Buybacks and Wealth Destruction
publication date: Mar 17, 2020
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author/source: Brian Nelson, CFA
Buybacks and Wealth Destruction
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From Value Trap: "According to S&P Dow Jones Indices, S&P 500 stock buybacks alone totaled $519.4 billion in 2017, $536.4 billion in 2016, and $572.2 billion in 2015. In 2018, announced buybacks hit $1.1 trillion. Given all the global wealth that has been accumulated through the 21st century, it may seem hard to believe that another Great Depression is even possible. However, in the event of a structural shock to the marketplace where aggregate enterprise values for companies are fundamentally reset lower, the vast amount of cash spent on buybacks would only make matters worse. The money that had been spent on buybacks could have been distributed to shareholders in the form of a dividend or even held on the books as a sanctuary of value within the enterprise during hardship. Buybacks, unlike dividends, can result in wealth destruction in a market economy, much like they can with companies. This is an important downside scenario that is often overlooked." -- Value Trap, published 2018
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By Brian Nelson, CFA
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March 16, 2020, is one for the record books.
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The Dow Jones Industrial Average (DIA) recorded its worst point loss in history, yet again, swooning almost 3,000 points to close at 20,188.52 (a near-13% fall). During the session, the S&P 500 (SPY) closed down 11.98%, to 2,386.13, marking the third-worst percentage decline ever, after only Black Monday of October 19, 1987, and the Crash of 1929 (October 28, 1929), two of the most momentous daily crashes of all time. Barron's reported that the Dow Jones Industrial Average has now "swung more than 9% for 3 straight sessions, the first time since October 1929." As we noted in Value Trap:
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There may be just one other period in history that had more price-agnostic trading than today, and that may be the period pre-dating the publication of John Burr Williams' work The Theory of Investment Value, or roughly 1928-1940. This was the most sustainably volatile period in stock market history, as measured by daily percentage changes in the S&P 500. In the 1920s, stocks and bonds were mass marketed to the general public, and many were just speculating on the price behavior of securities they didn't understand. Back then, there may not have been much value-conscious trading activity at all. Today, as index investing and ETFs backed by traditional quantitative theory proliferate, market volatility may once again approach those levels, and if not checked, surpass them.
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You are witnessing stock-market history, my friends.
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In his latest briefing near the close of the trading session March 16, President Donald Trump noted that the U.S. may not be able to get the coronavirus outbreak under control until July or August, months later than what the market had been anticipating. This news made an already-weak trading session even worse, as selling accelerated into the close. Our team continues to monitor new developments, and more and more, we're seeing companies draw down their credit facilities out of concern that liquidity won't be available when the going gets really tough. Micron (MU) and Kraft Heinz (KHC) are the latest after Boeing (BA) to draw down their credit lines.
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Things are starting to get serious for the aircraft maker, in particular. As we predicted in our latest note on Boeing, "Boeing Down 15%, Turbulence Still Ahead," S&P cut the firm's corporate rating two notches to BBB from A- on March 16, and the rating agency said "the credit rating was on watch for further downgrades, should the position deteriorate further." The company's shares finished the trading session March 16 an incredible ~24% lower, and we can't rule out government assistance for the aerospace giant, which it might need if predictions calling for a $11-$12 billion cash burn during 2020 come to fruition.
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Boeing now has the dubious honor of being added to the growing list of companies that have destroyed valuable and soon-to-be-much-needed shareholder capital/cash through buybacks (e.g. GE, IBM, RadioShack). According to the latest tally, Boeing repurchased more than $100 billion of its own stock since 2013, as its share price was booming, instead of parking the vast majority of that capital on the balance sheet for times such as this, a conservative move that almost certainly would have prevented panic selling by shareholders (and dilution that may yet come). Here's more about what we say about buybacks in Value Trap:
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...Because buybacks amplify a market economy's leverage to both good and bad things, they can create unusual risks, particularly if a fundamental shock to a market economy (e.g. rising interest rates, reversion to less-favorable corporate tax policies) that lowers stock values occurs after a large buyback spending spree.
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Where the net cash resting on balance sheets prior to share buybacks would retain its value under any economic condition per enterprise valuation, a reset lower in stock values caused by higher-than-expected interest rates or a reversion to less-favorable tax policy, as examples, would effectively mute any perceived benefit from buybacks. Within enterprise valuation, net cash is a source of undeniable wealth of a market economy regardless of changes in future expectations. Once that cash is put to work in buybacks, however, the market economy becomes further leveraged, and should the value of the market economy be reset lower as a result of a change in future expectations (monetary, political or otherwise), those buybacks only compound wealth destruction.
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Where the net cash resting on balance sheets prior to share buybacks would retain its value under any economic condition per enterprise valuation, a reset lower in stock values caused by higher-than-expected interest rates or a reversion to less-favorable tax policy, as examples, would effectively mute any perceived benefit from buybacks. Within enterprise valuation, net cash is a source of undeniable wealth of a market economy regardless of changes in future expectations. Once that cash is put to work in buybacks, however, the market economy becomes further leveraged, and should the value of the market economy be reset lower as a result of a change in future expectations (monetary, political or otherwise), those buybacks only compound wealth destruction.
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The markets are experiencing unprecedented levels of volatility, something that could only have been expected as a result of the proliferation of price-agnostic trading (indexing/quant trading) during the past decade. On March 16, the CBOE VIX Index closed at 82.69, higher than even the highest levels achieved during the Great Financial Crisis. In one of our latest research pieces here, we go into three distinct scenarios that outline what the markets could be facing in coming months, and the range of probable outcomes has only widened.
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That said, while it seems very likely that we may not have hit bottom in the markets yet, long-term investors might start to consider nibbling on some of their favorite ideas in the Best Ideas Newsletter portfolio, Dividend Growth Newsletter portfolio, High Yield Dividend Newsletter portfolio, and Exclusive publication. By the time we get the "all clear" on COVID-19 from government officials, the markets may have already been starting to factor it in for weeks to months. The snapback could be as fierce as this drawdown.
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One announcement in case you missed it: Beginning April 2020, as a separate feature to our website, we'll be starting to release via email options-related ideas (two per month) and commentary, as well as educational information, to those who have subscribed to this feature. We will denote options commentary with the word 'OPTIONS' at the start of any email title for those adding this feature. If you are interested in learning more about options, please consider our new service here ($500/year).
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Please stay safe out there as COVID-19 continues to spread, now up to over 4,000 cases in the US at last count. We're available for any questions.
---Kind regards,
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Brian Nelson, CFA
President, Investment Research
Valuentum Securities, Inc.
brian@valuentum.com
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Related airline equities: AAL, ALK, DAL, HA, JBLU, LUV, SAVE, UAL
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Also tickerized for holdings in the DIA.---
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Brian Nelson owns shares in SPY. Some of the other companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.
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