For
most of us operating in the financial world, the sounds of the 2008 crisis
still echo in our heads. How can we forget the dreadful week of September, 15,
2008, when Lehman Brothers collapsed followed by American International Group
(AIG)? Who could forget the ominous depleting stock markets, rampant
foreclosures, job losses, panicky bailouts and deteriorated retirement
accounts? Today, it is a much different story altogether. Many would say that
we have had a strong rally for too long. What goes up will naturally come
down.
As
of late, the “B” word is being thrown around. It’s a “B” for a bearish market
is what various experts are advocating. There are some who maintain the opinion
of Canadian bond investors, avoiding bear market terms altogether given the central
bank’s ability to gradually raise the interest rate as the economy strengthens.
But one can never be too certain when scrutinizing the stock market. Always
remember the words of Warren Buffett on investments: “Never test the depth of
the waters with both feet.” The point is that one should exercise the
appropriate precaution when assessing risks in the financial market. We must
account for everything. Following the spirit of Mr. Buffett, it’s not too
rigorous to see certain signs indicating a tumultuous market ahead.
Let’s
look at stock buybacks. What you can immediately note is the sheer volume of
stock buybacks this year. According to the S&P Dow Jones indices, the
number is a staggering $241.2 billion during the first quarter of 2014. Compare
that with the previous record of US$233.2 billion (set in 2007) and you will
immediately note that something is going astray. It is important to understand
why companies buy back their stock. Once we have an understanding on this, we
can assess what is what in the market. Often times, companies repurchase shares
in order to re-fabricate their earnings per share. The buyback shrinks the
denominator. So you can see that even if a company is not doing so well, a
simple buyback can boost the earnings per share, making it seem like the company
is doing better than it actually is. The Economist
call this phenomenon “The Repurchase Revolution.” And it is a revolution
that is a global wide practice. Home Depot, for instance, has spent 28 cents of
every dollar of cash flow on dividends and a further 52 cents on share
repurchases. This is the company that only a few years back spent
extraordinarily on building new shops to accommodate for the rampantly growing
demand. According to the Economist,
for every dollar that was earned, 62 cents was put into capital investments.
But Home Depot is not alone. Neither is the rest of the lot on the S&P 500.
This practice has spread internationally to Europe and even Far East Asia. The
overwhelming fear of this global practice is that there is only one dominating
buyer in the market. The lack of individuals involved in buying presents a
growing concern for the market.
What
happens when companies stop buying? Well we know what happened last time. The
stock market crashed. And the numbers are showing that we may be reaching
similar levels. Let’s look at the infamous Lehman Brothers. Data from the Economist shows that in May 2008, just
months before its bankruptcy, Lehman spent a staggering $1 billion on share
buybacks. What is more interesting is that a total $207 billion in shares were
repurchased by the American financial sector between 2006 and 2008. In 2009,
taxpayers were burdened with injecting $250 billion into banks to save them.
The other problem that companies face is financing the buyback. While it is
true that bigger companies have billions in cash stored for a rainy day, it
does not necessarily mean that they are easily willing to spend it. Under
American tax laws, companies have to pay tax on foreign profits if they bring
the proceeds back to the United States. Perhaps this is why tech giant Apple
borrowed $12 billion domestically to help finance their buyback in 2012 despite
having a sizable $132 billion in cash sitting abroad.
Conclusively,
while buybacks may have its advantages, we cannot ignore what happened in 2008.
The simple fact is that buybacks are undoubtedly setting the preliminarily
stages of an all too familiar scene. Companies will have to reassess how much
of their money is going towards buybacks and how much they are investing in
growth (e.g. capital).
Disclaimer: This article was posted with the permission
of a third-party contributor and the opinions contained therein do not
necessarily reflect those of Smallcappower. Smallcappower does not endorse
any investment advice provided by these third-party contributors.
Please
consult your investment advisor before making any investment
decisions. Ubika Corporation and its divisions Smallcappower, Ubika
Communication and Ubika Research are not registered with any financial or
securities regulatory authority in Ontario or Canada, and do not provide
nor claims to provide investment advice or recommendations to any visitor of
this site or readers of any content on this site. – See more at: http://www.smallcappower.com/posts/small-cap-power-disclosure
