WHAT IS THE UPSIDE?

Anyone listening to our podcast knows that I’m a US stock market bear and have been since February 2015. Although I believe the stock market is really heading into a bad direction, I don’t want to become over-confident and ignore the bulls. As a result, the number one question I’ve been asking smart investors since the start of 2015 is: “what is the upside”. More importantly, quantify the upside.

Lately, the most popular response I’ve received is “Corporate buy-backs” are the upside. Although I love a good challenge when it comes to stock investing arguments, I think individuals making this argument are missing a key variable. Mohnish Pabrai, Buffett, and other investing greats like to say that they are better investors because they understand business, and they are better businessmen because they are investors. I think that quote is an important idea to highlight because individuals making the “corporate buy-back” argument are thinking too much like investors and not enough like business owners.

Corporate buy-backs are nothing more than financial gymnastics. The easiest physical model I can use to demonstrate this idea comes from physics when we think of potential energy and kinetic energy. When a company takes money from it’s balance sheet (potential energy) and buys back its own shares to create more market value per share (kinetic energy) for existing owners, no real value was created for the business as a whole. In that situation, energy was neither created nor destroyed, it was simply transmuted. That doesn’t create business value. That doesn’t take markets to new levels over the long haul.

Buy backs should be looked at from the following context. Assume there are 4 men that own a company. The business has been making good money in the previous years and the gentlemen have been able to accumulate a nice “war chest” of cash and investments in their balance sheet. One day, three of the gentlemen decided that they don’t want to own the business with the fourth gentlemen. As a result, they try to convince him to sell his 25% equity in the business. The catch is the three men offering the equity purchase want to use money from the war chest to buy him out. After the men settle on the deal, the war chest is significantly lower, and the company still produces the same earnings and revenue the following quarter. You see, stock buy backs don’t add any more revenue producing assets to the balance sheet. Instead assets are sold or liquidated in order to conduct the equity realignment. No value was actually created for the business as a whole, and in some cases, it’s even destroyed (depending on the terms of the entire exchange).

As you can see, the “share buy-back upside” argument isn’t a growth opportunity. Sure, it makes the earnings per share go up, but what about the total revenue or total net-income. That won’t change. Instead, buybacks are a way for existing shareholders to release the potential energy (or retained earnings) to the owners.

Now, if a company has an enormous amount of retained earnings and no way to employ the capital at a decent return, that money should be given to someone that can employ it more effectively. The last thing an owner wants to do is conduct the stock buy-back when equity is most expensive (which is what I think is happening today).

Not only do I think this upside argument stinks, I think it will actually amplify the magnitude of a downturn when the time arises. This is because companies are going to lack the potential energy needed to dynamically adjust to the next bear market. Remember, they are using retained earnings to pay a premium for their own shares.

As a former helicopter pilot, one of the most dangerous places to fly was low and slow. In that situation, you lacked potential energy and kinetic energy. With neither energy assets at my disposal, I couldn’t perform an auto-rotation to safety if my engine stopped working (The auto rotation is a really cool maneuver that allows helicopters to land if they lose power during flight – you need altitude or speed to do it though). That’s what many corporate managers are doing today. They are conducting stock repurchases to artificially prop-up their earnings per share (so it looks like real growth), but they are destroying their ability to conduct fantastic acquisitions in the future at better prices and better terms.

So, back to my original question, what’s the upside?

Beyond the share buy back argument, I’m not hearing too much else these days.

As for the quantifiable bear arguments, I’ve listed a few off the top of my head below:

• The high yield bond market is crashing
• China and Brazil demand is dragging on the world economy
• Japan is running out of liquidity and is likely to crash
• Japan is conducting QE right now and they still might crash
• US Businesses are priced at a CAPE P/E of 25 (only time it was higher was in 2000, 2007, and 1929)
• The commodities market is causing enormous concerns in the energy sector and it’s ability to remain profitable
• The debt in the commodities sector is in excess of a trillion dollars
• Student loan debt is now in excess of a trillion dollars
• Multiple commodity trading companies (one is in the top 10 world wide with market cap) might have it’s debt reduced to junk status. This could have compounding impacts like Leman brothers did in 2008
• Cash has beat bonds and stocks in 2015 and it’s starting to scare common investors
• Billionaires like Carl Icahn say there’s a looming crash and people should not chase a 1% return with a 30% down-side risk – creating fear in the markets. (Here’s the video)
• The dollar continues to get strong making it extremely difficult for US companies to turn a bigger return compared to last year’s results.
• The FED says it’s going to tighten before the end of 2015. That would further augment the strong dollar and weaker commodities
• Commodity producing countries have enormous amounts of dollar denominated debt, and as the dollar gets stronger their interest payments get harder to repay (Here’s a great summary of Billionaire Ray Dalio’s comments on this topic among many other current market conditions in SEP 2015).

And on and on…
I’m of the opinion that the credit cycle is contracting. The credit cycle is a self-reinforcing chain of events. If someone can make an argument that the cycle is expanding, please let me know. I’m desperately trying to prove myself wrong because it’s very important for anyone that’s trying to navigate this market effectively.

~Preston

P.s. As usual, I want to hear why my analysis is wrong. If you’ve got some comments or questions about this post, be sure to leave it here on our forum.

P.p.s. Watch this video if you haven’t seen it yet. It’s by Billionaire Ray Dalio.