How to Tell the Difference

 

One of the perks of living close to the office is that I get to go home for lunch. Most days my wife and I chit chat, discussing current news and our schedule. But every once in a while I’m at home alone for lunch and I turn on the TV. I’m immediately depressed, and it’s not because of the programming. It’s the commercials.

I’ve not studied the demographics of those who watch TV at noon on a weekday, but judging from the commercials it must be a combination of people who have been in an auto accident, been fired, never attended college or even finished high school and are currently unemployed or under-employed, or are really old.

And they all share one common trait… they’re gullible. The ads are outrageous! When it comes to commercials touting for-profit colleges, they always scream: “Invest in yourself!” I think I will, by not sending them money.

But that line got me thinking about how companies spend money…

It used to be that mature companies would pay dividends, using their cash-cow products to generate returns that benefited stockholders.

Young companies with great growth potential would plow any revenue back into research and development or fund growth in some other way.

Companies that were in the middle — established but still growing — would typically use their cash to grow through acquisition, upgrade their systems and equipment, and perhaps pay a small dividend as well.

All of this made sense. However, there is now a new use of corporate cash that’s getting a lot of attention. That is, buying one’s own stock.

Corporate buybacks aren’t new, but they were once relegated to companies that were more or less dying, or at least in a dying industry. After exhausting all other possibilities, company management would concede that it simply had no good alternatives and would buy its own stock.

Today, corporate buybacks are viewed a bit differently. Instead of signaling the death of a company or industry, they tell investors that companies are in it for themselves, or at least their shareholders and management.

It’s no secret that consumers haven’t bounced back with a vengeance, or that the economy is growing at a tepid pace, at best. Still, corporate America has been able to contain costs (read here: hold wages down) and thereby keep earnings on track, even if they aren’t growing dramatically.

Meanwhile, interest rates are exceptionally low. So companies are earning cash and can borrow cheaply, but they’re cautious about expanding because overall economic growth is sluggish at best.

So what does one do to keep the wheels of finance — and earnings per share (EPS) — turning? Why, use cash and borrowed money to reduce the number of shares outstanding, of course!

If earnings remain the same, but the number of shares is reduced, then EPS must go higher. Technically, each share isn’t worth any more, since the company used cash on hand or borrowed money to fund the purchase. However, because EPS goes up, a key measure of the health of the company suddenly improves. This makes the shares of the company more attractive to investors, which tends to drive up the share price.

In addition to making the shares more attractive, a rising EPS also rewards management. Of the 30 stocks in the Dow Jones Industrials Average, 26 use EPS as one of the measurements when setting executive compensation.

So how popular are corporate buybacks?

In 2013, the 30 companies in the Dow authorized over $200 billion in stock buybacks, or almost three times what they spent on research and development. It appears that the trend of buying one’s own stock has caught on.

I’m not saying it’s wrong or bad for a company to buy back its own stock. Apple is a great example of when this makes sense.

The company is huge. It has a market capitalization of almost half a trillion dollars. It generates tens of billions of dollars in free cash flow. With all of that green coming in, Apple has to make choices. Does it try to invest that money, or pay dividends (which it has), or buy back stock? In this case, the answer is all three.

That being said, there are times when a stock buyback is a sign of trouble.

Companies with falling revenue, shrinking earnings, and little prospect for growth will sometimes buy back their own stock to keep the price up.

The trick you need to learn is to be able to spot the difference.

Some companies track this exact thing. Trim Tabs, out of Sausalito, California, has made a business of tracking corporate financials. One of its measurements is called “Float Shrink,” which watches the change in the number of shares of a company held outside of the company.

Trim Tabs has even created an exchange-traded fund to buy shares of companies that are healthy and growing, yet buying back their own shares… like Apple.

In a crazy world where economies seem sickly at best, yet companies are booking strong profits, it helps to have a variety of ways of figuring out which companies have the best chance of a rising stock price.

If they appear healthy and are screaming “I invest in myself!” then they could be a good choice.

Rodney

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About Author

Rodney Johnson works closely with Harry Dent to study how people spend their money as they go through predictable stages of life, how that spending drives our economy and how you can use this information to invest successfully in any market. Rodney began his career in financial services on Wall Street in the 1980s with Thomson McKinnon and then Prudential Securities. He started working on projects with Harry in the mid-1990s. He’s a regular guest on several radio programs such as America’s Wealth Management, Savvy Investor Radio, and has been featured on CNBC, Fox News and Fox Business’s “America’s Nightly Scorecard, where he discusses economic trends ranging from the price of oil to the direction of the U.S. economy. He holds degrees from Georgetown University and Southern Methodist University.