How Income Streams Dry Up!

Folks, the following is really important!  It's worth investing some time to process the points below.

In my last blog, I examined the metaphor of dividends as a sluice diverting some of the broader river of money a company generates.  As long as the river is swelling, the sluice can grow too.  Earnings growth can be problematic though, and so too can the growth of dividends.

There are many demands made on a company's income stream.  Surprisingly, perhaps, one of the greatest threats is the very thing that companies try to generate: cash.  As it swells, so too do the temptations to "do" something with it.  Some of these things are perfectly fine, even critical.  Research and development, infrastructure investments, employee development ... all these might have a big payoff down the line.  However, a whole bunch of things are far more questionable.  Outsize salaries and bonuses to top management are astonishingly effective in draining money from the income stream.  Trophy investments of all kinds can vaporize huge sums of money. Helpful hint: if your hot start-up buys a sports arena or builds a name-brand highrise, run, don't walk, for the exits!

This brings me to one of my biggest gripes: stock buybacks.  These are a terrific way to vaporize money.  Here's the shill.  Take "excess" cash, and use it to buy the company's stock on the open market, thus shrinking the number of shares outstanding.  If a company buys up 10% of  its stock over a couple of years time, then, in theory, its income will accrue to fewer shareholders.  So, their stock will be worth more, and the price will go up!  Great idea, right?  Actually, it's terrible.

Let's do the math, vastly simplified.  Assume a company with $1 million net worth, with $200,000 in cash, and $800,000 in other assets (plant, inventory, patents, etc.).  Say it has 100,000 outstanding shares.  Say it earns $100,000 a year.  How would the this stock be valued?  Well, the simplest would be the breakup value: sell off everything and distribute the proceeds to the stockholders.  In this case, that would be $10 per share.

In real life, though, those earnings of $100,000 would be the starting point.  A company is, after all, usually worth more than its physical assets.  It's an earnings machine.  Based on opinions about whether the earnings will grow over time, a price/earnings multiple will usually be assigned: say 10 to 1 for a company with average prospects.  To that, the cash ($2 per share) would be added, resulting in a price of $12 per share, higher than the breakup value. Note here that cash is a special category.  It's not locked up; you can do anything you want with it. You can use it to build the business or protect the business from hard times.  You can give it to the investors as a dividend.  You can lend it out to others, thus turning it into an income stream.  That's why you would add cash in, dollar for dollar, to the per share value of the company.

Now assume a Carl Icahn vulture buys in, and then demands a buyback to "enhance shareholder value," citing the magic of enhanced per-share earnings.  There is a HUGE intellectual gap in his presentation, however.  Here's a startling idea: if you spend money, then you don't have it.  It's like cake.  You can look at it, luscious and tantalizing, or you can eat it.  You can't do both (at the same time, of course, of course).  Yes, earnings per share will rise if you purchase back a portion of the outstanding shares, but the company itself is now worth less, dollar for dollar, than before.

In this example, using the $200,000 in cash to buy 16,666 shares at $12/share will reduce the number of shares outstanding to 83,334.  With $100,000 yearly earnings, each share now earns $1.20 a share.  Great, right?  BUT, you can no longer add in the cash!  It's gone!  So, applying the same PE multiple of 10 to the $1.20, you end up EXACTLY where you were before, with a stock worth $12 a share. I would argue, strongly, that the company is actually worse less than before, because cash is NOT trash.  It's vital to the future of a company, as it can grow sales if properly invested, or at least cushion a company from bad times.

So why does Carl want the company to initiate a buyback?  Simply put, it's a great way to make a fast buck.  Announcing the buyback, and then initiating it, puts upward pressure on the stock.  Suddenly, extra cash is chasing the shares available for sale.  Demand outruns supply (temporarily), and the price jumps.  So, Carl sells into a rising market, pockets the quick gain, and departs.  He could care less about "stockholder value!"  He's a scorpion, stinging companies is what he does.  Lesson for non-scorpions?  Stock buybacks only benefit the folks who sell!  Those who stay are left with a company whose cash has been frittered away to others.  I think it's a form of financial rape
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But, you ask, why couldn't the game go on ... forever?  That is, if buying stock back puts upward pressure on the price, then a permanent buyback program would permanently lift stock prices, thus rewarding shareholders precisely as planned.

Asking the question pretty much answers it.  No stock buyback program is permanent.  No company ever promises it.  They can't, and would be idiots to do it.  The future is unknowable, and stock buybacks are, by and large, expensive.  When the money runs short, the buybacks cease.  Gravity ensues.

Even if the money didn't run short (and it almost always does), you would still run into the law of diminishing returns.  Eventually, the company will have bought all the outstanding stock, at ever-rising prices.  The last man standing (Michael Dell perhaps) owns a single hugely expensive share, and the company is no longer public.  What would you call a game where you're buying something that gets more and more expensive, precisely because you're buying it? The Hunt brothers discovered the answer when they tried to corner the silver market. 
 
If you look at the history of stock repurchases, it becomes clear that they are a zero-sum game.  Any rise in the stock price is due largely to increased, and temporary, demand.  Once that demand is met (i.e., once the company stops the buy-back), the price settles right back. Why do companies stop their purchases?  Lots of reasons.  A common one is that they never intended to complete the buyback.  They rely on the announcement to goose the price, and quietly shelve the buy-back after a few months.  Equally common is the economic cycle.  Buybacks occur when money is plentiful.  An economic downturn ends the game instantly. 

This brings me to  the question of timing.  Executives who decide to pump earnings by repurchasing stock have, historically, had terrible timing.  Invariably, they initiate buybacks when times are good, and cash is burning a hole in their pockets.  Then, once the economy has cratered (it happens pretty regularly), they suddenly hoard the cash like ... gold!  In fact, companies will, facing economic distress, often issue stock at distress prices in order to shore up their cash reserves.  This is classic buy-high sell-low behavior.  Guess who pays the price?  It's not the CEOs, who typically get massive bonuses when the stock is up (due to buy-back jiggering), and then float away on golden parachutes once the shit has encountered the inevitable fan.

Occasionally you will see a company like IBM, which has bought back a large amount of stock, and still seen the stock price rise over time.  Does this constitute proof that stock buybacks are the reason?  Quite the contrary, I would argue.  IBM has been very good at increasing revenues, even to the point that stock buybacks dwindle against the income growth.  Where would investors be if IBM had diverted this cash to dividends instead?  Far better off, I would insist.  The money would be in the hands of the stockholders now, instead of in the hands of departed sellers.

One of the worst abuses of the stock buy-back is to fund employee and executive bonuses.  The company plumps down a pile of cash, and then hands the stock over to the hired hands.  So, the stock isn't retired at all, the PE ratio is not lowered at all, and the stock owners have their ownership diluted (as they now own a company worth less than before).  This might be OK, if these incentives actually worked.  There is, however, almost no evidence that it does.  The explosion of executive compensation in the 2000-2012 period has no relationship to the performance of the companies at all!  Since this was a period of relative stagnation, a rational system would have frozen executive salaries during the decade.

What can you do about all this?  Very little directly.  You should, however,  use the information to control your enthusiasm about the next hot stock.  Your company may grow from an acorn to the heavens, and you still might not reap even a fraction of the rewards.  If you are thinking about a given stock, take a close look at its recent record of employee compensation and incentives.  If they're at the high end, then you may be sure that management's interests are no longer aligned with yours.  You'd be better off avoiding a train due for a crash.  You can be sure that those discredited CEOs and CFOs will not lose a dime in the pileup, but you will lose a sock-full.

If a company really intends to reward its shareholders, there is a very simple way to do it:  the dividend!   Here is the ideal: a regular, sustainable dividend, adjusted periodically for inflation and income growth, but modest enough to leave the company with sufficient cash to grow the business.  Old fashioned, isn't it?  Alas, if only this simple recipe weren't so damnably difficult to do (as I pointed out in an earlier blog)!

To return to my broader theme, can you see a little better why I prefer bonds? 

    

Income Streams, Upriver and Down

I just love bonds, but, as I said in my last post, I can't recommend them right now.  Well, that's not strictly true; it's just that I can't recommend my favorite investing technique, which involves the regular purchase of BAA 30-year bonds.  Yields are simply too low; rising rates will trash principal if you buy at today's inflated prices.

So, what should you do?  In the frantic hunt for yield, the flavor of the month is the high-dividend stock, particularly one with rising dividends.  Do the math, say the gurus: even a stock with a moderate dividend  will beat bonds handily if that dividend grows over time.  They spin lovely scenarios like this: a company with a 3% dividend increases that dividend steadily over a ten-year period, say at a rate of 5% annually.  So, a $100 stock will initially yield $3.  After ten years of growing at a 5% rate, that $3 becomes nearly $5.  Assuming the price/earnings ratio stays the same, that $100 stock is now worth $166!  Add in the cumulative dividends (say $40), and you've doubled your money!  Factor in the favorable tax treatment (15%) given to dividends, and you've beaten bonds to death!  Lovely, right?

As I've pointed out before, there serious problems with the scenario.  They derive, in the main, from the fact that dividends and interest are very different things.  In the broadest sense, both are sluices from a larger income stream.  What is the larger stream?  Well, it's the money a company generates by doing what it does: lending money, selling automobiles, refining copper, brewing up syrup-laden lattes, etc.  Interest is one of the company's core expenses whereas dividends are diverted from the income stream after expenses are paid.  Logically, therefore, interest comes first and dividends trail, badly.

If a company's expenses rise more rapidly than its ability to increase sales or raise prices, then the viability of the dividend is jeopardized.  THAT, folks, is exactly what happens, over and over and over.  A company will establish a very nice record of paying steadily rising dividends, only to cut them severely, or even eliminate them, when tough times arrive.  This isn't a rarity; it's predictable.  Yes, recessions do damage a company's cash flow, and perhaps its ability to pay the dividend.  But they are also a great excuse for cutting back on an obligation that will become unsustainable in the future.  That is partly why dividends were pared so savagely in 2008/9 and  2001/2.  In fact, EVERY recession brings waves of dividend cuts.  You can count on them, and they absolutely trash the lovely scenario painted above.  The haircut is twofold: you get less income, and the stock price drops to account for the diminished payout.  It can take years to recover.

Instead of running off after yield alternatives, my advice is to be patient.  If you're lucky enough to be receiving regular interest payments from a Bodacious portfolio, you can just sit on the money for awhile.  To that money you can add redemptions (remember, you've laddered BAA bonds over a 30-year spectrum).  Cash and cash equivalents will build steadily.

You will probably be surprised how rapidly today's low-interest environment will fade.  Until then, I suggest you stick with bonds: just of a different type.  If you look for investment grade bonds with a 1-2 year maturity, you'll discover that it's perfectly feasible to capture yields in the 2.5% to 3% range.  That's generous enough to pay your taxes and cover today's inflation as well.  Yeah, you're not gonna get ahead, but you're not falling behind either.  Sometimes, staying even is a very good thing, all by itself.  As bond income and redemption cash comes in, you can ladder your purchases, buying 1-2 years out, two or three times a year.

Then, you wait, like a spider.  Eventually, rates will rise.  Eventually, they will rise enough to let you go out on the maturity spectrum, and capture yields that will beat inflation and taxes, and still leave you a generous return.  If you get to one of those rare moments when yields have soared, and prices plunged, then you can go for the long bomb: using leverage to lock in cyclically peak yields.