Since my fellow editors and I share the lineup here at Economy & Markets, I don’t speak with you as much as I’d like.
Because we don’t have time to dilly-dally about less important matters, today I’m again here to remind you that no matter what we do in this market, where nearly every company uses some financial chicanery to prop up its bottom line, we need proof that profits go to us, the shareholder – and that they go to us first.
Of course not every company is overly aggressive, but that is a definite warning sign to bail on a stock. I have seen that movie many times in my career. It’s a slasher flick and usually ends pretty badly.
Again, as a reminder, the proof that a company pays its investors first comes in the form of dividends. It’s a profit share check paid to you directly from the company in an amount determined by the number of shares, or percentage, you own in the company.
Going back over 40 years, companies that pay dividends vastly outperform companies that do not:
Another way to pay investors first is through share buybacks, but not all buybacks are the same. At Hidden Profits, we take great care to analyze the quality of the shareholder yield a company is providing, and that includes buybacks.
Buybacks could be used to boost earnings per share. In fact, buybacks have been the key driver of market returns in this bull market since 2009. That alone is a weak way to increase value.
Buybacks could also be used to fund executive compensation schemes. Management teams are highly incentivized to keep the stock price up to meet the short-term demands of Wall Street. This may not be the best capital allocation strategy.
Furthermore, the buybacks may come at inflated prices. Buying $1.00 for $1.10 never made much sense to me.
In a nutshell, there is good shareholder yield and bad shareholder yield.
At Hidden Profits, our methodology has fine-tuned the shareholder yield model to focus on good shareholder yield.
Take International Business Machines Corporation (NYSE: IBM), for example. The company’s management team has taken on billions of dollars in debt to buy back stock (at much higher prices), while the business itself implodes. IBM’s revenues have been in decline for years! The balance sheet has become bloated and the quality of cash flow has deteriorated.
Any sensible investor would question this capital allocation strategy. Does IBM’s management team have your best interests in mind? What are they doing to grow the business and generate higher earnings quality? What’s the point of buying back stock at much higher prices when the business is a melting ice cube?
On the other side of the playing field, consider auto goods retailer AutoZone, Inc. (NYSE: AZO). The company’s management team has bought back over $17 billion in stock over the last 18 years.
The company generates huge amounts of cash flow consistently from year to year. It easily exceeds net income, upping its earnings quality profile. While there is debt on the balance sheet, it’s only up fractionally in recent years. Meanwhile, the stock has gone to the moon.
At Hidden Profits, we want to buy companies like that – companies that pay us first. But, not at the expense of low-quality earnings or failure to reinvest in the business with an eye on future cash flows.
So, what’s the upshot?
Through testing and real-world experience we’ve found that, by focusing on management teams with investors’ best interests in mind, the returns are multiples of what is earned by buying and holding the S&P 500.
In this day and age of buyback mania, make sure the stocks you’re buying don’t use it as an accounting technique to mask a deteriorating business. Make sure the buyback plan is designed to return cash to you first from quality sources while the business can continue to thrive without the excess cash…
Just like we do at Hidden Profits.
John Del Vecchio
Editor, Forensic Investor