Jack Welch, the former CEO of General Electric (GE), was considered one of the greatest CEOs of the 20th century. During his tenure at the large industrial conglomerate between 1981 and 2001, the share price rose 4,000 percent. Fortune magazine named him “manager of the century” in 1999. His cult-like following among corporate managers netted him a $7.1 million book deal in 2001.
But Welch was playing a long con—one that allowed him to amass nearly $1 billion in GE shares, pay, and options.
That’s because Welch knew that each quarter, Wall Street analysts would look at the company’s earnings per share (EPS). If it beat expectations, the share price would rise. If it didn’t beat expectations, the price would fall.
So it was important to Welch that the company beat earnings each quarter. So they did, like clockwork, often by a single penny. The SEC even won a $50 million settlement for the company’s manipulative practices to hit exact and precise earnings numbers.
That fine was chump change; it was less than one eighth of Welch’s severance pay of $417 million (still the biggest golden parachute in history).
But Wall Street wasn’t too concerned with these SEC violations, as long as the company was hitting earnings. It would take the financial crisis for investors to realize that GE was on the verge of becoming insolvent thanks to its heavy use of short-term commercial paper to fund operations (and manage earnings).
During the crisis, the supposedly well-managed company that had always beaten earnings by a penny shed 80 percent of its value, more than twice the decline in the S&P 500 in 2008.
Today, GE is shedding its various parts accumulated under the Welch years, and returning to more of a pure-play industrial firm. It’s one of the few big names routinely hitting multi-year lows as we enter this manic stage of the market.
Clearly, the damage has been done. And Welch still has an estimated net worth of $750 million, while millions of GE shareholders took it on the chin and thousands of GE employees lost their jobs.
I’d like to say that GE is the only company that does this. Unfortunately, it isn’t. Many companies can use legally acceptable accounting standards to increase or decrease reserves, depreciate equipment at slower or faster rates, or make other sorts of assumptions that might or might not be true.
What matters to many companies isn’t the long term, it’s hitting the short-term earnings per share numbers to keep Wall Street traders happy.
But it isn’t just an accounting issue. It’s pervasive. And at this point in the market, it’s worth paying close attention to. If stocks do fall, you’ll know which ones are worth buying on a pullback and which ones are worth totally avoiding.
So think about the flip side of managing earnings. What if, instead of growing earnings, a company focused on the other part of the equation: the outstanding shares?
That’s what many firms are doing today with the practice of share buybacks. By buying back shares, companies don’t have to make more money or resort to increasingly challenging accounting gymnastics. Instead, they’re shrinking the pie. If earnings are the same, they’ll still be higher on a per share basis when there are less of them out there.
Right now, buybacks represent a true danger in the market because it’s reached an unsustainable level. Consider this: Corporate America is spending over $120 billion a quarter, or over $1.5 billion per day, buying back shares. That’s creating a huge floor in market prices—for now.
The only time more money was spent on share buybacks than in 2016 and 2017 (year-to-date) was in the third quarter of 2007, right before markets tanked.
But the scary part is that, according to FactSet, 146 of the companies in the S&P 500 Index spent more money on this activity than they received in net income. That’s like spending $2,000 a month when you only bring in $1,800—it’s not sustainable.
Yet nearly 30 percent of S&P 500 companies are now spending more on buybacks than what they bring in! These aren’t fly-by-night companies. These are the blue chips. Every American with a 401(k) or stock index fund is exposed to this danger—and they likely don’t even know it.
The blame, like most of the problems that could boil over into a potential crisis, rests with today’s ultra-low interest rates. Corporations can issue bonds with coupons as low as 3-4 percent. They can then turn around and pay a dividend or buy back shares or otherwise “return” this borrowed money to shareholders.
At the end of the day, all this cheap debt is doing is encouraging companies to roll the dice now on programs like buybacks to move shares higher. Without a cash cushion to deal with the next recession—or a prolonged period of slow growth like right now— many major US stocks will have their future in doubt during the next crunch.
On paper, buybacks can sound good. After all, a buyback is a tax-efficient way to return capital to shareholders. If you owned 1 million shares of a company with 100 million shares outstanding, you’d own 1 percent of the company. If they bought back 90 million shares, your 1 million shares would now be 10 percent of the company.
That sounds great, which is why Wall Street generally loves buybacks. But the numbers speak for themselves: at today’s levels, buybacks are unsustainably high. They’ll falter soon. Most companies are spending too much today and not thinking about the possibility of a recession tomorrow, where cash being spent on buybacks could be used to buy competitors for pennies on the dollar or survive a decline in revenue.
Bottom line: Watch out for stocks with big buybacks. It’s being funded by ultra-low interest rates, and that era is slowly starting to end. Companies with big buybacks sound good as a short-term trade, just as Jack Welch’s managed earnings made GE look like an amazing stock to own. But it’s not sustainable and it’s making the market as a whole look safe when in reality it’s getting increasingly risky.
Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and writes the monthly newsletter Crisis Point Investor.
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