Finding investment opportunity in the post stock-buyback era
Where will investment opportunities be found in the post stock-buyback era?
Let’s first consider the implications of the demise of stock buybacks:
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On a tightrope, without a net ...
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- The end of upward bias on equity prices:: As estimated in the article on assessing the buyback era — since 1983, buybacks totaled $5.7 trillion (in 2008 dollars), which pushed stock prices upwards for over a generation, weakening corporate financial structures, and eventually leading to the Crash of 2008.
Stock buybacks were essentially stock manipulation on a grand scale, sanctioned by SEC Rule 10b-18, largely unperceived by the public.
This meant that you didn’t have to be smart to earn a decent return in the stock market, despite the hiccups of 1987 and 2000. Just “buy and hold” a diversified portfolio in an unmanaged index fund in which no analysis was involved in selecting investments — just “buy and hold” and be happy. (Of course, as demonstrated by the Crash of 2008, there was an inevitable bill that eventually came due.)
Without buybacks to push stock upwards, investment risks will now have shifted. There will be a premium on stock selection based on facts. Stock investors will be on a tightrope, without the buyback safety net. It’s back to Graham & Dodd — but in a modern context. - A down draft from a surge of IPOs: The need for capital to repair the damage of the buyback era, as well as practical repercussions from policies of the Obama administration (corporate taxation, regulation, unions, emissions , inflation, the dollar, and trade), are likely to favor corporations that are well-capitalized and more resistant to government interference.
Inflation alone, if as high as expected, should restrict access to bonds as a source of capital, leaving only equities. The era of buybacks could be followed by decades with positive flows into IPOs, which would exert downward pressure on stock prices.
Investors need to be smarter to pick winners in a market without an upwards bias.
What the crash of 2008 revealed
The dominant feature of the Crash of 2008 was that nobody seemed to know what was going on. No one knew how much stocks or other securities were really worth. The Efficient Market Hypothesis was in tatters.
No one could trust Standard & Poors, Moody’s, Fitch’s, Morningstar, Bloomberg, Thomson’s, the Securities and Exchange Commission, Lehman Brothers, Citicorp, the Federal Reserve, or the US Department of the Treasury.
It wasn’t that there was no information. This was not 1929. On the contrary, there was a tsunami of financial information available on the Internet, largely hidden in millions of SEC files, government documents, and institutional websites — unanalyzed and uninterpreted.
Most of this information was free, but few had the time, resources, or inclination to dig it out. Besides, if stocks were going to rise anyway, in the long run, why bother?
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Too much information, like too much water, can be counter-productive
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What passed for information was mainly derived from security prices, freely available on Yahoo.com and elsewhere, parsed and regurgitated as simple and exponential moving averages, Bollinger bands, money flow indices, moving average convergence-divergence, parabolic stop-and-reverse indices, rate of change and relative strength indices, fast and slow stochastics, simple and exponential moving average volumes, the Williams %R indicator, betas, and a host of other greek letter indicators.
The commercial information services left huge portions of the financial markets unreported and unanalyzed.
Information even on major traded securities was limited to price graphs, simple financial data derived from financial statements, and a brief summary of the line of business. Essential information on the terms and conditions of particular issues was generally omitted, as was explanation of the laws, regulations, and major contracts that constrained operations.
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A typical stock report
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A typical Standard & Poor’s stock report was only seven pages long, one of which would be disclaimers. The report would contain many opinions, including opinions of other analysts, but little explanation of the terms and conditions of the securities, stock buyback practices, executive remuneration, ties with affiliates, pension fund burdens, or off-balance sheet contingencies.
Morningstar and Thomson reports on closed-end funds generally failed to provide the terms and conditions of auction market preferred shares, without which it would be impossible to gauge the risk of holding these securities, even to common shareholders.
Superficiality marked most investment thought in Q4 2008, as could be seen in a host of message boards, investment blogs, tweets, and sundry grunts and groans that were meant to pass for rational discourse on the Internet.
Finally, what information was offered from commercial source, was far from free, as the Efficient Market theorists had postulated. A year’s subscription to Bloomberg could set you back $25,000, although not much more than was available elsewhere on the Internet was actually delivered.
A case of the one-eyed man
Erasmus said, In regione caecorum rex est luscus, which I first learned in Portuguese as, “Em terra dos cegos, quem tem um olho é rei.”
And so it may well be in the new markets, in which the “one-eyed man” will be the stock analyst who is able to escape the disdain for fundamentals that typified the buyback era, and pass into the light of informed equity selections based on hard, deeply-researched, factual data.
The reason that the end of the generalized use of buybacks should require a modification of investment practices is the effect of this change on market covariance — the tendency of stock prices to all move in the same direction, together.
Expectations of historical covariance have guided “Modern Portfolio Theory”, fund management, and investor behavior for a long time.
The end of the buyback movement is a cataclysmic event, that combined with inflation, modification in the trade deficit, and radical new measures being introduced by the Obama administration — can be expected to shake up the covariance model which investors have taken for granted for a generation.
 In the land of the blind, the one-eyed man is king ...
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The buyback movement, together with other factors, caused stock prices to move more closely in tandem for a variety of reasons:
- Manipulation: Stock buybacks were nothing more than price manipulation. And the manipulation was all in one direction — upwards.
- Index funds and the Common Stock Legend: Investors came to expect all stocks to rise together in the long-run and bought stocks indiscriminately through index funds. Non-selective investment leads to increased covariance.
- Popularity of technical analysis: Stock selection based on chart reading has come to dominated investment behavior. The “trading screens” that stock-brokers offer clients on the Internet are all skewed towards technical analysis. The motto of technical analysis is “the trend is your friend”. This means that more and more people were following the crowd, rather than the facts about individual securities. Stock price, itself, became the principal “fact”.
- The trade deficit and the secular decline in bond prices: Buybacks were possible because of a generation of easy money, funded in the ultimate analysis by the ever-increasing US trade deficit. The obverse of the long-term decline in bond interest rates was a long-term rise in stock prices. Increased covariance in bond prices was mirrored by increased covariance in stock prices.
Covariance is not a market constant. Covariance is unlikely to ever disappear — markets have always been dominated by the psychology of crowds — but how closely individual stocks track the market has varied over long periods. (See: “Testing for Covariance Stationarity in Stock Market Data”, Pagan and Schwert.)
Furthermore, the buyback movement and the associated covariance of stock prices is a long-term sociological phenomenon — investor behavior will not change overnight.
Chart-readers will continue to read their charts. Modest investors will continue to invest in index funds.
In this lies the opportunity for the “one-eyed man” who will turn to the hard road of investing on the basis of fundamentals.
Remember, the buyback movement is not ending because corporate executives have suddenly got religion and have decided to stop ripping off shareholders. Rather, behavioral change is being forced upon them by a shortage of easy credit, a government that takes a dim view of executive remuneration, hard times, bank de-leveraging, and their own over-reliance on asset-lite management techniques.
In other words, the opportunity for the “one-eyed man” lies in a change of corporate behavior that will be reflected in a change in investor behavior only later.
Not your grandfather’s Graham & Dodd
The book on fundamental analysis in this new market is yet to be written. Benjamin Graham and David Dodd published their classic work in the 1930s, in a market that was far less complicated than today.
Their basic advice — focus on the facts and commonsense to determine investment value — is valid more than ever. However, the techniques for getting at these facts have changed and fundamental analysis has become much more difficult. In this difficulty lies opportunity.
There were far less “facts” available in the 1930s than today, but on the other hand, the market was simpler.
Today, the problem of complexity goes beyond the obvious difficulty with derivatives. We also must consider:
- Investment in foreign markets with different laws and customs and less information.
- Exponentially more complex corporate structures based on supply-chain contracts, matrix management across different corporations, and multi-corporate groups without consolidated financial statements.
- An over-abundance of information and the high cost of analysis in time and money
- The multiplicity of product lines and the risk of massive product liability from some mistake in a far off corner of the world. (Like the “Nick Leeson” effect on Barings Bank.)
I’ll write more about this later and how to address the challenge of fundamental analysis in the new era.
In the meantime, you might take a look at these articles:
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