Here We Go Again
In the late 1990s, I knew several local investors who were excited about investing in the greatest “new frontier” we had seen in decades, the internet. These high net worth individuals bought into dot-com IPOs (which had no hard assets or revenues), just as they were going public, knowing their just-minted shares would increase in value by 25 to 100 percent within days, at which time they’d sell for a tidy profit, and move on to the next one.
“Aren’t you afraid you’re eventually going to get burned?” I asked one investor. “No,” he said, “because when I do, the gains I made on all the other deals will more than offset this one loss. In the meantime, it’s easy money.”
Investors like him made out just fine. But when the dot-com bubble burst, stock prices across the board plunged. Many companies—dot-coms and otherwise—folded. And the sudden lack of confidence in stock valuations launched a recession.
In the mid-2000s, I spent a little time in the residential housing market, as tens of millions of Americans were taking out home equity loans and home equity lines of credit. Their property values had gone up since they took out their original mortgage, and a home equity loan or line of credit felt like free cash. Some $350 billion in credit card debt shifted into these instruments. Others spent proceeds on trips, cars, kids’ college; some used it to reinvest in their homes—and then refinance again. Others knew they shouldn’t be able to qualify for a mortgage, but they took the money anyway.
A lot of people just shrugged when asked, “Don’t you think this is too good to be true?” Along the way, U.S. home prices more than doubled between 1998 and 2006, the sharpest increase in recorded history. As with the dot-com bubble, many made out quite well. Then, in 2007-08, home values dropped as mortgage defaults rose, “valuation” lost its meaning, the markets panicked, spending stopped and the Great Recession was born.
Now we’re falling for another financial game that will once again hurt our economy and our stock portfolios. It’s a two-pronged approach to inflate the value of publicly traded stocks: reduce business spending/reinvestment, and increase spending on stock repurchases and dividends.
Buybacks and dividends were created to pay a return to investors. Today, they’re being misused by a growing number of corporations to pump up stock prices that would otherwise drop due to their operational performance: buybacks reduce the number of existing shares, making each share worth more; stocks with nice dividends are even more valuable to investors.
Among S&P 500 companies, stock buybacks surged 15 percent, to $166.3 billion, from February to April this year compared with one year ago and one quarter ago, according to FactSet Research Systems. In the same period, buybacks among S&P 500 businesses accounted for 73 percent of net income—an increase of 25 percent from a year ago—and 146 companies spent more on buybacks in the trailing 12 months than they generated in earnings. That’s the same level as just before we entered the Great Recession.
Meanwhile, hundreds of companies with low-growth or no growth are increasing their dividends. Chief among them is IBM. Despite its weakening sales and profitability, its dividend of $5.60 a share bolsters its stock price—so much so that its price appreciation is one of the biggest contributors to the Dow Jones Industrial Average’s gain this year.
Rising stock values based on such smoke and mirrors give the public (and the Fed) the false sense that all is healthy in the stock market. Eventually, buybacks and dividends will taper off, and the reduced reinvestment in these businesses will catch up to them in the form of lost market share.
We’re already starting to see this. By early August, the nation’s largest public companies logged their fourth straight quarter of shrinking profits and weak sales. The Commerce Department also reported that economic growth for the first half of 2016 grew at only 1 percent, the weakest start since 2011. The primary reason is a reduction in business spending since last fall (which TCB’s quarterly, forward-looking economic indicator survey flagged).
Stock repurchases and dividends serve a valid purpose in moderation, and when a company’s revenue is growing organically. Any company spending a significant chunk of its cash in these areas while sales are slowing or flat is doing so only to enrich its executives, whose compensation is likely based more on stock performance than on the company’s current and future market share, revenue growth and sustainable profitability. We have a couple of local retailers that come to mind on this note.
But on the more positive side, we have the likes of Tennant Co., which reported a 3.4 percent increase in net income for its most recent quarter ending July 26. Revenue grew only 0.7 percent but it wouldn’t have grown at all had it not been for R&D investments years earlier to create new products: sales from products introduced within the last three years represented 35 percent of sales.
Tennant is buying back shares and paying dividends. But it’s keeping these activities under control, while increasing spending on R&D and other longer-term, growth-oriented initiatives.
As a result, its executives aren’t compensated as well as those at companies with more robust stock buybacks. But Tennant—its jobs and its benefit to our economy and society—will be here long after companies that are prioritizing short-term shareholder return over sustainability.
And investors know what its stock is truly worth today.