With the S&P 500 off -1% from its all-time record high, many bears have continued to wait for and talk about a looming crash. For the naysayers, the main focus has been on the distorted monetary policies instituted by the Federal Reserve, but as I pointed out in Fed Fatigue is Setting In,QE and tapering talk are not the end-all, be-all of global financial markets. One need not look further than the dozen or so countries listed in the FT that have bond yields below the abnormally low yields we are experiencing in the U.S. (10-Year Treasury +2.75%).
Although there are many who believe a freefall is coming, much like a trampoline, a naturally occurring financial mechanism has provided a relentless bid to boost stock prices higher…a buyback bonanza! How significant have corporate stock repurchases been to spring prices higher? Jason Zweig, in his Intelligent Investor column, wrote the following:
In the Russell 3000, a broad U.S. stock index, repurchased $567.6 billion worth of their own shares—a 21% increase over 2012, calculates Rob Leiphart, an analyst at Birinyi Associates, a research firm in Westport, Conn. That brings total buybacks since the beginning of 2005 to $4.21 trillion—or nearly one-fifth of the total value of all U.S. stocks today.
To further put this gargantuan buyback bonanza into perspective, a recent Fox Business article described it this way:
Companies spent an estimated $477 billion on share buybacks last year. That’s enough to buy every NFL team 12 times over, run the federal government for 50 days or host the next nine Olympic Games with several billion left to spare. This year, companies are expected to ramp up buybacks by 35%, according to Goldman Sachs.
The bears continue to scream, while purple in the face, that the Fed’s QE and zero interest rate program (ZIRP) shenanigans are artificially propping up stock prices. The narrative then states the tapering and inevitable Fed Funds rate reversal will cause the market to come crashing down. While there is some truth behind this commentary, history reminds us that not all rate rising cycles end in bloodshed (see 1994 Bond Repeat or Stock Defeat?). Even if you believe in Armageddon, this rate reversal scenario is unlikely to happen until mid-2015 or beyond.
And for those worshipping the actions of Ms. Yellen at the Fed altar, believe it or not, there are other factors besides monetary policy that cause stock prices to go up or down. In addition to stock buybacks, there are dynamics such as record corporate profits, rising dividends, expanding earnings, reasonable valuations, improving international economies, and other factors that have contributed to this robust bull market.
At the end of the day, as I have continued to argue for some time, money goes where it is treated best – and generally that is not in savings accounts earning 0.003%. There is no reason to be a perma-bull, and I have freely acknowledged the expansion of froth in areas such as social media, biotech, Bitcoin and other areas. Regardless, there is, and will always be areas of speculation, in bull and bear markets (e.g., gold in the 2008-2009 period).
Investing involves a mixture of art and science, but with a few exceptions (i.e., fraud), numbers do not lie, and using math when investing is a good place to start. A simple but powerful mathematical formula instituted at Sidoxia Capital Management is the “Free Cash Flow Yield”, which is a metric we integrate into our proprietary SHGR (a.k.a.,“Sugar”) quantitative model (see Investing Holy Grail).
Quite simply, Free Cash Flow (FCF) is computed by taking the excess cash generated by a company after ALL expenses/expenditures (marketing, payroll, R&D, CAPEX, etc.) over a trailing twelve month period (TTM), then dividing that figure by the total equity value of a company (Market Capitalization). Mechanically, FCF is calculated by taking “Cash Flow from Operations” and subtracting “Capital Expenditures” – both figures can be found on the Cash Flow Statement. The Free Cash Flow ratio may sound complicated, but straightforwardly this is the leftover cash generated by a business that can be used for share buybacks, dividends, acquisitions, investments, debt pay-down, and/or placed in a banking account to pile up.
The great thing about FCF yields is that this ratio (%) can be compared across asset classes. For example, I can compare the FCF yield of Apple Inc – AAPL (+9.5%) versus a 10-Year Treasury (+2.75%), 1-year CD (+0.85%), Tesla Motors – TSLA (0.0%), Netflix, Inc – NFLX (-0.001%), or Twitter, Inc – TWTR (-0.003%). For growth and capital intensive companies, I can make adjustments to this calculation. However, what you quickly realize is that even if you assume massive growth in the coming years (i.e., $100s of millions in FCF), the prices for many of these momentum stocks are still astronomical.
An important insight about the current corporate buyback bonanza is that much of this price boost is being fueled by the colossal free cash flow generation of corporate America. Sure, some companies are borrowing through the debt markets to buy back stock, but if you were the Apple CFO sitting on $159,000,000,000 in cash earning 1%, it doesn’t make a lot of sense to sit on the cash earning nothing. It also doesn’t take a genius (or Carl Icahn (Trades, Portfolio)) to figure out borrowing at record low rates (2.75% 10-year) while earning +10% on a stock buyback will increase shareholder value and earnings per share (EPS). More specifically, when Apple borrowed $17 billion at interest rates ranging from 0.5% – 3.9%, a shrewd, rational human being would borrow to the max all day long at those rates, if you could earn +10% on that investment. It is true that Apple’s profitability could drop and the numerator in our FCF ratio could decrease, but with $45 billion smackers coming in every year on top of $142 billion in net cash on the balance sheet, Apple has a healthy margin of safety to make the math work.
Where the math doesn’t compute is in insanely priced deals. For example, the recent merger in which Facebook Inc (NASDAQ:FB) paid $19 billion (1,000 x’s the estimated 2013 annual revenues) for a 50-person, money-losing company (WhatsApp) that is offering a free service, makes zero financial sense to me. Suffice it to say, the FCF yield on WhatsApp could cause Warren Buffett (Trades, Portfolio) to have a coronary event. Yes, diamond covered countertops would be nice to have in my kitchen, but I probably wouldn’t get much of a return on that investment.
Share buybacks are not a magical elixir to endless prosperity (see Share Buybacks & Bathroom Violators), but given the record profits and record low interest rates, basic math shows that even if stock prices correct (as should be expected), the trampolining effect of this buyback bonanza will provide support to the market.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients hold long positions in certain exchange traded funds (ETFs), AAPL and a short position in NFLX, but at the time of publishing SCM had no direct position in TSLA, TWTR, FB, Bitcoin, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.