Stock Buybacks Are Nothing But Margin Speculation

Authored by Valentin Schmid via The Epoch Times,

Not only individual speculators are all-in the stock market; companies are, too...

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Buying stocks on margin is buying stocks with money you don’t have. Usually, it’s speculators who engage in this risky practice that can be profitable as long as the market keeps going up.

Let’s say you have $10,000 in an account with your stockbroker. Under normal circumstances, you could buy up to $30,000 worth of stock with a $20,000 loan from the broker. Let’s assume you are lucky and the stock goes up 50 percent. The position is now worth $45,000, and your equity has increased by $15,000 to $25,000. This means you can increase your position size again to $75,000 and buy more stock, because most brokers only require you to keep 30 percent of cash or stock as collateral.

This is why using margin is so powerful in a rising market and why margin debt in the accounts of the New York Stock Exchange (NYSE) has kept pace with the records in the S&P 500 and the Dow Jones industrial average, reaching an all-time high of $581 billion in November 2017.

In a falling market, the whole exercise becomes less fun, and speculators trading on margin were one of the reasons behind the vicious crash of 1929.

Let’s assume you just bought more stocks and your total position in company A was $75,000 with your initial cash outlay, with profits totaling $25,000, as in the example above.

If the market moves 10 percent against you, your position is worth $67,500 and your equity is worth $18,500, but the loan is still worth $50,000 and you are supposed to keep $20,250 as collateral. In order to make up the difference between your collateral value ($18,500) and the margin requirement ($20,250) of $1,750, you can either deposit more cash or sell some securities to decrease the margin position.

Most people will sell some of their position, which puts further pressure on stock prices. Sometimes brokers do this without asking their customers; this is the infamous “margin call.” This leads to an avalanche of selling in a market that has borrowed too much.

The selling leads to further price declines, which lead to more margin calls, which leads to more selling. This is what caused the relentless decline in prices on Black Monday (-12.81 percent) and Black Tuesday (-11.73 percent) in October 1929, as there weren’t any buyers with cash left to step in when everybody who borrowed to buy stocks had to sell.

The Everything Bubble

In 2018, it’s no secret that this market runs on leverage and borrowing. And although the percentage of NYSE margin debt compared to the total stock market capitalization of the Wilshire 5000 is not at the all-time high seen in 2007 (2.5 percent), it sits just a tad below, at 2.2 percent.

The U.S. government is all-in on debt, with a record debt-to-GDP ratio of 104 percent, and it’s only the household sector that lowered debt because it refused to go all-in on mortgages again.

Instead, this time around, it’s the U.S. nonfinancial corporate sector that boosted its debt outstanding to a record of $13.7 trillion. And it is using part of it for buying its own stocks on margin, although it is called by a different name this time: “share buybacks.”

In the third quarter of 2017 alone, S&P 500 companies bought back $129.2 billion of their own stocks. The biggest spenders were Apple Inc. ($7.8 billion) , Citigroup Inc. ($5.4 billion), and JPMorgan Chase & Co. ($4.8 billion).

Since the second quarter of 2012, S&P 500 companies bought back $2.7 trillion of their own shares, according to S&P data. At the same time, their outstanding debt securities have risen by $1.7 trillion.

Of course, companies have borrowed for other reasons and have also financed the share buybacks with generally good earnings. However, the increase in debt together with the share buybacks is not coincidental.

“International Monetary Fund estimates suggest that large U.S. corporations have experienced a negative net equity issuance of $3 trillion since 2009 due to share buybacks, thus significantly boosting their equity leverage ratio,” notes the Institute of International Finance. In other words, corporates have less equity and more debt now—exactly what one should expect if companies issue debt and buy back equity.

Apple, which previously did not have any long-term debt, has issued more than $100 billion to buy-back shares as it waits to repatriate $269 billion in cash sitting abroad. Microsoft borrowed $17 billion in a single bond issue in January 2017. IBM boosted its long-term debt from $42 billion to $45 billion in 2017 but added $3 billion to its share repurchase program.

The whole process is convenient for companies because equity is more expensive to finance than debt in a zero interest environment, and it artificially boosts earnings per share by keeping earnings the same but reducing the number of shares.

At the end of the day, however, this is nothing but margin speculation.

Company Margin Speculation

Similar to the individual stock speculator in the example above, a company has a certain amount of equity it can leverage. Of course, with big companies, there is not one number like the 30 percent margin requirement for the individual. However, the dynamics are similar.

As long as the total value of the equity of a company keeps going up in a rising market, the company can keep issuing bonds against ever-rising equity values. Nevertheless, the total debt-to-equity ratio for large companies has increased from 50 percent in 2007 to a record high of 83 percent in spite of the rising market.

In a low-interest rate environment and a functioning economy, the companies can easily pay the interest on the bonds they issue out of the cash flow, as the total interest payments are low. Refinancing is also not a problem.

However, what happens if the market starts falling because interest rates rise or there is a recession, or both? No, companies won’t receive a margin call—there is no such provision in most company debt.

If equity values fall by half, and the debt stays the same, the debt-to-equity ratio will double—too much for the bond market to roll over the loans at the same low-interest rates. So either the company pays back the loans—which it can’t because it spent the money on shares that are now only worth half as much—or it refinances against a much higher interest rate.

This will squeeze cash flows, especially in a tight economic environment, and it won’t be long until companies start selling shares again—at much lower prices this time—just to survive. The biggest companies in the United States run the risk of ending up like speculators caught in a margin call.

Comments

jcaz ReturnOfDaMac Tue, 01/16/2018 - 15:18 Permalink

Absolutely true.  I'll give you another example-  Sherwin- Williams.   I know for a FACT that management assured employees three years ago that they would elevate the price of their stock via buybacks, and suggested to all their managers that it was "very timely" to load up their 401K's with the common stock.    There is NO OTHER organic reason why the price of SHW has risen as much as it has during that time- EPS growth has been a cinch with fewer and fewer shares- comical manipulation.

In reply to by ReturnOfDaMac

New_Meat Tue, 01/16/2018 - 15:09 Permalink

why do CFOs buy at the top?  Even with OPM debt, why not sell shares into the strength? 

Are the Boards that stoopid?  ... oh ... nevermind

ReturnOfDaMac New_Meat Tue, 01/16/2018 - 17:40 Permalink

Ok one more time I'll spell it out:

1. Invent/Market/SELL product in USSA

2. Manufacture in orange's "shithole" countries

3. Import frm shithole at HIGH PRICE(profits in shithole)!

4.  Corp shows little profit (no tax)

5.  Corp treas. borrow money to buy shares at HIGH PRICE

6.  C-suite Mgt sells shares at high price

7.  Mgt gets rich, stock gets jacked up, taxman starves, icing: pleebes get bill if it goes titsup

Kapiche?

In reply to by New_Meat

taketheredpill Tue, 01/16/2018 - 15:18 Permalink

At some point this circle jerk ends...yield starved investors get income....managers get vested options....equity investors get capital gains...everybody wins. Until they lose.

 

taketheredpill Tue, 01/16/2018 - 15:24 Permalink

Worth noting is the potential impact on High Yield now versus 2008:

The HY ETFs weren't around before 2007 and now they are considered attractive because they are large and liquid and you can sell anytime...right?

The Government made banks safer by limiting how much corporate bond inventory they can hold. Which means less stink bids in a sell-off.

All that money that went into share buy-backs didn't go into P&E, which means the worst case debt floor price is lower.

In 2008 you might assume the economy recovers and assume a forward GDP around 4%.  Today....?

In 2007 the % of HY issuance that was Cov-Lite peaked around 30%.  I think it's double that today as lenders are as desperate for yield as crack addicts.

konadog Tue, 01/16/2018 - 15:42 Permalink

I’ve been saying this for years, both here and on Seeking Alpha. Took nothing but flak. The simple truth about buybacks is that the company management is tacitly saying that they are bereft of ideas to expand the offering of profitable products or services (while paying themselves $millions in exchange for providing the skills of chimpanzee).

darteaus Tue, 01/16/2018 - 15:53 Permalink

Disagree.  The C-Level has cash, and sees no alternative investments with better returns given the risk level of the current regulatory, political and/or economic climate.

Or they could just be greedy SOBs trying to pump the stock price now for their bonuses.

hooligan2009 Tue, 01/16/2018 - 16:15 Permalink

couple of things...

one - get your arithmetic (not complex maths) right this ".. your position is worth $67,500 and your equity is worth $18,500, but the loan is still worth $50,000 " does not square - you are "out" by a thousand bucks or almost a few percent. (kids error).

on the major thrust, you are right BUT you make no contention on the management controlling a company, rather than shareholders - hence you miss the point - managers are paid by shareholders; if management owns more stock than shareholders, who owns the company, having provided the risk capital?

HenryHall Tue, 01/16/2018 - 16:44 Permalink

>> Stock Buybacks Are Nothing But Margin Speculation

Not really.

A company that buys its own stock is doing the exact opposite of a company that makes a rights issue. Think about it, ignoring commissions, if a company makes a rights issue of x amount of stock and then buys that x amount of stock back at the same price it is in the exact same position as when it started.

A company that makes a rights issue does so because it sees a new opportunity and wants to expand to exploit the opportunity. Such as by raising the capital needed to build a new factory to produce either more goods or new types of goods.

A company that buys back its own stock is doing the reverse - it is effectively downsizing. It recognizes that the business in which it is engaged is shrinking or less profitable and sees no alternative but to run a smaller or leaner operation with less capital deployed. This is called progress.

Greed is King Tue, 01/16/2018 - 18:42 Permalink

Buybacks are fraud, pure and simple. This is how it works, the Directors are already milking the company dry via huge salaries and bonuses, but it`s not enough, they`ve been infected with the greed disease, and once infected with that disease, there`s no such thing as enough. So, they take their undeserved bonuses in shares in the company, they then borrow huge amounts on behalf of the company to buy back company shares on the market, hey presto, the share values go up, and they then sell their own shares at a very substantial profit. But what about the debt they`ve got the company in, because as soon as they`ve offloaded their own shares, the company is still no more profitable than it was before, and all the shares they`ve acquired via buy back if not also offloaded are now overpriced and will sooner rather than later fall in price again, sooner rather than later because offloading their own shares will quite rapidly have the effect of reducing the share value, so what about the debt they`ve got the company in ?. They don`t care, they`ve made mega bucks for themselves, the company can go to the wall, they don`t care. It`s a variant on asset stripping, and that`s illegal as far as I know.

dunce Tue, 01/16/2018 - 23:05 Permalink

Years ago the first $200 of dividends was tax free. This encourage small investors to own stock. Widespread sales of mutual funds were the reason this tax break was cancelled. The first $1000 should be tax free so they would not be double taxed. This would be of no value to mutual fund or ETFs  Which is a good reason to not give these rackets tax breaks they never pass on. The funds also sell the votes of the shares they own and don't pass that on either.  The little guy is systematically screwed. Buybacks are always timed to give management tax advantaged easy profits on their so called incentive options.