Funny Business The Stock Market Illusion

With share buybacks, dividends and acquisitions, companies are doing all they can to keep their investors happy, even if that means going dangerously into debt.
The eternal struggle between bull and bear.

How can a company increase its earnings per share, even though its actual earnings are stagnating or slumping? The secret is share buybacks. Buy back some of your existing stock. Annual profits can now be divided among a lower number of shares. Voila. Earnings per share rises, even if earnings don't.

Take the sports clothing giant Nike. The U.S.-based company recently announced that it would be buying back $12 billion in shares over the next four years. Nike will pay out another billion dollars in 2016 in dividends, also helping boost its share value.

And yet the company reported annual net profit of less than $4 billion. But no one seems to mind; the share price rose by 50 percent in 2015, and chief executive Mark Parker is being lauded for an excellent year.

These kinds of market manipulations are becoming common. In the last year, America's 500 largest companies spent about $600 billion on stock buyback schemes – more than ever before. Nearly $400 billion flowed to investors in the form of dividends – another record amount. Together these amount to $100 billion more than those U.S. corporations earned in 2015.

Managers are looking for growth that they aren’t getting organically. Tobias Mock, Executive Director, Standard & Poor's

By comparison, the majority of German companies did not buy back any shares – or at most only in small doses. German business leaders are notoriously risk averse, and if anything, are criticized for hoarding too much cash. But in the boom years just before the financial crisis of 2008, many companies had purchased their own shares at a high price, a decision they regretted soon afterwards when orders and earnings disappeared and banks refused to lend. Since then many German companies have reverted to old habits, and maintain high liquidity reserves.

Of course some German companies do resort to U.S. style tricks to push up their share price, but they rarely go as far. Siemens, for example, bought €4 billion in shares back between May 2014 and October 2015 and in November, Siemens announced new buybacks of up to €3 billion euros. Insurer Munich Re spends €1 billion annually on a share buyback program. But both these companies do not finance buybacks with new loans like so many U.S. companies, and can still take control of their finances, even if interest rates were to rise again.

In the Mood to Buy-01

Look, by contrast, at Microsoft and Apple. In the past five years they bought back shares amounting to $157 billion. The actions of these giants “fits the pattern of investment-grade corporate issuers who, even if they don’t need to raise capital, are taking advantage of very, very favorable financing terms," said Jim Kochan, chief fixed income strategist at Wells Fargo. Microsoft picked up $23 billion on low-interest bonds since the beginning of last year, while Apple borrowed $40 billion in the same period, with investors seeing returns of sometimes less than 0.5 percent.

The purchase operations were not without consequences: In just three years, Microsoft’s liabilities tripled to $35 billion, while at Apple they went from zero to $64 billion. Almost all companies with strong foreign markets have seen their liquidity and their debt increase rapidly.

To fund their expensive price management, many companies sink deeper into debt. Nike floated a loan for $1 billion. And ailing IT giant IBM and General Motors, which was bailed out by the government in 2009, paid for their share buybacks with new debt as well.

Within 10 years, the 500 largest U.S. corporations have doubled their liabilities to the record amount of $3.5 trillion.

Almost 300 of the 500 largest U.S. companies have pulled off one of these tricks in 2015, increasing their earnings per share, a key indicator in the financial markets. Meanwhile, total net profits of these corporations looks to have fallen by almost 5 percent to $865 billion.

IT giants Oracle and Qualcomm borrowed $10 billion in the last four quarters to buy back their own securities. McDonald's also spent about $8 billion for share buybacks and dividends. That's twice as much as the fast-food chain earned in net profit in the same period.

The majority of German companies did not buy back any shares – or at most only in small doses. Many managers indicated that they had learned their lesson from bad experiences during the financial crisis

Investor demand for ever higher returns precipitated this turn of events. And companies are listening to these shareholders at the expense of prudice.

One example is General Motors, or GM. After the U.S. government bailed out the bankrupt carmaker during the economic crisis of 2008 and 2009, it was ordered to strengthen the balance sheet. The carmaker amassed about $25 billion in cash. But that once noble goal has long since passed, and instead the carmaker announced a buyback program of $5 billion dollars. That’s still $8 billion less than what activist investor Harry Wilson has pushed GM’s chief executive Mary Barra to buy back. GM’s liabilities have almost tripled in the past three years to nearly $47 billion. Since 2014, investors were sold $18 billion in bonds.

But this is not the only trick companies are pulling. Big buck mergers and acquisitions are also being used to justify and bolster share prices. In 2015, the equivalent of €4.5 trillion was spent purchasing companies – another questionable record.

"Managers are looking for growth that they aren’t getting organically," said Tobias Mock, executive director of the rating agency Standard & Poor's.

The longer the stock market boom endures, the more companies are buying competing companies for increasingly rising sums. Pharmaceutical giant Pfizer acquired the Botox-producers Allergan for $160 billion, while brewery giant Anheuser-Busch InBev bought rival SABMiller for $117 billion.

Two factors are fueling this recent development. The first is that directors are sitting on record-level cash cushions. The ten most financially powerful companies have access to cash reserves or more than €600 billion. But this isn’t earning interest.

The second factor affecting the three major industrial regions of America, Asia and Europe is that growth is slow. In the U.S., company profits are even falling.

"Due to often high share price valuation, companies are dependent on growth," Dirk Albersmeier, co-head of the Euro-business acquisitions at the investment bank JP Morgan, told Handelsblatt. "Those who cannot meet these expectations, have to make greater use of smart acquisitions." Otherwise, they are at risk of loss of value and of becoming acquisition targets themselves, Mr. Albersmeier added.

Therefore, he said, he believes that the takeover boom will continue in the new year – in Germany as well as internationally. Some examples: pharmaceutical company Boehringer will take over the veterinary business of French drug manufacturer Sanofi for €11.4 billion, Merck could be laying out more than €15 billion for laboratory supply distributor Sigma-Aldrich and Bayer paid around $14 billion for Merck’s over-the-counter business.

Dividends are another way to keep shares high. And this is one area where Germany is keeping up with the United States.

The DAX rose 10 percent in the past year, while small cap stocks in the MDAX managed an increase of 23 percent. And much of this growth has been caused by generous dividends. Between January and June, German companies will distribute some €45 billion in dividends – nearly €30 billion came solely from the 30 DAX companies. That's more than ever before.

Next spring, it is likely that almost all DAX companies will increase their dividends, including the electronics group Siemens and insurers Allianz and Munich Re, at the same time that their income stagnates. Even the utilities provider E.ON, which will have to account for a loss of around €6 billion in 2015, will treat its investors to a dividend of 50 cents per share.

In the fourth quarter the 500 largest U.S. companies increased dividends by just under 5 percent, while consolidated profits decreased by the same amount. For 2015, dividends increased by 10 percent, although the companies reported lower profits for the first time since 2008.

Experienced analysts look skeptically upon the dividend orgy. Christian Kahler of DZ Bank warned that "Investors should not blindly rely on the stock with the highest dividend yield," because it often serves simply to divert attention from bad transactions. Take the case of oil giant Exxon Mobil and Chevron. Last year, their profits were likely halved by sinking prices of crude oil. However, shareholders didn’t feel that pain. The oil giants kept their dividends high, and their shareholders happy, at least for now.

But if the financial crash has taught us one thing, it is if something appears too good to be true, it probably is. The stock market illusion cannot be maintained forever.

 

Ulf Sommer covers companies and markets. To contact the author: sommer@handelsblatt.com.

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