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Stock Buybacks: A New Wall Street Fad...Corporate "Cabbage Patch" Dolls of the 1990s Also, Results of the 1998 "Fluff Championship of the IT World"
PHOENIX - Some people cheer them, others jeer them, yet most investors haven't a clue if they should either sneer, or hold them dear.
What is the mystery item that's spooking some people on this Halloween night of 1998, the witching year as some believe? (try dividing it by 3 to understand why - see Annex Bulletin 98-04). It is the latest Wall Street fad; the expensive (multi-billion) corporate "cabbage patch" dolls of the 1990s - the stock buybacks.
As John Naisbitt noted in his 1980s bestseller book, "Megatrends," "fads are top down; trends are bottom up." As a result, fads tend to burn out like a flash in a pan; trends burn brightly for a long time.
During the last three years alone, corporate America has spent nearly half a trillion dollars on Wall Street's virtual "cabbage patch" dolls - without creating a single new job or a product. Stock buybacks attracted more money in 1990-1997 than did the economies of all developing countries in the world - combined! (about $550 billion, according to a United Nations report - see Annex Bulletin 97-38, 10/16/97).
This week, stock buybacks shot back into the news headlines as the IBM board fingered another $3.5 billion for share repurchases, raising the cumulative capital authorized since early 1995 to $27.5 billion. Here are some "sound bites"...
Bloomberg News Wire: "An Illusion of Prosperity."
"Their (IBM's) fastest-growing business is services, and you don't have to build factories for that,'' an analyst at Brown Brothers Harriman & Co. in New York, who has a "short- term buy'' on IBM shares, told Bloomberg News Wire on Oct. 27. "You have to do something with the money.''
"It's a waste of capital - it doesn't create a single product or a single job," this writer was quoted as saying in the same story. The comment was followed by a Bloomberg footnote that, "(Djurdjevic) has been a longtime critic of buyback programs at IBM and other companies."
Bloomberg added, "in the third quarter, Djurdjevic estimates that IBM's share buyback increased its earnings per share by 11 cents. 'It creates an illusion of prosperity by boosting the financial results without adding a cent to the bottom line,' Djurdjevic said."The New York Times: "A Wall Street Perversion." Meanwhile, the New York Times quoted on Oct. 28 an analyst with Merrill Lynch & Co, as saying that, "I think it's a reasonable use of cash. How many investment opportunities do they have that can return cost of capital? They should be investing up to that point, and beyond that they should return cash to the shareholders."
"But Bob Djurdjevic, president of Annex Research, called the repurchase a 'Wall Street perversion,' that benefits selling institutions to society's detriment, and artificially inflates current earnings and growth," the Times said.
"IBM has already spent several small countries' GDPs on share repurchases - $23 billion and counting - without creating a single product or a single job," he said. "It's a signal they don't have the imagination or creativity to employ the capital more productively."Dow Jones Newswires: "Paying Off Wall Street." "They generate a substantial amount of cash flow, and earning interest (on the cash) just isn't a good solution," a Gruntal & Co. analyst told the Dow Jones Newswires on Oct. 27. "Buying back stock is just one weapon they use to enhance shareholder value."
By contrast, the Dow Jones wire quoted "the publisher of the Annex Bulletin in Phoenix and frequent critic of IBM's buybacks," as saying that the program "demonstrates a lack of creativity."
"They're saying they can't think of a better way to invest in the (technology) industry," Djurdjevic said, adding that he is opposed to stock buybacks in general. "Instead they are paying off Wall Street (in exchange for) good opinions of IBM's stock."
Why Buybacks Are a Scam
So there you have it: a real conundrum, it would seem. Actually it is not. It is a scam. And here is how it works...
Let's suppose a CEO of a large publicly-traded company happens to be voted into office thanks to support from the large, publicly-traded Wall Street institutions. Let's suppose he does well, and turns a moribund company around. Then the time comes for him to pay back his sponsors.
So what does he do? Increase the dividends? Nah... of course, not. That way ALL shareholders, not just Wall Street institutions, would benefit from it.
Instead, the CEO and his Wall Street cronies cook up a scheme called stock buybacks. The CEO's company repurchases (tens of) billions of dollars of its shares, mostly from the Wall Street institutions, of course, which account for a giant share of the trading volume, compared to the "Ma and Pa" investors.
By a miraculous coincidence, most "respected" Wall Street analysts start hailing the CEO's stock as the greatest thing since sliced bread. (Some examples of such a hype were shown in the "Sound Bites" section of this Annex Bulletin).
So the "Ma and Pa" investors (as well as some uninitiated institutional players) pump billions of additional dollars into the CEO's company stock, pushing up its market value to record levels. Now, from a hypothetical to a real world example...
In IBM's case, despite its mediocre fundamentals, and a recent warning by its CFO to analysts NOT to increase their profit estimates for 1998 (see Annex Bulletin 98-36, 10/20/98), the Big Blue's stock kept setting all-time highs nearly every day of this week. Unperturbed by this dichotomy, Wall Street analysts continued to trip over each other to recommend this grossly overpriced stock to their investors as a "buy."
Which leads to a fairly obvious question: Are they stupid or bought? (We'll let you decide on that).
The Washington Scam
By the way, American taxpayers could also be asking the same question about the Washington politicians: Are they stupid or bought? For, just as our above hypothetical CEO took the money from IBM's general shareholders so as to share it with his Wall Street cronies, so do many of our politicians. They take our votes and our money to bail out Wall Street bankers.
Think the $40 billion-Mexico bailout; the $140 billion-and-counting Southeast Asia bailout; the $20 billion-Russia bailout; the upcoming $30 billion Brazil bailout... (see "Wall Street, Not Mexico Bailout," Annex Bulletin 95-08, 2/02/95). Put it all together, and what we're seeing is the birth of new global taxation system; the new "socialism international" whose main beneficiaries are the Wall Street "vulture capitalists," and the main victims western taxpayers. Worst of all, it's a new form of "taxation without representation."
In fact, even the corporate shareholders may have been fleeced the same way thanks to the stock buyback scam. How would IBM's CEO, Lou Gerstner, for example, assure the Big Blue's "Ma and Pa" general shareholders that the $23 billion-and-counting, which he and the IBM board had appropriated from them for the buying of Wall Street's "cabbage patch" dolls, DIDN'T end up wasted on some lost causes in Mexico, Indonesia, Korea, Russia, or Brazil?
("Haven't thought of it that way, but bet that's where some of IBM shareholders' money most likely did end up," said one senior executive of a FORTUNE 500 company to whom we made the above observation this week).
Or for that matter, wonder how Gerstner and his Wall Street pals would distinguish between the Asian style of "cronyism," against which the Street has been self-righteously railing, and their own kind?
They couldn't, of course. Instead of spending the company's money on some IT industry endeavor which would benefit the general shareholders, the IBM board has basically abdicated its control over such funds, and turned it over to Wall Street. For three years in a row now, the Big Blue has been spending more money on "cabbage patch" dolls than on its coveted research and development. In fact, it has spent about 20% more than its entire shareholders equity on this fad ($23.1 billion vs. $18.6 billion). What does that tell us about IBM board's faith in its R&D?
"So what would you have done instead if you were in their shoes," some reporters asked us this week?
"First, I would turn in my resignation immediately," I replied. For, any time a company's management publicly admits that it has "excess cash," as IBM's did, they should step aside and let someone else run the business who has more creativity and imagination (see Annex Bulletin 98-04, 1/20/98).
"Second, even if I stayed on; and even if I were as inept as the IBM board; I could have picked up the Yellow Pages and randomly bought thousands of IT companies for $23 billion," I said. "Chances are, even using such a shotgun method, one might have ended up with the next 'Netscape' or a 'Yahoo' in my business portfolio."
Third, I'd set aside a portion of the money for a "Save the Seals"-type fund. Its proceeds would be used to protect the fledgling, but creative, IT entrepreneurs from being clubbed to death by the industry's juggernauts, such as Microsoft, for example, before the young pups have a chance to grow up.
Instead, the IBM shareholders have lost $23 billion of real assets in return for $120 billion of "fluff," the here today, gone tomorrow stockmarket paper gains.
The "Barbie Doll" Scam
The Wall Street cronyism especially comes to light in the "barbie doll" scam.
A "barbie doll" scam? What's that?
It's the flip side of the "cabbage patch" fad. In fact, it is a complement to it. The "barbie doll" scam is the insider trading. At the same time as a company (IBM, for example) is BUYING back its shares, the insiders who are running it (!) are SELLING! In other words, it's financial incest.
This week, for example, IBM's CEO sold 142,000 shares for a gain of about $16.6 million. Five months ago, Gerstner flipped another 138,000 shares for a $14 million profit.
It should come as no surprise, therefore, that scores of IBM CEO's lieutenants followed their boss' lead down the path of greed. Of all IBM insider trades reported by Vickers Stock Research Corp. during the first half of 1998, 94% of the IBM insiders SOLD their shares. And that number is likely to go up when the third and fourth quarter insider trades are reported, as evident from Gerstner's last sale.
Debunking Some Myths
Defenders of the stock buyback scheme tend to cite three arguments in support of it. All are myths.
Myth #1: Proof of management confidence. The first myth is that it is the proof of the company management's confidence in the value of its own stock. This week, a CNN financial reporter, for example, said as much as he read the news about the latest round of IBM buybacks. And he said it with a perfectly straight face.
The reason we found such gullibility hard to believe is because it fails the "Logic 101" test. As you saw above, many senior IBM executives, including its CEO, took advantage of their own hype to SELL their stock options. And that's confidence?
To be sure, any amount of buying, especially in the billions of dollars, does tend to push a stock up. Any stock. But that's an artificial boost; a scam just as if a home owner were to bid against other bona fide arms-length buyers to prop up the value of his own house. In other words, it's creating an illusion of prosperity.
Furthermore, despite all the hype which the stock buyback fad has received, only about 20% of the publicly traded enterprises have exercised stock buyback programs. But since they are the 'household name' companies, like IBM, or GM, or Texaco, one gets the impression that the practice is more widely spread.
Now, let's apply "Logic 101" again. If buying back one's shares were indeed a sign of management confidence, what are we supposed to believe, that conversely, executives in 80% of corporate America don't see the value in their companies?
Of course, it doesn't mean that. It means that four-fifths of corporate America is still minding its business, rather than allowing itself to be distracted by the Wall Street buzz.
Myth #2: Best use of cash. Another self-serving stockmarket myth is that Wall Street knows best how to invest your money. Such a theme was discernible from the various analysts' comments in the "Sound Bites" section of this Bulletin.
Maybe it does. Or maybe does not. One thing is for sure, though: Every time your funds are funneled through Wall Street, the bankers take a cut. Which tends to undercut their objectivity in making such self-serving statements.
Nevertheless, this myth is clearly selling well. As you saw in the Annex Bulletin 98-31 (8/13/98), the Wall Street's institutional holdings have soared from the 7% share of the total U.S. equities in 1950, to 48% in 1997, according to the New York Stock Exchange (NYSE) Fact Book 1997. During the same time frame, the share of the stockmarket equity held by the U.S. (Main Street) "households" has declined from 90% to 44%, despite a 8% compound annual growth between 1950 and 1997.
As a result, the U.S. stockmarket equities broke the bank by the end of 1997, the global financial crises notwithstanding. They reached a record, $13 trillion level.
Just to put things in perspective - that's 1.6 times the U.S. GDP. Back in 1950, their corresponding share was only 48% of the U.S. GDP, with the institutions accounting for a mere 3% of the economy. The result has been a loss of market power for Main Street, and a surge of it for Wall Street. As in any casino, it takes a sucker to enrich the "house" through the gambler's greed or gullibility.
Myth #3: A variation on "best use of cash." "When a company repurchases shares on the open market it reduces the available pool of shares in the overall market," an industry analyst wrote to us this week in defense of the stock buybacks. "The capital is then freed up to invest elsewhere."
Sure. IBM shareholders' capital is being "freed" to be invested by SOMEONE ELSE! So this is merely a variation of the Myth #2. Once again there is an underlying assumption that "Wall Street knows best" how to spend your money for you. As you saw earlier, about 80% of corporate America disagrees with that notion.
The IT "Fluff" Championship
Even closer to home, in the IT industry, stock buybacks are far from prevalent. We have just finished an analysis of 10 IT leaders from the various segments of the industry. Three are conglomerates (IBM, HP, Unisys); two are IT services vendors (EDS, CSC); two are software companies (Microsoft and Computer Associates); two are PC makers (Compaq and Dell); and one is a midrange systems provider (Sun Microsystems). Our objective was to determine which ones of these 10 companies have the greatest amount of "fluff" in their stock prices (i.e., market hype, or hot air - if you prefer).
So we dubbed the whole exercise the "Fluff Championship of the IT World." And, of course, we used our "fluff ratio" (market cap over equity), among other financial indicators, to try to figure who the champ is.
And the winner is...
No. You're getting colder.
No. But now you're getting warmer.
No. But warmer; almost there.
No. Now you're getting colder again.
Well, who then?
Dell! This Texas-based PC maker is the 1998 "fluff" champion of the IT world. Dell's "fluff ratio" was 51.8, meaning 98% of its $83 billion market cap was made up of "fluff," versus only $1.6 billion of equity.
In fact, this $83 billion-piece of fluff is yet to make its first $1 billion in annual profits (Dell's FY98 net was $944 million, up from $518 million in FY97, and $260 million in FY96).
But, like IBM, what Dell was lacking in substance, it more than made up in stock buybacks. Since the start of its share repurchase program two-and-a-half years ago, and through its second quarter of FY99 (ended Aug. 2), the company had bought 171 million of its own shares. We figure that's about $2.4 billion-worth, or 1.5 times the company's equity.
But while Dell outspent all of its peers on stock buybacks in relative terms, it also topped all of them in terms of the "bang for the buck." Or more accurately - in terms of the "fluff for the buck." Dell's $2.4 billion or so of real money bought it over $81 billion-worth of Wall Street "fluff" - for a record 33.2 "fluff" multiple.
(By the way, it's a funny "coincidence," isn't it, how both Dell and IBM got aggressive in stock buybacks at about the same time?).
Not surprisingly perhaps, Microsoft came in second (but a distant second!), in the 1998 "Fluff Championship of the IT World." Its "fluff ratio" was 15.5, more than three times lower than Dell's, yet still giving it a 94% (of market cap) "fluff" content (versus Dell's 98%).
Microsoft also came second in the "fluff" multiple contest, having bought 31.7 times more "fluff" for the amount of real money it had spent on stock buybacks.
But unlike Dell and IBM, Microsoft's relative costs were much lower. The company spent only about half of its $16.6 equity on stock buybacks. Guess when a company has a monopoly which gives it a virtual license to print money, it doesn't need to spend as many dollars kow-towing to Wall Street. Microsoft's legal costs, on the other hand, are starting to offset some of that, as the government is trying to revoke its money printing license. But that's another story...
The "bronze" in our 1998 "Fluff Championship of the IT World" went to CA, which came in with a "fluff ratio" of 9.0, and a "fluff" multiple of 29.2. This gave this software company's market cap an 89% "fluff" content.
By the way, CA has spent very little money on stock buybacks relatively speaking - less than a third of its equity. Which means that most of its "fluff," like Microsoft's, stems from other reasons (like the high profit margins and low capital investments typical of software companies).
As for IBM, it didn't even rate a "bronze," despite having spent almost an order of magnitude more money on stock buybacks than any other competitor. The Big Blue's "fluff ratio" was 7.4, giving it an 87% "fluff" content. But IBM's "fluff" multiple of only 5.2 (times the amount the company had spent on stock buybacks) put it as dead last among the six IT companies which did repurchase their shares.
This is also another indicator of how heavily IBM has had to pay up for Wall Street to overlook its warts. One of them being that IBM was the only one of the top 10 IT firms which we analyzed to have experienced a DECLINE in equity since the end of 1994 (-20%). And no wonder, considering that IBM has spent 1.2 times its equity on the "cabbage patch" dolls during the same time frame.
As for the rest of the companies in our survey, four of them either spent no money on stock buybacks, or the amounts weren't material (EDS, CSC, Compaq, Unisys). HP and Sun Microsystems did repurchase some of their shares since 1994, but only to the tune of 20% to 40% of their equity.
So what does that tell us? That the Wall Street casino is for suckers?
If so, what else is new? Most sensible people would have figured that out for themselves by now. Isn't the Las Vegas casino for suckers, too?
The only difference is in the dress code. One is stylish and pin-striped; the other garish and loud.
But they both have one thing in common: The suckers. The "Mr. and Mrs. Middle America;" the "get-rich-quick" "Archie Bunkers" of the 1970s, who keep filling the casino owners' pockets as if there were no tomorrow. And they may eventually get their wish (of "no tomorrow") when the Babyboomers start cashing their retirement checks, only to find that there is only greed in their accounts.
"O tempora, o mores..." What is America coming to?
Happy bargain hunting!
Also, check out the Annex Bulletin on the IT global services leaders - "Top Five IT Services Firms."
Editor: Bob Djurdjevic
5110 North 40th Street, Phoenix, Arizona
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