The Riches of Humility

The average American consumer may be cash-poor, but the
average American corporation is not. A few of these cash-
rich corporations are spending their money very wisely…by
investing in their own shares.

America’s corporate titans are flush with cash. The S&P 500
companies alone hold about $22 trillion in cash
equivalents, which represents about 10% of their total
assets. Increasingly, many corporations are using their
liquid funds to buy back stock. The top 25 S&P 500
companies bought back about 1.6% of their shares last year,
at a cost of $60 billion. About half of all S&P 500
companies reduced their share count from the prior year –
the highest total we have seen in four years.

For mature, cash-spinning business, the "plain vanilla"
stock buyback can be an exceptional way to boost
shareholder value. Author Louis Lowenstein calls it a "form
of financial humility," because when a management team
adopts a regular and significant buyback program, it is
essentially admitting that it has no better way to invest
the cash – not even in the expansion of its business.

Likewise, boosting dividend payouts represents another form
of financial humility. By paying dividends, corporate
managements implicitly admit that they can envision no
better use of company cash.

We like financial humility…especially in a company whose
core operations are performing well.

Sometimes managements try too hard. Over the years, many of
the management teams that were blessed with extra cash have
devised clever ways of squandering it. They have embarked,
for example, on ill-fated plans to acquire flawed
competitors or to diversify into unrelated businesses. In
the process these managements have wasted money that could
have produced a higher return in the service of much less
creative endeavors: Buying back stock or paying dividends.

Stock buybacks can be a firm’s best investment, in
particular if its shares are trading cheaply. It is an
investment in a business that management already knows very
well. The Sage of Omaha, Warren Buffet, lays out the
advantages of plain vanilla stock buybacks in his 1984
Annual Report:

"The obvious point involves basic arithmetic: major
repurchases at prices well below per-share intrinsic
business value immediately increase, in a highly
significant way, that value…Corporate acquisition
programs almost never do as well and, in a discouragingly
large number of cases, fail to get anything close to $1 of
value for each $1 expended."

Investors ought to remember the point about acquisitions.
Michael Porter, an accomplished corporate strategist,
studied acquisitions between 1950 and 1986 (a universe of
over 2,000 acquisitions). The results showed that most
acquisitions failed to produce satisfactory returns. Of
these acquisitions, about 53% of the acquired businesses
were subsequently divested or shutdown. Porter noted that
the results were conservative, because corporate honchos
quietly buried a number of their failures.

Buy backs are easier to execute well than acquisitions.
Nevertheless, insiders often buy their stock at inopportune
times. The trick, of course, is to buy the shares when they
are cheap. In this, corporate America seems to have used
poor judgment at times. In 1982, for example, when U.S.
stocks were dirt-cheap, American corporations purchased
only one-tenth of one percent of their shares outstanding,
or about $2.2 billion worth of stock. Five years later,
corporations spent 30 times as much money buying stocks,
only to watch their prices crash in October of that year.

The chart below shows the bad timing of the last few years;
heavy buying in the late 1990s bubble years and a slowdown
in years where it would have been profitable.

The difficult question to answer is this: Are corporations
buying back stock because they believe the stock is cheap,
or is it simply an exercise in bad timing? Hard to know for
sure, but the market’s valuations seem to indicate that in
most cases, corporations are tossing shareholder money in
the wind.

Most of the poor timing, we suspect, stems from impure
motives. Companies often conduct share buybacks that do not
advance the interests of ALL shareholders. For example, the
"greenmail" paid to hostile suitors to "go away" is
obviously unfair to the existing shareholders, who are
unable to realize the premium paid to the suitor. Another
abuse is when corporate chieftains buy back stock to
deceive the market by "keeping up appearances" even when
they knew that the business is crumbling on the inside.
Other questionable practices include buybacks funded with
large amounts of borrowed money, or buybacks used to fund
excessive employee stock option plans, etc.

Happily, some companies still conduct "plain vanilla" share
buybacks – the type that increases shareholder value.
Hudson City Savings is one such company. Public since 1999,
the company has repurchased 55 million shares over the last
six years, or about half the stock sold in its initial
offering! The stock has surged from a split-adjusted $6 to
about $35 today — a nearly six-fold return on the original

Sometimes it pays to be humble.

Did You Notice…?
By Eric J. Fry

If not for the poor, the rich would struggle to make ends

"Poor countries have become the financiers of the United
States," the New York Times observes, "fueling one of the
most extravagant consumption drives in world history. From
1996 to 2004, the American current account deficit – which
includes the trade deficit as well as net interest and
dividend payments – grew to $666 billion from $120 billion,
swelling the nation’s demand for foreign financing by $546
billion. "

Somewhat surprisingly, "developing countries" are providing
most of this cash.

"The current accounts of developing countries swung from a
deficit of $88 billion in 1996," the New York Times
continues, "to a surplus of $336 billion last year – a $424
billion change that has covered some four-fifths of the
increase in the deficit of the United States."

We rich Americans are not stealing the money, of course.
The poor are providing the funds of their own free will.
Even so, the phenomenon feels a bit perverse. (Imagine
walking up to a homeless person and asking for a loan). It
also feels unsustainable. And if the wellspring of borrowed
money were to run dry, we rich might begin to feel much
more poor than our "poor" creditors.

"Conventional economic thought suggests that funds should
flow the other way," the Times correctly observes.
"Capital-rich industrial nations like the United States,
where workers already have a large stock of capital goods
to work with – like high-tech factories and advanced
information technology networks – should be sending money
to places rich in labor but with a meager capital stock."

For as long as funds are flowing in the "wrong" direction,
we Americans may continue to enjoy our dubious prosperity.
But woe to us if funds begin flowing the "right" way!

"For the developing world to be lending large sums on net
to the mature industrial economies is quite undesirable as
a long-run proposition," says Fed Governor Ben Bernanke.

We think Ben might be right this time.

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