up in order to increase managements’ compensation, but you still want to be well diversified in corporate America, Berkshire Hathaway (NYSE: BRK.A, BRK.B) could be the stock for you.
Buffett didn’t follow the internet craze in the 1990s when most condemned him as old-fashioned. It took the NASDAQ index 17 years to reach its dotcom bubble height again. Now, as Buffett is against buybacks that are above 120% of book value, we have a similar situation to the 1990s. Buffett is considered old-fashioned while corporations indulge in low debt and high stock prices. What is Buffett doing? He is piling up cash to be ready when the FED bubble crashes. When will it crash? I would love to know. However, let’s first see how the market reacts to the next recession before saying “this time is different.”