Thursday, September 04, 2014

Yet Another Reason the Stock Market Is Overvalued

In my online stock valuation class I teach, The Analysis and Valuation of Stocks, I have my students grab the annual report of a company of their choosing and use it for analytical purposes in the class.  Over the now 12 years I've offered this class, I've seen trends in the different companies they've chosen.

Garmin, remember them?
Palm?  Those were fun times!
Blackberry?  Ah, the early 00's.

However, of even more interest was the financial trends that were spotted when we'd get into the nitty gritty of it.  Most recently two trends that are related

1.  "Cash Flow from Operations" continually exceeding "Cash Flow from Investing"


2.  A almost nearly always guaranteed repurchase of shares.

Before you fall asleep let me explain these things to you and why they are very relevant to everybody today.

First, "Cash Flow from Operations" (CFO) and "Cash Flow from Investing" (CFI) are two "boring" financial statistics that all companies have.  Most people focus on "net profit" or the bottom line, but savvier analysts know to look at CFO and CFI.

The reason is (without going into a long and boring detailed explaination of non-cash accounting) CFO is the amount of actual cash the company is generating while CFI is the amount the company spends on maintaining and expanding it's operations.  Ergo the "cash from OPERATIONS" goes to pay for the "cash expended on INVESTING."

These two numbers I believe tell you more about a company than any other financial numbers.  First, it tells you if the company is profitable and not just on paper, but actual cash (CFO).  Second it tells you if the company is expanding or contracting (CFI should be a negative number showing the company IS expanding and investing).  And third, it tells you if it can finance its expansions and operations with the money it generates internally.  Ergo, if CFO generated exceeds the amount spent on CFI this is a GREAT thing because the company neither has to borrow money or issue new shares to expand.  It is SO PROFITABLE it can do it in house.

There is a problem, however.

As I noticed most of my student's companies were generating a lot more CFO than they were expending on CFI.  Yes, profits have recovered from the depths of the Great Recession, but this economy wasn't booming.  And most of the profits I knew came from cost cutting, not investing in new plants and equipment, expanding operations, and thus employment.  Ergo, what the financial statements of these companies were telling me was the reason for such excess CFO over CFI was not because of healthy CFO, but rather low expenditures on investments and CFI.  This is why corporations can have these "record profits," but employment growth and private investment is not forth coming.

Second, now enter in stock repurchases.

Say you're a CEO of a corporation that is generating a lot of cash flow, but not expanding or investing a lot.  Well, you're left with the enviable position of having a lot of extra cash on hand.  But if you're not going to invest that cash, you have to do something with it.  So what do you do?

Stock repurchases.

Repurchasing a company's stock is NOT investing and does NOT show up in the CFI.  Additionally a company repurchasing its shares does NOT create any ACTUAL investment.  No factories are built, no facilities constructed, no people employed.

It does however boost the price of your stock because it "undilutes" the amount of shares outstanding.  This not only boosts the stock price and makes your shareholders (who indirectly vote you into your executive position) happy, but also makes your stock options much more valuable.

Ergo, the trend you see of companies with excess CFO who like to repurchase their shares.

It is here I would like to show you the S&P 500's "statement of cash flows," but unfortunately you have to pay for such research.  Instead I'll merely pull some key, large companies we're all familiar with and highlight this phenomenon on their cash flow statements.

Though your eyes may be glazing over, if you look at the highlighted (red) sections you'll see these companies (Colgate, Exxon, and Apple) making tons of money (CFO), but not fully reinvesting it (CFI).  The remaining cash is (primarily) used to repurchase shares (and sometimes pay dividends) or buy other stock's shares (highlighted in blue).

These corporate actions not only speak volumes as to what the "holy trinity" of corporations, investors and employers (all 3 in 1) think about investing in the US, but also have serious ramifications for US stock valuations.

First, they're saying, "Are you nuts?  Invest here?  Sorry, we're going to spend what we have to to ensure our current investments don't rot, make what meager investments we see that are truly profitable, but sorry, economic growth and the investment climate is just not worth it.  We're just going to repurchase shares because THAT'S OUR BEST USE OF OUR MONEY."

Second, in doing so they further inflation a stock market bubble that is already inflated with trillions of 401k, IRA, 403b, and other pension/retirement fund money.  This has driven the S&P 500 well beyond it's historical PE of 15 to a now dizzying 26 implying a 73% overvaluation that only idiot Americans would cheer for and IRA Zombies invest in.

Ultimately, though, there is a hidden lesson corporations and investors are indirectly telling the American public (and western civilization citizens in general).  And that lesson is one of:

"Fuck you."

I don't know how long it will take "corporation hating" Americans to realize that those same corporations who they love to loathe and blame their laziness and lack of work ethic problems on are also the primary source of:

1.  Jobs
2.  Careers
3.  Economic innovation and growth
4.  Retirement wealth

in this country.  And the fact they have made it so inhospitable financially, politically and socially to be a corporation here that corporations would rather

1.  Spend money repurchasing their shares
2.  Spend money buying other companies' shares
3.  Open factories overseas
4.  Bribe/lobby politicians
5.  Pull a Medtronic or Burger King

than hire and invest in the US should be a wake up call to all the Obama-supporting college graduates working as barristas for $9/hour. i.e.- even the dumbest of leftists should have the mental capacity to understand these basic lessons of economics and human incentive.

Sadly, however, western minds have been so damaged and polluted with self-pitying victimization and laziness they'd rather sit and mope, feeling sorry for themselves, blaming those "white-male-ly" corporations, and thusly condemning themselves to a life of poverty and mediocrity, than spend the energy it would take to get a basic education in accounting and economics.  But, hey, at least they "weren't part of the system man!" and stuck it to those "corporations, man!"

Regardless, for all those Americans who hate corporations and are too busy to be bothered with cash flow statement accounting, enjoy listening to "Rage Against the Machine" when you're 50 and maybe, MAYBE, making that last payment on your student loans.


Peregrine John said...

What then should be our response? Or more to the point, how should we best exploit this situation for profit and lulz? Simply staying away is holding still in a boat with a slow (inflationary) leak. There must be a way to actually enjoy the decline instead of just observe it, but it seems a bit early for mass short-sales.

Anonymous said...

Are there are any macrotrend stats indicating that more firms are engaging in internal and external share buybacks and reducing investment in long-term assets?

Anonymous said...

I noted that AEI had similiar analysis the other day, and said this was short termerism or some other thing.

My question is why aren't there any profitable projects? If there are profitable projects and they aren't investing in them, why not?

Glen Filthie said...

Look to your depression era Grandmother, PJ.

If you can't trust the banks (their rate of return is abysmal)...and you can't safely invest because the gov't will steal buy a strong box, and stash your money away until it is safe to invest again.

That would require America to pull its head out of its collective ass, you might be at it for a few years.

Buy silver too.

Anonymous said...

The Western world's economies are like a meth addict whose brain has finally thrown in the towel. Zombified.

Anonymous said...

I like your economic articles they explain things really well to a layman like myself.

Albert said...

Why would they be paying their last payment on student loans at 50? That would require that they've made any kind of financial sacrifice to pay more than the bare minimum.

Wandering MGTOW said...

To: The Captain; Brilliant as always. Keep up the good work!

To: Peregrine John and Anonymous; The answers are for you to find by doing loads of research. Read up on those who did very well over the long term for a start.

You may decide stocks are not for you - with good reason - 95% of stock market players lose money.

In that case, you might think about other avenues of investment.

Southern Man said...

NO! Do NOT listen to the man behind the curtain! The stock market is UNDERVALUED if anything! BUY MORE STOCK! For at least ten more years, anyway...

Black Poison Soul said...

IMO the situation isn't just that the stock market is overvalued or undervalued. I'm trying to take a step back and look at the bigger picture. The situation is that the company is actually in the stock market.

Instantly when that happens, the focus is no longer on doing stuff within the company that will cause it to grow solidly and reliably over time. The focus then becomes to make the stock-holders happy in this instant: making the value of their stocks (and dividends) rise in the short-term.

When upper-management is being partially-compensated in options, they also become stock-holders. It then becomes very tempting to do a quick pump up of the value, exercise the options, sell on a high note, retire.

It becomes a three-way conflict of interest: the good of the company, the good of the stockholders, and the good of the insider getting ready to jump ship.

Or am I completely off-base with these thoughts about the rigging of the markets?

Thanks for the info about the CFI, it was not something that I'd ever been exposed to.

By the way, the "fuck you" lesson I already gathered simply from them moving their manufacturing overseas. Once the local middle-class is gone and there's nobody to buy cheap imported shit, they'll look for "another market".

Anonymous said...

Share buybacks are simply a more tax efficient way of returning the shareholders' money back to them - money that can't be profitably reinvested back into the business. BUT I think you have a valid point in one respect - borrowing cheaply at home and using that cash for buybacks, rather than paying high corporate taxes on repatriated cash that is trapped overseas. The solution there is quite simple - have a "tax holiday" lowering the repatriation tax from 35 percent down to 15 percent for three years. Billions of dollars would return to the USA, investment here would boom, and the economy would kick ass. Of course, as long as Democrats rule, this cannot happen. It would lower the power of government.

Goober said...

Jesus, don't buy silver.

Or gold.

There's a reason that the radiowaves are exploding with folks trying to sell you both, and it isn't because it's a good, solid investment right now.

If it was such a fantastic investment, why are they trying to seel it right now?

Why is it near an all time high?

I was always taught that "making money 101" said "buy low, sell high."

Not the opposite.

Price is high right now, and the pressure to "buy, buy, buy!" is at an all time high, too.

So does that make the guys buying sound investors, or dupes getting ripped off by companies convincing them to buy their overpriced shit at the peak of it's value?