Is Wall Street Playing Dirty?

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It’s at times like these when I think of Warren Buffett’s famous quote: “You only find out who’s swimming naked when the tide goes out.”

I suspect quite a few companies may find themselves in need of a new pair of swim shorts when higher interest rates — or a prolonged economic downturn — finally come to pass.

You see, it’s surprisingly easy and common among corporate chief financial officers (CFOs) to, well, how should we put this? Let’s say to legally “fudge” the earnings of the companies they work for.

That’s probably not a surprise to you.

What is surprising is that CFOs themselves agree.

Researchers from Duke and Emory Universities surveyed nearly 400 CFOs a few years ago regarding earnings misrepresentation. The CFOs said: “They believe a remarkable 20% of firms intentionally distort earnings” while still using generally accepted accounting methods.

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How is that possible?

Ultra-low interest rates make it easy to use certain tricks to paper over those earnings distortions, making a company look more solid than it really is.

Stock buybacks are one such trick.

In saner times, stock buybacks are an investor’s best friend. When a company buys its own stock (and removes those shares from trading), it makes all of its remaining shares more valuable.

Imagine a company’s total number of shares as a whole pizza — and everyone who has a claim on that pizza gets a bigger slice. That’s how I think of it.

Stock Buybacks: A Smoke Screen for Poor Earnings

Today, though, most stock buybacks are a joke. Every shareholder’s “piece of the pie” is a little larger, after a company buys back millions of its own shares. But each slice has less pepperoni, less cheese and less sauce.

Why?

Because at the core of the issue is the fact that the company’s earnings have declined and that’s never a good sign. Companies are using stock buybacks to make weak sales and profits look better than they really are.

Earlier this year, the Fortuna Advisors research firm ran a study for the Associated Press. The subject: How many companies make their financial performance look better through stock buybacks?

The results make you realize just how widespread the practice is. The study found that nearly half the companies in the S&P 500, 216 in all, get a bigger boost in profits by buying back their stock than they do from the business itself.

And remember what I said about each slice having less pepperoni? Some companies, over the five years’ worth of buyback data studied, were even able to turn losses or flat financial performance into gains. Lockheed Martin, Cintas and Wellpoint were among those listed.

The study’s author Gregory Milano calls buybacks of this type “game playing — a legitimate, legal form of manufacturing earnings growth.”

No wonder stock buybacks are so popular. As Birinyi Associates noted recently, companies announced more buybacks just in the first six months of 2015 than in all of 2008, 2009, 2010 or 2012. Birinyi estimates companies will announce a new all-time record of $996 billion worth of buybacks by year’s end.

If companies came up with that cash through their own business operations, that’s one thing. But that’s not how it works in the world of ultra-low interest rates.

The Fed Is Feeding the Addiction

Companies borrow the money needed for the buyback instead of raising it through revenue growth.

According to Bloomberg and Sundial Capital Research, S&P 500 companies issued a record $58 billion in bonds in the second quarter. Those firms listed buybacks as one of the key uses for the money.

I can give you a more recent example. In August, the payroll services company ADP announced its first-ever buyback program funded by corporate debt. The plan is to sell $2 billion worth of bonds, then use the money to buy back 25 million shares (about 5% of its total float).

Moody’s, the debt-rating agency, slammed the announcement and cut ADP’s bond rating. The agency said the deal “represents an abrupt shift away from the company’s historically conservative financial practices.”

The list goes on and on.

So when do the abuses, in the name of stock buybacks, come to an end? It’s all about the Federal Reserve. If corporations are addicted to ultra-low interest debt, then the Fed is their street dealer. Neither party wants to risk the consequences of cutting off the supply.

So it’s not for nothing that the managing director of Blackrock, a firm with $4.7 trillion in assets under management, recently called the surging popularity of stock buybacks “an economic distortion.”

Perhaps the better pair of words is “economic mirage.”

Regards,
Image for JL Yastine The Sovereign Society
JL Yastine
Editorial Director, The Sovereign Society