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2019-02-27 08:15 by Karl Denninger
in Market Musings , 286 references Ignore this thread
Buybacks And Lies*
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The lie factory in the media continues with regard to the economy and markets -- and it's you who take it up the chute.

Lawmakers on both sides of the aisle have recently criticized stock buybacks, including Sen. Chuck Schumer, D-N.Y., and Sen. Bernie Sanders, I-Vt., in a New York Times op-ed and Sen. Marco Rubio, R-Fla., in a tweet storm about his plans to release legislation on the subject. As the Tampa Bay Times notes, this is something “you might expect from Bernie Sanders or Elizabeth Warren, but not necessarily the Florida Republican.”

These objections to stock buybacks are, in a word, misguided. Critics’ complaints rest on the premise that they maximize shareholder earnings to the detriment of workers and at the expense of investments in the company. But this reflects a fundamental misunderstanding of how stock buybacks work and what drives business leaders’ decisions about spending profits and deploying capital.

False.

My complaint with them is that they are frauds.

Faux Snooz continues:

When a company turns a profit, one basic way to address the balance is to buy back shares; it’s a common mechanism for companies to distribute earnings to shareholders. The alternatives are to increase investment or pay out more in dividends, the latter of which is functionally identical to buying back shares.

No it's not.  Leaving aside tax differences, which are significant, the financial and market impact of buybacks is not functionally equivalent to a dividend.

When a company pays out dividends the total number of shares does not change.  Therefore the EPS does not change either for a given level of earnings.

If you earn $1 billion dollars and have one billion shares then the EPS is $1.00.  If you pay out half of that billion dollars in dividends then the EPS next quarter, assuming you still make a billion dollars, remains $1.00.

Now let's assume you take that half-billion and buy back shares.  The denominator gets smaller.  This means that for the same billion dollars in earnings next quarter (the size of the company hasn't changed) the EPS goes up.

This is a major functional difference.  It sounds like a free lunch to many people -- EPS goes up and since the "P/E" ratio is a common way to value stocks the instant effect on P/E is for it to fall, and thus price per share will tend to rise to make P/E the same.

This sounds like a buyback is superior to shareholders, and thus ought to be not only permitted but every firm should do it instead of issuing dividends.

If only it was that easy.

If only Unicorns that crapped out Skittles existed.

If only.....

When you reduce the denominator it is true that EPS goes up for a given level of earnings.  But so do the losses per share when there are losses, and by an exactly equal amount.  In other words market violence, which is called "volatility", associated with said firm's results increases exactly at the same ratio.

There is no free lunch in this regard.

Second, however, and the reason that buybacks were generally illegal before the government changed the rules is that this fact is actively hidden by everyone involved -- on Wall Street, in the media, in earnings reports and the statements made by everyone involved.

Why would all these people intentionally mislead the public?

Simple: They use buybacks as a mechanism to rob you as a shareholder.

Let's take a hypothetical company that issues 1,000 shares of stock.  We'll make it nice and small.  The insiders -- that is, the founders, mostly, and other key people at the outset hold 250 of those shares; they sell the rest of them to the public.  (This, by the way, is another scam that is commonly run -- companies sell a minority of shares to the public by one means or another and thus prevent the public shareholders from ever voting out the officers and directors!  That's fraud because such a firm is not publicly-owned and ought to be flatly illegal in the so-called public markets -- if you wish to do this you ought to be limited to selling to accredited investors who understand what's going on and are willing to buy what amounts to a private placement with no voting rights -- because that's what these companies are!)

Ok, so we have our 1,000 share company with 250 of them held by inside executives -- probably half of that 250 is held by the founder who is frequently the CEO.  All good so far; the other 750 shares are enough that you, along with the other public shareholders, can vote out and eject the CEO and board.

Now the company runs and makes a profit.  So what the board does is vote to buyback 100 of the shares in the public market.  What just happened?

The public's interest of 75% of the company just got cut; the insiders held 25% but now they hold 28%!

It doesn't end there.  The 100 shares gets bonused out as "restricted stock units" to the officers and directors!  So the total number of shares doesn't decrease; now there are 350 shares in the hands of insiders and only 650 in the hands of the public.

Do this for two more years and the public no longer has any control over the board or executives since they are now a minority and cannot vote anyone out!

You just had control of the company stolen from you.

The same strategy is sometimes used by closely-held firms where you have outside minority shareholders.  The reason you have to be an "accredited" investor to buy such a position is that it is very easy for the majority holders, who are usually the founders and running the place day-to-day, to steal from you and absent some extremely strong controls you have written into the bylaws of the company if and when it happens there's damn near nothing you can do about it.  Unless you're very savvy and insist on such as part of your deal you are open to a rank ramjob that will diminish your investment by an arbitrary amount as soon as the insiders decide to screw you.

There is nothing in the law, for example, to prevent the majority holder of such a firm who is the CEO from voting to bonus out more shares to himself as part of his compensation.  This dilutes your ownership interest and as a minority shareholder you can't vote a stop to it.  The only hope you have is to sue and you will probably lose so long as the firm can show that it's making money and the executive(s) who got the bonus are substantially why it's making money.  In other words you're almost certain to take it up the pooper with exactly zero recourse, and if you do sue not only will you almost-certainly lose the company defends against your lawsuit with what is ultimately your money since it comes out of company coffers and not the CEOs personal checking account.

Stock buybacks where the executives and other insiders are getting share grants are the exact same scam played out in the public markets.  The claim that it "makes value go up" is a lie.  Until you sell your shares all you have is numbers on a screen; the lower the float in a given firm (that is, the fewer shares outstanding) the less-likely you can sell them without moving the price downward, and thus your so-called "gain" is likely to be illusory.  In addition you permanently give up your voting control piece by piece until you have effectively none; while you may still own the same number of shares the public ownership of the whole is reduced and at the point it reaches less than 50% you have no voting control whatsoever.

Buybacks, in short, are nothing more than a parlor trick.  They look real good so long as the economy is very strong and there are no recessions.  But as soon as the inevitable downturn comes you discover that not only are losses magnified exactly as are "earnings" but you have had your ability to throw management out on their ear either diminished or completely destroyed by an under-the-table trick at the same time.

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Tdurden
Posts: 1116
Incept: 2015-01-29

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I've unfortunately had a front row seat to to all sorts of corporate ****ery for the past couple of years. The company where I work former CEO spent the better part of a decade "growing" the company through acquisitions since he proved unable to grow it organically. Worked out ok for them for a time. That is until the last acquisition. CEO and his buddies got a real surprise when the deal closed. Turns out some hedge funds took up some sizable positions, at least one big enough to cross the 5% mark and pushed the weak board to have management of the firm they just bought take over the company. I find it highly unlikely that this wasn't planned in advance with the executives of the acquired company, but I'm just naturally cynical at this point.

Anyway, here we are a year later and new management finds they aren't any better at growing this white elephant than the last team, so they broke several promises and took a giant clever to the dividend payouts. Now some of the hedge fund guys that put them in charge are filing their 13D's and demanding seats on the board with the goal of selling off the profitable assets. This could very well turn out like my ex-wife's family re-unions...loud, ugly and mildly entertaining.

You don't have to be an expert in old gangster movies to know that you should always be careful about who you let do favors for you.

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"I'd like to live just long enough to be there when they cut off your head and stick it on a pike as a warning to the next 10 generations that some favors come with too high of a price." -Vir Cotto Babylon 5
Jays
Posts: 16
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What are larger, slower growth, stable companies that currently have access to inexpensive money to do? I agree with much of what you have written on the problems with buybacks. That said, could you explain: With the current low interest rate environment what is, as an example, McDonalds (MCD) a slow growth company in a slow growth industry, to do to provide better return for their investors in a very competitive investment environment ?
Kgmqt
Posts: 200
Incept: 2013-08-19

Minnesota
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Quote:
Now the company runs and makes a profit. So what the board does is vote to buyback 100 of the shares in the public market. What just happened?

The public's interest of 75% of the company just got cut; the insiders held 25% but now they hold 28%!

It doesn't end there. The 100 shares gets bonused out as "restricted stock units" to the officers and directors! So the total number of shares doesn't decrease; now there are 350 shares in the hands of insiders and only 650 in the hands of the public.


So, if run to the extreme could this also be insider trading? You have the CEO creating a mechanism to move shares or % of shares from one side to the other. The timing on this is known. What prevents them from making certain business decisions that drive the stock down/up to align with these buybacks?
Tickerguy
Posts: 175429
Incept: 2007-06-26
A True American Patriot!
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Quote:
That said, could you explain: With the current low interest rate environment what is, as an example, McDonalds (MCD) a slow growth company in a slow growth industry, to do to provide better return for their investors in a very competitive investment environment ?

Innovate. That's what you're supposed to do. It's what powers the standard of living (productivity) over time.

If you're not going to do that then why should you get any of the benefits of corporate ownership (e.g. limited liability, etc)

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Nadavegan
Posts: 361
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The South
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Innovation is hard. Deceitful math is unfortunately fairly easy.

I have met lots of executives over the years. The true innovators have been very few. But every damn one of them could game a P&L.
Banditfist
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Huntsville, Alabama
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If a company have any outstanding debt, they are paying interest on that debt (costs). Outstanding shares have no interest cost to the company. So why would any company buyback shares before paying off debt?

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"I'm sure I can't remember" ~ Ben Bernake 25 Jun 2009

Wa9jml
Posts: 514
Incept: 2017-04-29

DeKalb, Illinois
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I used to take my duties as a shareholder seriously. When I got the proxy forms, I would always vote against the banksters on the board of directors, against the ridiculous pay for the senior executives, and against any expansion of stock options. I always got out voted, and so now when I get proxies, they go right into the shredder. Very few firms are run for the benefit of non-employee shareholders. They are all run for the plundering senior executives.
Aztrader
Posts: 8661
Incept: 2007-09-10

Scottsdale, AZ
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If you want to find out if a company is really growing or not, you go back five years and check the debt/equity and book value. Many of these companies have issued billions in debt for their buy backs. I believe McDonalds actually has a negative book value due to all the debt. Wall street completely ignores this thanks to Non-GAAP accounting. Yesterday I say Dillards claim they beat earnings and raised estimates, but missed revenues. How does a retailer do this? It's called gaming the books. All of these companies seem to be doing this. The one's that aren't playing the games are the ones getting their prices killed by telling the truth. The computers only want to see positive news and will destroy a stock if it's negative. Currently, almost 90% of the volume is coming from automated trades. These companies announce a buy back and the stock takes off. They announce that they beat earnings, not mentioning that they bought back 3% of their stock during the quarter. It's all smoke and mirrors to keep the computer buyers happy and buying.
The entire market has become a rigged casino. We knew this when JPM announced that they had only 2 losing days last year. Statistically, that is impossible unless you are the one running the game. Watching this rally from January makes me wonder if the Fed set up the markets for the drop, only to save it for their masters. That sell off should have only resulted in maybe a 50% retracement and it shouldn't have happened in only 2 months. The volume has been very lethargic and I am seeing articles that individual buyers have dried up. If someone turned off the computers, the bloodbath would be unreal.
Peterm99
Posts: 8457
Incept: 2009-03-21

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Aztrader wrote..
. . . gaming the books.
Has most likely been happening since the beginning of time.

Nevertheless, Kanjorski and a whole bunch of others deserve to roast in hell for eternity for making it easy by turning it into a gov't endorsed practice.

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". . . the Constitution has died, the economy welters in irreversible decline, we have perpetual war, all power lies in the hands of the executive, the police are supreme, and a surveillance beyond Orwells imaginings falls into place." - Fred Reed
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