31/5/20: S&P500 Shares Buybacks: Retained Earnings and Risk Hedging

Shares buybacks can have a severely destabilizing impact on longer term companies' valuations, as noted in numerous posts on this blog. In the COVID19 pandemic, legacy shares buybacks are associated with reduced cash reserves cushions and thiner equity floats for the companies that aggressively pursued this share price support strategy in recent years. Hence, logic suggests that companies more aggressively engaging in shares buybacks should exhibit greater downside volatility - de facto acting as de-hedging instrument for risk management.

Here is the evidence:

Note how dramatically poorer S&P500 Shares Buybacks index performance has been compared to the overall S&P500 in recent weeks. Since the start of March 2020, S&P500 Shares Buybacks index average daily performance measured in y/y returns has been -15.04%, against the S&P500 index overall performance of -0.89%. Cumulatively, at the end of this week, S&P500 Shares Buybacks index total return is down 10.18 percent against S&P500 total return of -0.967 percent.

While in good times companies have strong incentives to redistribute their returns to shareholders either through dividends or through share price supports or both, during the bad times having spare cash on balancesheet in the form of retained earnings makes all the difference. Or, as any sane person knows, insurance is a cost during the times of the normal, but a salvation during the times of shocks.

6/5/20: S&P500 and Fundamentals: What should matter, doesn't

S&P500 and earnings per share: what should matter, doesn't

We are now in extreme territory of the markets ignoring basic corporate fundamentals.

16/4/20: Lessons in Corporate Finance: COVID19

My article summing up some corporate finance lessons from the COVID19 crisis is now available at The Currency: https://www.thecurrency.news/articles/14752/as-we-rebuild-the-economy-we-need-to-escape-the-perilous-spiral-of-corporate-debt.

18/3/20: What's Scarier? Corporate Finance or COVID?

Larger corporates in the U.S. are seeking public supports in the face of COVID19 pandemic, from airlines to banks, and the demand for public resources is likely to rise over time as the disease takes its toll on the economy.

Yet, one of the key problems faced by companies today is down to the long running strategies of creating financial supports for share prices that companies pursued over the good part of the last decade, including shares buybacks and payouts of dividends. These strategies have been demanded by the activist investors across numerous campaigns and by shareholders, and have been incentivized by the pay structures for the companies executives.

Artificial supports for share price valuations are financially dangerous in the long run, even though they generate higher shareholder value in the short run. The danger comes from:

1. Shares buybacks using companies cash to effectively inflate share prices, reduce free float of shares and lower the number of shareholders in the company, thereby reducing future space for issuance of new shares;
2. Shares buybacks have often been accompanied by companies borrowing at ultra-low interest rates to purchase own firm equity, reducing equity capital and increasing debt exposures;
3. Shares buybacks generate future expectations of more buybacks, even during the times of financial weaknesses;
4. Shares buybacks also reduce future firms' capacity to borrow by either increasing debt to equity ratio, increasing overall debt loads carried by the firm or both;
5. Payouts of dividends also use cash reserves the company can hold to offset any future risks to its financial wellbeing and to invest in organic growth and R&D;
6. Payouts of dividends create future expectations of higher dividends from investors, reducing firm's capacity to deploy its cash elsewhere;
7. Payouts of dividends increase cum dividend prise to earnings ratios, reducing the overall capacity of the firm to raise capital cheaply in the future.

These are just some of the factors that overall imply that shares buybacks and payouts of extraordinary (or financial unsustainable) dividends can be a dangerous approach to managing corporate finances. 

So here is the evidence on just how deeply destabilizing the scale of shares buybacks and dividends payouts has been within the S&P 500 sector:

In Q3 2019, shares buybacks and dividends yielded USD1,246.73 billion on a four-quarters trailing basis, fourth highest quarter on record. Overall market yield contributions from buybacks (3.12%) was higher than that from dividends (1.81%), with combined yield of 5.05%. In simple terms, any company operating today will have to allocate 5.05 percent of its return to simply match shares buybacks and dividend payouts yields. This is a very high fence to jump.

Put differently, what the above data shows is that just one, single quarter - Q3 2019 - has managed to absorb more resources in shares repurchases and dividend payouts than what the corporate America is currently asking in financial supports from Washington. 

What's scarier? Corporate finance or corona virus?.. 

17/9/19: Flight from Fundamentals is Flight from Quality: Corporate Risk

Great chart via @jessefelder highlighting the extent to which the bond markets are getting seriously divorced from the normal 'fundamentals' of corporate finance:

Source: https://twitter.com/jessefelder/status/1151586992033083393?s=20

Corporate debt has expanded at roughly x2 the rate of growth of corporate earnings since the start of this decade. And corporate bond yields are persistently heading South (see: https://trueeconomics.blogspot.com/2019/07/16719-corporate-yields-are-heading.html) and investment for growth is falling (see: https://trueeconomics.blogspot.com/2019/07/7719-investment-for-growth-is-at-record.html). Which continues to put more and more pressure on corporate valuations. As a friend recently remarked, at 2% interest rates, the game will be over. It might be over at 2% or 3% or 1.5%... take your number pick with a pinch of sarcasm... but one thing is certain, earnings no longer sustain markets valuations, real corporate investment no longer sustains financialized investment models, and economy no longer sustain real, broadly-based growth. Something must give.

20/2/19: Crack and Opioids of Corporate Finance

More addictive than crack or opioids, corporate debt is the sand-castle town's equivalent of water: it holds the 'marvels of castles' together, util it no longer does...

Source: https://twitter.com/lisaabramowicz1/status/1098200828010287104/photo/1

Firstly, as @Lisaabramowicz correctly summarises: "American companies look cash-rich on paper, but average leverage ratios don't tell the story. 5% of S&P 500 companies hold more than half the overall cash; the other 95% of corporations have cash-to-debt levels that are the lowest in data going back to 2004". Which is the happy outrun of the Fed and rest of the CBs' exercises in Quantitive Hosing of the economies with cheap credit over the recent years. So much 'excessive' it hurts: a 1 percentage point climb in corporate debt yields, over the medium term (3-5 years) will shave off almost USD40 billion in annual EBITDA, although tax shields on that debt are likely to siphon off some of this pain to the Federal deficits.

Secondly, this pile up of corporate debt has come with little 'balancesheet rebuilding' or 'resilience to shocks' capacity. Much of the debt uptake in recent years has been squandered by corporates on dividend finance and stock repurchases, superficially boosting the book value and the market value of the companies involved, without improving their future cash flows. And, to add to that pain, without improving future growth prospects.

9/1/19: Corporate tax inversions and shareholder wealth

Our new paper "U.S. Tax Inversions and Shareholder Wealth" has been accepted for publication in the International Review of Financial Analysis:

The paper abstract:
"We examine a sample of corporate inversions from 1993-2015 by firms active in the U.S. markets and find that shareholders experience positive abnormal returns in the short-run. In the long-run, inversions have a deleterious effect on shareholder wealth. The form of the inversion and country-pair differences in geographic distance, economic development and corporate governance standards are determinants of shareholder wealth. Furthermore, we find evidence of a negative and non-linear relation between CEO total return and long-run shareholder returns."

30/12/16: Corporate Debt Grows Faster than Cash Reserves

Based on the data from FactSet, U.S. corporate performance metrics remain weak.

On the positive side, corporate cash balances were up 7.6% to USD1.54 trillion in 3Q 2016 y/y, for S&P500 (ex-financials) companies. This includes short term investments, as well as cash reserves. Cash balances are now at their highest since the data records started in 2007.

But, there’s been some bad news too:

1. Top 20 companies now account for 52.5% of the total S&P500 cash holdings, up on 50.8% in 3Q 2015.
2. Heaviest cash reserves are held by companies that favour off-shore holdings over repatriation of funds into the U.S., like Microsoft (USD136.9 billion, +37.8% y/y), Alphabet (USD83.1 billion, +14.1% y/y), Cisco (USD71 billion, +20.1% y/y), Oracle (USD68.4 billion, +22.3%) and Apple (USD67.2 billion, +61.4%). Per FactSet, “the Information Technology sector maintained the largest cash balance ($672.7 billion) at the end of the third quarter. The sector’s cash total made up 43.6% of the aggregate amount for the index, which was a jump from the 39.3% in Q3 2015”
3. Despite hefty cash reserves, net debt to EBITDA ratio has reached a new high (see green line in the first chart below), busting records for the sixth consecutive quarter - up 9.9% y/y. Again, per FactSet, “at the end of Q3, net debt to EBITDA for the S&P 500 (Ex-Financials) increased to 1.88.” So growth in debt has once again outpaced growth in cash. “At the end of the third quarter, aggregate debt for the S&P 500 (Ex-Financials) index reached its highest total in at least ten years, at $4.57 trillion. This marked a 7.8% increase from the debt amount in Q3 2015.” which is nothing new, as in the last 12 quarters, growth in debt exceeded growth in cash in all but one quarter (an outlier of 4Q 2013). 3Q 2016 cash to debt ratio for the S&P 500 (Ex-Financials) was 33.7%, on par with 3Q 2015 and 5.2% below the average ratio over the past 12 quarters.

Net debt issuance is also a problem: 3Q 2016 posted 10th highest quarter in net debt issuance in 10 years, despite a steep rise in debt costs.

While investment picked up (ex-energy sector), a large share of investment activity remains within the M&As. “The amount of cash spent on assets acquired from acquisitions amounted to $85.7 billion in Q3, which was the fifth largest quarterly total in the past ten years. Looking at mergers and acquisitions for the United States, M&A volume slowed in the third quarter (August - October) compared to the same period a year ago, but deal value rose. The number of transactions fell 7.3% year-over-year to 3078, while the aggregate deal value of these transactions increased 23% to $564.2 billion.”

The above, of course, suggests that quality of the deals being done (at least on valuations side) remains relatively weak: larger deals signal higher risks for acquirers. This is confirmed by data from Bloomberg, which shows that 2016 median Ebitda Multiple for M&A deals of > USD 1 Billion has declined to x12.7 in 2016 from an all-time high in 2015 of x14.3. Still, 2016 multiple is the 5th highest on record. In part, this reduction in risk took place at the very top of M&As distribution, as the number of so-called mega-deals (> USD 10 billion) has fallen to 35 in 2016, compared to 51 in 2015 (all time record). However, 2016 was still the sixth highest mega-deal year in 20 years.

Overall, based on Bloomberg data, 2015 was the fourth highest M&A deals year since 1996.

So in summary:

• While cash flow is improving, leading to some positive developments on R&D investment and general capex (ex-energy);
• Debt levels are rising and they are rising faster than cash reserves and earnings;
• Much of investment continues to flow through M&A pipeline, and the quality of this pipeline is improving only marginally.

Source: https://www.bloomberg.com/gadfly/articles/2016-12-30/trump-set-to-refill-m-a-punch-bowl-in-2017

18/7/16: Gamed Financial Information and Regulation Misfires

A recent interview by the Insights by Stanford Business, titled “In Financial Disclosures, Not All Information Is Equal” (all references are supplied below and all emphasis in quotations is mine) touched upon a pivotal issue of quality of information available from public disclosures by listed companies - the very heart of the market fundamentals.

The interview is with Stanford professor of accounting Iván Marinovic, who states, in the words of the interviewer, that “financial statements are becoming less and less relevant compared to other sources of information, such as analysts and news outlets. ...there is a creeping trend in financial disclosures away from the reliance on verifiable assets and toward more intangible elements of a business’s operations.”

In simple terms, financial information is being gamed. It is being gamed by increasing concentration in disclosures on ‘soft’ information (information that cannot be verified) at the expense of hard information disclosures (information that can be verified). More parodoxically, increasing gaming of information is a result, in part, of increasing requirements to disclose hard information! Boom!

Let's elaborate.

In a recently published (see references below) paper, Marinovic and his co-author, Jeremy Bertomeu define ‘hard’ and ‘soft’ information slightly differently. “The coexistence of hard and soft information is a fundamental characteristic of the measurement process. A disclosure can be soft, in the form of a measure that “can easily be pushed in one direction or another”, or hard, having been subjected to a verification after which “it is difficult to disagree”."

For example, firms asset classes can range "from tangible assets to traded securities which are subject to a formal verification procedure. Forward-looking assets are more difficult to objectively verify and are typically regarded as being soft. For example, the value of many intangibles (e.g., goodwill, patents, and brands) may require unverifiable estimates of future risks.”

The problem is that ‘soft’ information is becoming the focus of corporate reporting because of coincident increase in hard information reporting. And worse, unmentioned in the article, that ‘soft’ information is now also a matter of corporate taxation systems (e.g. Ireland’s ‘Knowledge Development Box’ tax scheme). In other words, gamable metrics are now throughly polluting markets information flows, taxation mechanisms and policy making environment.

Per interview, there is a “tradeoff between reliability and the relevance of the information” that represents “a big dilemma among standard setters, who I think are feeling pressure to change the accounting system in a way that provides more information.”

Which, everyone thinks, is a good thing. But it may be exactly the opposite.

“One of the main results — and it’s a very intuitive one — shows that when markets don’t trust firms, we will tend to see a shift toward financial statements becoming harder and harder. [and] …a firm that proportionally provides more hard information is more likely to manipulate whatever soft information it does provide. In other words, you should be more wary about the soft information of a firm that is providing a lot of hard information.”

Again, best to look at the actual paper to gain better insight into what Marinovic is saying here.

Quoting from the paper: “...a manager who is more likely to misreport is more willing to verify and release hard information, even though issuing hard information reduces her ability to manipulate. To explain this key property of our model, we reiterate that not all information can be made hard. Hence, what managers lose in terms of discretion to over-report the verifiable information, they can gain in credibility for the remaining soft disclosure. Untruthful managers will tend to issue higher soft reports, naturally facing stronger market skepticism. We demonstrate that untruthful managers are always more willing to issue hard information, relative to truthful managers."

Key insight: "...situations in which managers release more hard information are also more likely to feature aggressive soft reports and have a greater likelihood of issuing overstatements.”

As the result, as noted in the interview, “…we should expect huge frauds, huge overstatements precisely in settings or markets where there is a lot of credibility. The markets believe the information because they perceive the environment as credible, which encourages more aggressive manipulations from dishonest managers who know they are trusted. In other words, there is a relationship between the frequency and magnitude of frauds, where a lower frequency should lead to a larger magnitude.”

In other words, when markets are complacent about information disclosed and/or markets have greater trust in the disclosures mandates (high regulation barrier), information can be of lower quality and/or risk of large fraud cases rises. While this is intuitive, the end game here is not as clear cut: heavily regulating information flows might be not necessarily a productive response because markets trust has a significant positive value.

Let’s dip into the original paper once again, for more exposition on this paradox: “We consider the consequence of reducing the amount of discretion in the reporting of any verifiable information. The mandatory disclosure of hard information has the unintended consequence of reducing information about the soft, unverifiable components of firm value. In other words, there is a trade-off between the quality of hard versus soft information. Regulation cannot increase the social provision of one without reducing the other.”

Now, take European banks (U.S. banks face much of the same). Under the unified supervision by the ECB within the European Banking Union framework, banks are required to report increasingly more and more hard information. In Bertomeu-Marinovic model this can result in reduced incidence of smaller fraud cases and increased frequency and magnitude of large fraud cases. Which will compound the systemic risks within the financial sector (small frauds are non-systemic; large ones are). The very disclosure requirement mechanism designed to reduce large fraud cases can mis-fire by producing more systemic cases.

In its core, Jeremy Bertomeu and Ivan Marinovic paper shows that “certain soft disclosures may contain as much information as hard disclosures, and we establish that: (a) exclusive reliance on soft disclosures tends to convey bad news, (b) credibility is greater when unfavorable information is reported and (c) misreporting is more likely when soft information is issued jointly with hard information. We also show that a soft report that is seemingly unbiased in expectation need not indicate truthful reporting.”

So here is a kicker: “We demonstrate that …the aggregation of hard with soft information will turn all information soft.” In other words, soft information tends to fully cancel out hard information, when both types of information are present in the same report.

Now, give this a thought: many sectors today (think ICT et al) are full of soft information reporting and soft metrics targeting. Which, in Bertomeu-Marinovic model renders all information, including hard corporate finance metrics, reported by these sectors effectively soft (non-verifiable). This, in turn, puts into question all pricing frameworks based on corporate finance information whenever they apply to these sectors and companies.



References for the above are:

The Interview with Marinovic can be read here: https://www.gsb.stanford.edu/insights/financial-disclosures-not-all-information-equal.

Peer reviewed publication (gated version) of the paper is here: http://www.gsb.stanford.edu/faculty-research/publications/theory-hard-soft-information

Open source publication is here: Bertomeu, Jeremy and Marinovic, Ivan, A Theory of Hard and Soft Information (March 16, 2015). Accounting Review, Forthcoming; Rock Center for Corporate Governance at Stanford University Working Paper No. 194: http://ssrn.com/abstract=2497613.

17/6/16: Credit markets on the ropes?

In their research note, titled aptly “Credit Metrics Bode 1ll”, Moody’s Analytics produced a rather strong warning to the corporate credit markets, a warning that investors should not ignore.

Per Moody’s: “The current business cycle upturn is in its latter stage, aggregate measures of corporate credit quality suggest. The outlook for the credit cycle is likely to deteriorate, barring improved showings by cash flows and profits, where enhanced prospects for the latter two metrics depend largely on a sufficient rejuvenation of business sales.”

In other words, unless corporate performance trends break to the upside, credit markets will push into a recessionary territory.

“Recessions materialized within 12 months of the year-long ratio of internal funds to corporate debt descending to 19.1% i n Ql -2008, Ql-2000, and Q4-1989. As derived from the Federal Reserve's Financial Accounts of the United States, or the Flow of Funds, the moving year long ratio of internal funds to corporate debt for US non-financial corporations has eased from Q2-2011's current cycle high of 25.4% to the 19.1% of Ql-2016.”

Moody’s illustrate:

Now, observe the ratio over the current cycle: the peak around the end of 2011-start of 2012 has now been fully and firmly exhausted. Current ratios sit dangerously at 4Q 2007 and close to 1-3 quarters distance from each previous recession troughs.

The safety cushion available to the U.S. corporates when it comes to avoiding a profit recession is thin. Per Moody’s: “The prospective slide by the ratio of internal funds to corporate debt underscores how very critical rejuvenations of profits and cash flows are to the outlooks for business activity and credit quality. Getting profits up to a speed that will keep the US safely distanced from a recession has been rendered more difficult by the current pace of employment costs."

Here’s the problem. Employment costs can be cut back to improve profitability in a normal cycle. The bigger the cut back, the more cushion it provides. But in the current cycle, employment costs are subdued (do notice that this environment - of slower wages and costs inflation - is the same as in 2004-2007 period). Which means two things:

1. U.S. corporates have little room to cut employment costs except by a massive wave of layoffs (which can trigger a recession on its own); and
2. U.S. corporates have already front-loaded most of the risk onto employment costs during the Great Recession. Which means any new adjustment is going to be even more painful as it will come against already severe cuts inherited from the Great Recession and only partially corrected for during the relatively weak costs recovery period since then. 

Moody’s are pretty somber on the prospect: "As inferred from the historical record, restoring profits through reduced labor costs is all but impossible without the pain of a recessionary surge in layoffs. Thus, barring a recession, employment costs should continue to expand by at least 5% annually."

That’s the proverbial the rock and the hard place, between which the credit markets are wedged, as evidenced by the recent dynamics for both Corporate Gross Value Added (the GDP contribution from the corporate sector) and the nominal GDP:

Again, the two lines show steady downward trend in corporate performance (Corporate GVA) and slight downward trend in nominal GDP. In terms of previous recessions, sharp acceleration in both trends since the end of 4Q 2014 is now long enough and strong enough to put the U.S. onto recessionary alert.

Per Moody’s: "As of early June, the Blue Chip consensus projected a 3.2% annual rise by 2016's nominal GDP that, …signals a less than 3% increase by corporate gross value added. [This]... implies a drop by 2016's profits from current production that is considerably deeper than the - 2.5% dip predicted by early June's consensus. Moreover, as inferred from the consensus forecast of a 4.4% increase by 2017's nominal GDP, net revenue growth may not be rapid enough to stabilize profits until the second-half of 2017, which may prove to be too late for the purpose of avoid ing a cyclical downturn."

In other words, there is a storm brewing in the U.S. economy and the credit markets are exhibiting stress consistent with normal pre-recessionary risks. Which is, of course, somewhat ironic, given that debt issuance is still booming, both in the USD and Euro (a new market of choice for a number of U.S. companies issuance in response to the ECB corporate debt purchasing programme):

Just as the corporate credit quality is deteriorating rapidly:

You really can’t make this up: the debt cornucopia is rolling on just as the debt market is flashing red.

27/4/16: The Debt Crisis: It Hasn't Gone Away

That thing we had back in 2007-2011? We used to call it a Global Financial Crisis or a Great Recession... but just as with other descriptors favoured by the status quo 'powers to decide' - these two titles were nothing but a way of obscuring the ugly underlying reality of the global economy mired in a debt crisis.

And just as the Great Recession and the Global Financial Crisis have officially receded into the cozy comforters of history, the Debt Crisis kept going on.

Hence, we have arrived:

Source: http://www.zerohedge.com/news/2016-04-27/debt-growing-faster-cash-flow-most-record

U.S. corporate debt is going up, just as operating cashflows are going down. And so leverage risk - the very same thing that demolished the global markets back in 2007-2008 - is going up because debt is going up faster than equity now:

As ZeroHedge article correctly notes, all we need to bust this bubble is a robust hike in cost of servicing this debt. This may come courtesy of the Central Banks. Or it might come courtesy of the markets (banks & bonds repricing). Or it might come courtesy of both, in which case: the base rate rises, the margin rises and debt servicing costs go up on the double.

15/4/16: Tech Sector Finance: Gravity of Gravy

Previously, having posted on disconnection between S&P500 market valuations and basic corporate finance (earnings and distributions) - see that post here: http://trueeconomics.blogspot.com/2016/04/15416-corporate-finance-s-and-bubble.html - it is time to remind us all what a popping bubble looks like.

Earlier this month, I was in San Francisco, the epicentre of the corporate finance-free world of tech. Not surprisingly, few smoke breaks and few chats over a glass of wine with some tech folks revealed a very interesting insight: every single one tech CEO/CFO/COO (but not CTO) I spoke to was concerned with evaporating funding in the markets for non-public equity financing around the Silicon Valley.

Need confirmation? Here is a chart through 1Q 2016 on Tech IPOs trends:

Source: https://www.theatlas.com/charts/Nkk4jHLCe

And a note from the WSJ: http://www.wsj.com/articles/startup-investors-hit-the-brakes-1460676478 on same with a handy graph:

And the numbers of deals? Why, off the cliff too:

Source: https://www.theatlas.com/charts/Vk8_bYUAl

There is not panic, yet, but there is panic already in works: techies are retrenching on new hiring and there are rumours of some layoffs in younger companies. Meanwhile, states-sponsored agencies seeking to lock start ups and existent players into relocating to their countries or landing in the countries with regional HQs are still shopping around, as if money will always be there to rent plush offices and the case-styled furniture for those whiz kids who make up apps with little cash flow behind them...

It all might be temporary. Or it might be the beginning of the real thing. But one thing is certain: on a long enough timeline, one can defy gravity of basic corporate finance only as long as the interest rates defy gravity of risk pricing.

15/4/16: Corporate Finance, S&P500 and Bubble Trouble...

Classical corporate finance tells us that companies should be valued on their earnings with past earnings being indicative of future earnings (predictive component). Which is tosh. In today's world that is.

Q4 2016 saw highest payouts to shareholders (combined cash dividends and share repurchases) in over 10 years (couple of slides from my course presentation):

And yet... yet... earnings have hit the brick wall back in Q3 2014 and have been trending down ever since:

You really can't call S&P500 anything but a sail-in-the-Fed-wind. There are no fundamentals sustaining it above 1600-1650 range. At least, not corporate fundamentals.

Unless, of course, one expects the recent extraordinary payout performance to remain indefinitely present in the future. Which only a sell-side analyst or a lunatic can...

19/4/15: Three Strikes of the New Financial Regulation: Part 4 – CMU's Economics

My fourth instalment on the latest policy innovation in Finance in the EU, covering the shaky economics of the Capital Markets Union is available on LearnSignal blog: http://blog.learnsignal.com/?p=173#more-173.