A Buyback or Biotech Bubble?
General Motors' announcement that it will buy back $5 billion worth of stock raises the question of whether the stock buyback has turned into a shareholder activist shakedown.The stock buyback bubble is something that receives little attention from the media but buybacks have soared to record levels, and by the way, it has little to do with the "activist tide" and everything to do with a compensation system run amok.
G.M. did not open its coffers willingly. Harry J. Wilson, a former member of the auto industry crisis task force led by Steven Rattner, gave it a helping hand. A few weeks ago, Mr. Wilson announced a campaign to press G.M. to buy back $8 billion worth of stock, leading four hedge funds with a total stake of about 2 percent in the automaker. As part of this, Mr. Wilson was nominated to run for a board seat.
Because G.M. was bankrupt only a few years ago, it seems a bit foolhardy for the company to willingly part with billions of dollars of hard-earned cash. But in a world where stock buybacks and shareholder activism are all the rage, it makes perfect sense on paper, if not in reality.
As activist hedge funds take aim at companies left and right from their spreadsheet-laden war rooms in Manhattan’s glass towers, their expertise is financial engineering, not running companies. And so the activists love to argue for sales, split-ups, stock buybacks and other financial machinations. The idea is that a quick financial event is more likely to generate immediate returns than the harder and longer-term work of building value.
According to a report by the law firm Schulte Roth & Zabel, as recently as 2013, 13 percent of activist campaigns sought a cash return. The call to return cash is based on the fact that United States companies are extraordinarily profitable and are building cash mountains when interest rates are at record lows. With limited ability to earn decent returns, activists have pushed hard for companies to return the cash to shareholders.
Companies that want to return money to shareholders have a choice: They can pay a dividend or buy back shares. In the former case, the calculus is easy. Assuming that there are no big tax issues, a dividend is just a return of cash to shareholders. But buybacks do more by taking shares out of the market. A buyback does not create wealth; theoretically, the cash disappears with the shares. But it does increase earnings per share and usually lifts the stock price, giving the remaining shareholders a bigger piece of the upside.
Buybacks make sense if a company’s management thinks its shares are underpriced and thus thinks it is getting a bargain. The peril in any stock repurchase, of course, is that the company pays too much.
But when have executives ever thought their company’s stock was overpriced? So companies choose the buyback. According to a highly influential article criticizing buybacks in The Harvard Business Review by William Lazonick, 54 percent of earnings — $2.4 trillion — went to stock buybacks and 37 percent went to dividends for the 449 companies in the Standard & Poor’s 500-stock index that were publicly listed from 2003 to 2012. According to a Barclays report, stock buybacks totaled $535 billion for the year that ended September 2014.
But returning cash isn’t all that a buyback or even a dividend does. The core idea behind a share repurchase is that it will make the company more disciplined.
Think about a world where you can have all the doughnuts you want. You just might eat a few too many. If a company like G.M. has an extra $5 billion sitting around, the thinking goes, it might decide not to invest wisely in the business or make smart acquisitions but instead simply use the cash less efficiently, like paying higher executive salaries.
Mr. Wilson’s argument for a large stock buyback was based on this conceit. In an interview with CNBC, he said that in the auto industry, when “times are good, they overinvest and make bad acquisitions, they overspend.”
But buybacks can leave a company without needed cash. G.M. had many buybacks before the financial crisis, totaling $20.4 billion from 1986 to 2002. It certainly could have used the cash then. Mr. Wilson is aware of this issue and stated in the CNBC interview, “We have always agreed that the company should have enough cushion” but that it was “enormous.”
And there is always the risk of overpaying for shares, especially now. With zero-interest rates, the stock market is bound to be high, and buying now may not make sense. In fact, most buybacks these days tend to destroy value because of their inflated prices.
Other problems can arise with buybacks. Mr. Lazonick has argued that repurchases leave little for “productive investment” and should be banned. The Economist called them “corporate cocaine” and cautioned that some companies may be borrowing too much to pay for them. Companies may also end up using buybacks to manage expectations for earnings per share, especially when large numbers of stock options are outstanding.
Still, the noted valuation expert Aswath Damodaran asserts that much good could come from share buybacks and that banning or regulating buybacks falls “squarely in the feel-good but do-bad economic policy realm.”
The vibrant debate shows the pros and cons of share repurchases, but G.M. was apparently unswayed by the cons.
The automaker quickly capitulated to the $5 billion buyback, with Mr. Wilson agreeing to withdraw his candidacy for the board, despite disagreement from another large shareholder, Warren E. Buffett. In an interview with CNBC, he said, “I think the idea of trying to do something now that gets a little pop in the stock should not be on” G.M.’s agenda.
At the end of the day, G.M. decided it was better to retreat than to fight. The activists know that the companies are feeling defensive. Even though Mr. Wilson’s group owned just 2 percent of the company, a contest would have been difficult and expensive. The $5 billion turned out to be the cost of doing business. As Marketplace put it, “Please shut up and here’s some money.”
Going forward, G.M. will aim to keep $20 billion in cash on its balance sheet and return free cash flow beyond that to shareholders. It had built up about $25 billion in cash as its sales and profits rebounded after its 2009 government-led bankruptcy.
The G.M. episode may signal a turning point. In good times, it is easy to get too comfortable. Technology companies like Google and Microsoft are stockpiling foreign cash. Others are racing to buy back shares at high valuations. But the good times inevitably end, this time most likely led by the activist stampede.
The haste in which G.M. rushed to comply to Mr. Wilson’s demands, and they and other companies shed cash rather than fight, shows that the activist tide pushing the stock buyback may have gone too far. Let’s hope that it doesn’t wash out companies and shareholders.
Yes folks, we can blame "evil" activist hedge fund managers but America's CEOs have never had it this good. Ultra low rates, cheap debt, record cash levels are allowing them to buy back shares at a record pace, artificially boosting their earnings-per-share and padding their disgustingly bloated compensation which also includes lavish pensions as they shed defined-benefit plans and jobs to cut costs and increase profits.
Forgive my sarcasm, but if this is the "golden era of capitalism," god help us all. And make no mistake, everyone is in on this buyback binge. I check out news articles on buybacks every day, and it shocks me to see how many big companies are buying back their shares. Yahoo (YHOO) just got approval from its board to buy back an additional $2 billion in company shares, and Merck's (MRK) board just approved a whopping $10 billion repurchase program.
And Apple's buyback activity may not be enough for Carl Icahn, but during the fourth quarter of 2014, it was good enough to top the S&P 500. According to a new analysis from financial research firm FactSet, Apple spent more in buybacks than any other S&P company — even as year-over-year buyback spending for the overall index declined:
FactSet reported that during the fourth quarter, aggregate share buybacks by S&P companies totaled $125.8 billion, down 4.4% compared to the same time in 2013 and down 13.5% over buybacks in the third quarter of 2014. Overall, 362 companies — 72% of the index — participated in buybacks during the final quarter of the year, a figure that is consistent with the average participation rate over the past five years.To be sure, buybacks are no panacea and they have backfired on a few companies. Moreover, there is an increasing unease on how much of the extraordinary stock market gains since 2009 have been fueled by share buybacks. Institutional Investor just published a great article, Stock Buybacks Wrestle With an Aging Bull, which discusses the concerns companies should ponder before approving share repurchase programs.
On a company-by-company basis, Apple’s $6.1 billion in share repurchases during the quarter was the most of any company on the S&P. This figure marks a 20% increase year-over-year but a 64% drop quarter-over-quarter.
“In the previous quarter, Apple spent the second-largest dollar amount on share repurchases by an individual company in the S&P 500 since 2005 at $17 billion,” FactSet analyst John Butters wrote in the report Tuesday. “Over the past three quarters, Apple has spent $16.9 billion on share repurchases on average. As a result, on a trailing 12-month basis, Apple has now spent the highest amount on buybacks, $57 billion, of all the companies in the index.”
For perspective, that $57 billion spending total is four times higher than the next-highest total: the $13.4 billion IBM spent in buybacks over the same period. Behind Apple and IBM is Exxon, with its $13.2 billion in buybacks over the trailing twelve months, Intel, which spent $11 billion over the same period, and Wells Fargo with $9.1 billion.
While Apple did lead the index in overall spending during the fourth quarter, its $1 billion year-over-year increase in spending was not the largest in the index. Intel — whose $4 billion in buyback activity during the quarter was second only to Apple — increased its spending by $3.5 billion. Johnson & Johnson increased its buyback by $2.3 billion, while Wells Fargo and Yahoo both increased theirs by $1.9 billion.
But of course, since overall buyback activity did dip 4.4% year-over-year, more sectors decreased their buyback than increased it. Seven of the S&P’s 10 sectors recorded a decrease in share repurchases, with the 95.8% drop in telecomm buybacks the largest plunge of the pack.
But as Bloomberg notes, American companies are in love with themselves, and they're not afraid to show it by buying back their shares at a record pace:
Corporate America’s love affair with itself grows more passionate by the month.No wonder big investors are openly worried and urging corporate titans to focus capital on the long term. Unfortunately, their warnings are falling on deaf ears and truth be told, many pensions are guilty of the same short-term behavior they're openly criticizing.
Stock buybacks, which along with dividends eat up sums of money equal to almost all the Standard & Poor’s 500 Index’s earnings, vaulted to a record in February, with chief executive officers announcing $104.3 billion in planned repurchases. That’s the most since TrimTabs Investment Research began tracking the data in 1995 and almost twice the $55 billion bought a year earlier.
Even with 10-year Treasury yields holding below 2.1 percent, economic growth trailing forecasts and earnings estimates deteriorating, the stock market snapped back last month as companies announced an average of more than $5 billion in buybacks each day. That’s enough to cover about 2 percent of the value of shares traded on U.S. exchanges, data compiled by Bloomberg show.
And while some claim that larger stock buybacks are a sign of increasing stock market efficiency, I agree with those who claim that buybacks are nothing more than a glorified accounting scheme to help boost corporate compensation spinning out of control.
The problem, of course, is that the share buyback bubble is an integral part of the rising stock market, dwarfing everything in the U.S. market. Just how important is buyback activity? As Oliver Renick of Bloomberg reports, Buyback Blackout Leaves U.S. Stocks on Own Prior to Earnings:
U.S. stocks are entering part of the year when one of their biggest support systems is turned off.How can individual investors play this buyback bubble? It turns out there is an ETF, PowerShares Buyback Achievers ETF (PKW), which assembles companies buying back their shares. You can view the top ten holdings and chart of this ETF below:
Buybacks, which reached a monthly record in February and have surged so much they make up about 2 percent of daily volume, are customarily suspended during the five weeks before companies report quarterly results, according to Goldman Sachs Group Inc. With the busiest part of first-quarter earnings seasons beginning in April, the blackout is getting started now.
While the data isn’t conclusive, owning stocks during the five-week stretch when repurchases were curbed has generated a return that trails the market average over the past two years, according to data compiled by Bloomberg. That’s not surprising to Eric Schlanger of Barclays Plc, who says companies buying back shares have helped keep equities aloft.
“Blackout periods are on radar screens now because of valuations, the length of the bull market, and the consensus that buybacks have been a major part of the bull market,” Schlanger, head of equities for the Americas at Barclays, said by phone. “With the S&P up around 2,100, people are going to be more attuned to possible fractures or previous areas of support changing than they were at 1,400.”
Companies in the Standard & Poor’s 500 have spent more than $2 trillion on their own stock since 2009, underpinning an equity rally in which the index has more than tripled. They spent a sum equal to 95 percent of their earnings on repurchases and dividends in 2014, data compiled by S&P and Bloomberg show.
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But if you ask me, you are better off investing in biotech ETFs (IBB and XBI) and stocks I recommended in my Outlook 2015 at the beginning of the year (read a comment in Seeking Alpha, A Bold Call For Biotech ETFs).
Importantly, I want you all to ignore the talking heads on CNBC and elsewhere warning you of a biotech bubble, and keep using any selloff in this sector to add to your positions just like I did last year during the big unwind and just as I did this week. Keep buying the major dips on biotech.
Here is just a small sample of over 200 biotech stocks I'm tracking (click on image):
Some of the smaller biotechs got whacked hard this past week. As I've repeatedly warned you, if you can't stomach huge swings of 20%, 30% or more either way, it's best to avoid the smaller biotech companies and just focus on the ETFs (IBB and XBI) or just buy shares of the big biotech giants like Biogen (BIIB), Celgene (CELG), Gilead (GILD) and others which make up the top ten holdings of the iShares Nasdaq Biotechnology (IBB).
As someone who suffers from Multiple Sclerosis, Biogen remains one of my favorite biotech companies. It's an incredible company discovering amazing drugs for patients suffering from neurological diseases, including Alzheimer's disease, where there's nothing really good available.
One thing is for sure, all this talk of a biotech bubble about to burst is absolute rubbish spread by ignorant fools or big hedge funds and mutual funds that are looking to get in on the action. As far as I'm concerned, there is no biotech bubble and investors ignoring this sector will severely underperform their peers in the next few years (you read that right, never mind what Zero Edge claims).
But the buyback bubble does concern me in a market where Nobel laureate Michael Spence rightly notes, equities are overvalued. Of course, as Keynes reminded us a long time ago, "markets can stay irrational longer than you can stay solvent," so I'm comfortable playing this buyback bubble and especially comfortable playing the secular bull market in biotech shares which I foresaw back in 2008 in my comment, The Age of Biotech.
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Below, an older clip from the Harvard Business Review discussing profits without prosperity. Take the time to watch this clip and you'll understand why American companies are in love with themselves.
And one of my favorite portfolio managers, LMM Chairman and CIO Bill Miller, shares his market forecast, and view of the biotech and homebuilder sectors. Miller says we're in a long lasting bull market, and he really likes Pandora's (P) stock as well as Intrexon (XON), which remains one his largest biotech holdings.
Listen carefully to Bill Miller, he knows what he's talking about, which is more than I can say for most skeptics who are going to get crushed avoiding stocks and the red hot biotech sector.
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