Thursday, March 7, 2019

Lyft Off? The First Ride Sharing IPO!

Last week, Lyft became the first of the ride sharing companies to announce plans for an initial public officering, filing its prospectus. It is definitely not going to be the last, but its fate in the market will not only determine when Uber, Didi, Ola and GrabTaxi will test public markets, but what prices they can hope to get. My fascination with ride sharing goes back to June 2014, when I tried to value Uber and failed spectacularly in forecasting how much and how quickly ride sharing would change the face of car service around the world. I have since returned multiple times to the scene of my crime, and while I am not sure that I have learned very much along the way, I have tried to right size my thinking on this business. You can be the judge as bring my experiences to play in my valuation of Lyft, ahead of its IPO pricing.

The Rise of Ride Sharing
The ride sharing business, as we know it, traces its roots back to the Bay Area, with the founding of Uber, Sidecar and Lyft providing the key impetus, and its impact on the car service business has been immense. In a post in 2015, I traced out the growth of ride sharing and the ripple effects it has had on the car service status quo, noting that revenues for ride sharing companies have climbed, the price of a taxi cab medallion in New York city has plummeted by 80-90%. The most impressive statistic, for ride sharing companies, is not just the growth in revenues, which has been explosive, but also how much it has become part of day-to-day life, not just for younger, more tech savvy individuals but for everyone.  While the growth was initially in the United States, ride sharing has taken off at an exponential rate in Asia, with India (Ola), China (Didi) and Malaysia (GrabTaxi) all developing home grown ride sharing companies. The regulatory push back has been strong in Europe, slowing growth, but there are signs that even there, ride sharing is acquiring a foothold.

There are many factors that can explain how and why ride sharing so quickly and decisively disrupted the taxi cab business, but the latter was ripe for the taking for may reasons. First, the taxi business in the 2009 had changed little in decades, refusing to incorporate advance in technology and shifting tastes, secure that it did not have to adapt, because it had a captive market.  Second, in most cities, rules and regulations that were throwbacks in time or lobbied for by special interests handicapped taxi operators and gave ride sharing companies, not bound by the same rules, a decisive advantage. Third, automobiles are underutilized resources for the most part, since most cars sit idle for much of the day, and ride sharing companies took advantage of excess capacity, by letting car owners monetize it. Finally, individuals often under price their time and do not factor in long term costs in their decision making and the ride sharing companies have exploited that irrationality. I think that the MIT study in February 2018 that showed absurdly low hourly wages (less than $4/hour) for Uber and Lyft drivers was flawed, but I also don't buy into the rosy picture that the ride sharing companies paint about the income potential in driving. 

It has not been all good news for ride sharing, as usage has increased. While revenues have come easily, the companies have struggled with profitability, reporting huge losses as they grow. Lyft reported losses of $911 million in 2018, in its prospectus, but Uber's loss was $1.8 billion during 2018, Didi almost matched that with a $1.6 billion loss and the only reason that Ola and GrabTaxi lost less was because they were smaller. Put simply, these company are money losing machines, at least at the moment, and if there are economies of scale kicking in, they are showing up awfully slowly. While some of this can be attributed to growing pains, that will ease as these companies age and grow bigger, a significant portion of the profitability shortfall can be attributed to how these businesses are designed. In my 2015 post, I argued that the low capital intensity (where ride sharing companies don't invest in cars) and the independent contractor model (where drivers are not employees), which made growth so easy, also conspired to make it difficult for these companies to gain economies of scale or stay away from cut throat competition. 

The Playing Field
In 2015, I argued, with tongue only half in cheek, that one possible model for the ride sharing companies to develop sustainable businesses was the Mafia's mostly successful attempt to stop intrafamily warfare in the 1930s by dividing up New York city among five families, giving each family its own fiefdom to exploit. (I prefer The Godfather version.). While that may have seemed like an outlandish comparison in 2015, it is interesting that in the years since, Uber has extricated itself from China, leaving that market to Didi, in return for a 20% stake in the company and then from South East Asia, in return for a share of GrabTaxi. In fact, the United States may be the most competitive ride sharing market in the world, with Uber and Lyft going head-to-head in most cities.

While Uber and Lyft are ride sharing companies, their evolution over the last decade offers a fascinating contrast in business models, for young companies. In a post in 2015, I drew the contrast between the two companies, as a prelude to valuing them. Uber was the "big story" company, telling investors that it wanted to be in all things logistics, expanding into delivery and moving, and all over the world. Lyft was the "focused story" company, setting itself apart from Uber by keeping its business in the United States and staying with car service, as its primary business.  I argued in 2015, that given how the two companies were priced, I would rather be an investor in Lyft than Uber. 

In the four years since the post, we have seen the consequences for both companies. While Uber's bigger story gained it a much higher pricing from investors, it has also brought the company a whole host of troubles, ranging from being a target for regulators to management over reach. Travis Kalanick, its high profile CEO, left the company in a messy and public divorce, and Dara Khosrowshahi, who replaced him, has scaled Uber's ambitions down, first globally by getting out of China and Southeast Asia, where it was burning through cash at an exponential rate, and then within the logistics business, by focusing on Uber Delivery as the key add on to car service. Lyft has stayed true to its US and car service focus, and it has paid off in a higher market share in the market. Both companies have jumped on the bike and scooter craze, with Uber buying Jump and Lime and Lyft acquiring Motivate. From the looks of it, neither company seems willing to concede to the other in the US market, and this fight will be fought on multiple fronts, in the years to come.

The Lyft Valuation
When valuing young companies, it is the story that drives your numbers and valuation, not historical data or current financials. I have stayed true to this perspective, in all of the valuations that I have done on ride sharing companies. In this section, I will lay out my story for Lyft, drawing on past behavior and the clues that are in their current plans, but it would be hubris to argue that I have a monopoly on the truth and a claim on the "right" story. So, feel free to disagree with me and you can use my valuation spreadsheet to reflect your disagreements.

The Story
Reviewing Lyft's (very long) prospectus, I was struck by the repetition of the mantra that it saw its future as a "US transportation" company, suggesting that the focus will remain primarily domestic and focused on transportation. While the cynical part of me argues that Lyft's use of the word "transportation" is intended to draw attention to the size of that market, which is $1.2 trillion, Lyft's history backs up their "focused" story. While I am normally leery of management stories for companies, I will adopt Lyft's story with a few changes:
  1. It will stay a US transportation services company: The total market that I assume for US transportation services is $120 billion at the moment, well over two and a half times larger than the taxi cab market was in 2009. That is, of course, well below the size of the transportation market, but the $1.2 trillion that Lyft provides for that market includes what people spend on acquiring cars and does not reflect that they would pay for just transportation services.
  2. In a growing transportation services market: One of the striking features of the ride sharing revolution is how much it has changed consumer behavior, drawing people who would normally never have used car service into its reach. I will assume that ride sharing will continue to draw new customers, from mass transit users to self-drivers, causing the transportations services market to double over the next ten years.
  3. With strong market-wide networking benefits: In 2014, when I first valued Uber, I argued that ride sharing companies would have local, but not market-wide, networking benefits. In effect, I saw a market where six, eight or even ten ride sharing companies could co-exist, each dominating different local markets. Observing how quickly the ride sharing companies have consolidated, over the last few years, I think that I was wrong and that the networking effects are likely to be market-wide. Ultimately, I see only two or three ride sharing companies dominating the US ride sharing market, in steady state. In my story, I see Lyft as one of the winners, with a 40% market share of the US transportation services market.
  4. A sustained share of Gross Billings: The concentration of the market among two or three ride sharing companies will also give them the power to hold the line on the percentage of gross billings. That percentage, which was (arbitrarily) set at 20% of gross billings, when the ride sharing companies came into being, has morphed and changed with the advent of pooled rides and how the gross billing number is computed. Lyft, for instance, in 2018, reported revenues of $2,156 million on gross billings of $8.054 million, working out to a 26.77% share. I will assume that as Lyft continues to grow and offers new services, this number will revert back to 20%.
  5. And a shift to drivers as employees: Since their inception, the ride sharing companies have been able to maintain the facade that their drivers are independent contractors, not employees, thus providing the company legal cover, when drivers were found to be at fault of everything from driving infractions to serious crimes, as well as shelter from the expenses that the would ensue if drivers were treated as employees. As the number who work for ride sharing companies rises into the millions, states are already starting to push back, and in my view, it is only a matter of time before ride sharing companies are forced to deal with drivers as employees, causing operating margins in steady state to drop to 15%.
There are some aspects of this story that some of you may find too pessimistic, and other aspects that others may find too optimistic. You are welcome to download the spreadsheet and make the story your own,

The Valuation
The story that I have for Lyft already provides the bulk of the inputs that I need to value the company. To complete the valuation, I add four more inputs related to the company:
  1. Cost of capital: Rather than try to break down cost of capital into its constituent parts for a company that is transitioning to being a public company, I will take a short cut and give Lyft the cost of capital of 9.97%, at the 75th percentile of all US companies at the start of 2019, reflecting its status as a young, money-losing company. I will assume that this cost of capital will drift down towards the median of 8.24% for all US companies as Lyft becomes larger and profitable.
  2. Sales to capital: While Lyft will continue to operating with a low capital-intensity model, its need for reinvestment will increase, to build competitive barriers to entry and to preserve market dominance. If autonomous cars become part of the ride sharing landscape, these investment needs will become greater, I will assume revenues of $2.50 for every dollar of capital invested, in keeping with what you would expect from a technology company.
  3. Failure rate: Given that Lyft continues to lose money, with no clear pathway to generating profits, and that it will remain dependent on external capital providers to stay a going concern, I will assume that there is a 10% chance that Lyft will not survive as a going concern
  4. Share Count: Lyft posits that it will have 240.6 million shares outstanding, including both the class A shares that will be offered to the public and the class B shares, with higher voting rights, that will be held by the founders. It also discloses that it did not include in the share count two share overhangs: (1) 6.8 million shares that are subject to option exercise, with a strike price of $4.68, and (2) 31.6 million restricted shares that had already been issued to employees, but have not vested yet. I will include both of these in shares outstanding, the options because they are so deep in the money that they are effectively outstanding shares and the restricted stock because I assume that the employees that have large numbers of RSUs will stay until vesting, to arrive at a total share count is 279.03 million.
Finally, the company has not made explicit how much cash it hopes to raise from the initial public offering, but I have used the rumored value of $2 billion in new proceeds, which will be kept in the firm to cover reinvestment and operating needs, according to the prospectus. With these assumptions in place, my valuation of Lyft is below:
Download spreadsheet
My story for Lyft leads to a value of equity of approximately $16 billion, with the $2 billion in proceeds includes, or $14 billion, prior to the IPO cash infusion. Dividing by the 279 million shares outstanding, computed by adding the restricted shares outstanding to the share count that the company anticipates after the IPO, yields a value per share of about $59. Any story about young companies comes with ifs, ands and buts, and the Lyft story is no exception. I remain troubled by the ride sharing business model and its lack of clear pathways to profitability, but I think Lyft has picked the right strategy of staying focused both geographically (in the US) and in the transportation services business. I also am leery of the special voting rights that the founders have carved out for themselves, but that seems to have now become par for the course, at least with young tech companies. Finally, the possibility that one of the big technology companies or even an automobile company may be tempted to enter the business remains a wild card that could change the business.

The Lyft Pricing
I am a realist and know that when the stock opens for trading on the offering day, it is not value that will determine the opening bid, but pricing. In the pricing game, investors look at what others are paying for similar companies, scaling to some common operating variable. With publicly traded companies in mature sectors, this takes the form of an earnings (PE), cash flow (EV/EBITDA) or book value (Price to Book) multiple that can then be compared across companies. With Lyft, investors will face two challenges.

  • The first is that it is the first ride sharing company to list, and the only pricing that we have for other ride sharing companies is from venture capital rounds that are sometimes dated (from the middle or early last year). 
  • The second is that every company in the ride sharing business is losing money and the book values have no substance (both because the companies are young and don't invest much in physical assets). 
Notwithstanding these limitations, investors will still try, by scaling to any operating number that they can find that is positive, as I have tried to do in the table below:

It is true that there is substantial noise in the VC pricing numbers and that the operating numbers  for some of these companies are rumored or unofficial estimates. That said, desperation will drive investors to scale the VC pricing to one of these numbers with the gross billings, revenues and number of riders being the most likely choices. Uber has the highest pricing/rider and that the metric is lowest for the Asian companies, which have far more riders than their US counterparts; the revenue per rider, though, is also far lower in Asia than in the US. The companies all trade at high multiples of revenues and more moderate multiples of gross billings. In the table below, I have priced Lyft, using Uber's most recent pricing metrics as well as global averages, both simple and weighted:

To the extent that you accept these metrics, the pricing for Lyft can range from $5 billion to $22 billion, depending on your peer comparison (Uber, Global average, Global weighted average) and your scaling variable (Gross Billings, revenues or riders). In fact, if I bring in the rumored pricing of Uber ($120 billion) into the mix, defying circular logic, I can come up with pricing in excess of $30 billion for Lyft.  I think that they are all flawed, but you should not be surprised to see Lyft and its bankers to focus on the comparisons that yield the highest pricing.

Given the way the pricing game is structured, the pricing of the Lyft IPO is going to be watched closely by the rest of the ride sharing companies, since there will be a feedback effect. In fact, I think of pricing as a ladder, where if you move one rung of the ladder, all of the other rungs have to move as well. For instance, if investors price Lyft at $25 billion, about 12 times its revenue in 2018, Uber will be quicker to go public and will expect markets to attach a pricing in excess of $130 billion to it, given that its revenues were more than $11 billion in 2018. The Asian ride sharing companies, where rider numbers are high, relative to revenues, will try to market themselves on rider numbers, though it is not clear that investors will buy that pitch. Conversely, if investors price Lyft at only $12 billion, Uber may be tempted to wait to go public, and continue to tap into private investors, with the caveat being that those investors will also lower their pricing estimates. The pricing ladder can lead prices up, but they can also lead prices down, and timing is the name of the game.

The Waiting Game
It is still early and there is much that we still do not know. While some of the uncertainties will not be resolved in the near future, we will learn more specifics about the offering itself, including the amount that Lyft plans to raise on the offering day, over the next few weeks. Sometime soon, we will also get the a pricing of the company from the bankers that have been given the task of taking the company public, and I use the word "pricing" rather than "valuation" deliberately. The bankers' job is to price the company for the IPO, not value it. Not only should any talk of value from them be discounted, but if you do see a discounted cash flow valuation from a bank for Lyft, you can almost bet that it will be a Kabuki valuation, where they will go through the motions of estimating valuation inputs, when the ending number has been pre-decided.

YouTube Video

  1. Prospectus for Lyft
  2. Lyft Valuation
  3. Lyft Pricing
Posts on Ride Sharing (from 2015)

Wednesday, February 27, 2019

The Perils of Investing Idol Worship: The Kraft Heinz Lessons!

On February 22, Kraft Heinz shocked investors with a trifecta of bad news in its earnings report: sub-par operating results, a mention of accounting irregularities and a massive impairment of goodwill, and followed up by cutting dividends per share almost 40%. Investors in the company reacted by selling their shares, causing the stock price to drop more than 25% overnight. While Kraft is neither the first, nor will it be the last company, to have a bad quarter, its travails are noteworthy for a simple reason. Significant portions of the stock were held by Berkshire Hathaway (26.7%) and 3G Capital (29%), a Brazil-based private equity group. Berkshire Hathaway’s lead oracle is Warren Buffett, venerated by some who track his every utterance, and try to imitate his actions. 3G Capital might not have Buffett’s name recognition, but its lead players are viewed as ruthlessly efficient managers, capable of delivering large cost cuts. In fact, their initial joint deal to bring together Heinz and Kraft, two of the biggest names in the food business, was viewed as a master stroke, and given the pedigree of the two investors, guaranteed to succeed. As the promised benefits have failed to materialize, the investors who followed them into the deal seem to view their failure as a betrayal.

The Back Story
You don’t have to like ketchup or processed cheese to know that Kraft and Heinz are part of American culinary history. Heinz, the older of the two companies, traces its history back to 1869, when Henry Heinz started packing and selling horseradish, and after a brief bout of bankruptcy, turned to making 57 varieties of ketchup. After a century of growth and profitability, the company hit a rough patch in the 1990s, and was targeted by activist investor, Nelson Peltz, in 2013. Shortly thereafter, Heinz was acquired by Berkshire Hathaway and 3G Capital for $23 billion, becoming a private company. Kraft started life as a cheese company in 1903, and over the next century, it expanded first into other dairy products, and then widened its repertoire to includes other processed foods. In 1981, it merged with Dart Industries, maker of Duracell batteries and Tupperware, before it was acquired by Philip Morris in 1988. After a series of convulsions, where parts of it were sold and rest merged with Nabisco, Kraft was spun off by Philip Morris (renamed Altria), and targeted by Nelson Peltz (yes, the same gentleman) in 2008. Through all the mergers, divestitures and spin offs, managers made promises of synergy and new beginnings, deal makers made money, but little of substance actually changed in the products.

In 2015, the two companies were brought together, with Berkshire Hathaway and 3G playing both match makers and deal funders, as Kraft Heinz, and the merger was completed in July 2015. At the time of the deal, there was unbridled enthusiasm on the part of investors and market observers, and part of the unquestioning acceptance that the new company would become a force in the global food business was the pedigree of the main investors. In the years since the merger, though, the company has had trouble delivering on expectations of revenue growth and cost cutting:

The bottom line is that while much was promised in terms of revenue growth, from expanding its global footprint, and increased margins, from cost cutting, at the time of the deal, the numbers tell a different story. In fact, if investors were surprised by the low growth and declining margins in the most recent earnings report, they should not have been, since this has been a long, slow bleed.

The Earnings Report
The earnings report that triggered the stock price collapse, for Kraft-Heinz, was released on February 22, and it contained bad news on many fronts:
  1. Flatlining Operartions: Revenues for 2018 were unchanged from revenues in 2017, but operating income dipped (before impairment charges) from $6.2 billion in 2017 to $5.8 billion in 2018; the operating margin dropped from 23.5% in 2017 to 22% in 2018.
  2. Accounting Irregularities: In a surprise, the company also announced that it was under SEC investigation for accounting irregularities in its procurement area, and took a charge of $25 million to reflect expected adjustments to its costs.
  3. Goodwill Impairment: The company took a charge of $15.4 billion for impairment of goodwill, primarily on their US Refrigerated and Canadian Retail segments, an admission that they paid too much for acquisitions in prior years.
  4. Dividend Cuts: The company, a perennial big-dividend payer, cut its dividend per share from $2.50 to $1.60, to prepare itself for what it said would be a difficult 2019.
While investors were shocked, the crumb trail leading up to this report contained key clues. Revenues had already flattened out in 2017, relative to 2016, and the decline in margins reflected difficulties that 3G faced in trying to cut costs, after the deal was made. The only people who care about impairment charges, a pointless and delayed admission of overpayment on acquisitions, are those who use book value of equity as a proxy for overall value. The dividend cuts were perhaps a surprise, but more in what they say about how panicked management must be about future operations, since a company this attached to dividends cuts them only as a last resort.

The Value Effects
With the bad news in the earnings report still fresh, let’s consider the implications for the story for, and the value of, Kraft Heinz. The flat revenues and the declining margins, as I see them, are part of a long term trend that will be difficult, if not impossible, to reverse. While Kraft-Heinz may have a quarter or two with positive blips, I see more of the same going forward. In my valuation, I have forecast a revenue growth of 1% a year in perpetuity, less than the inflation rate, reflecting the headwinds the company faces. That downbeat revenue growth story will be accompanied by a matching “bad news” story on operating margins, where the company will face pricing pressures in its product markets, leading to a drop (though a small and gradual one) in operating margins over time, from 22% in 2018 (already down from 2017) to 20% over the next five years. The company’s cost of capital is currently 6%, reflecting the nature of its products and its use of debt, but over time, the benefits from the latter will wear thin, and since that is close to the average for the industry (US food processing companies have an average cost of capital of 6.12%), I will leave it unchanged. Finally, the mistakes of the past few years will leave at least one positive residue in the form of restructuring charges, that I assume will provide partial shelter from taxes, at least for the next two years.
Spreadsheet with valuation
The good news is that, even with a stilted story, Kraft Heinz has a value ($34.88) that is close to the stock price ($34.23). The bad news is that the potential upside looks limited, as you can see in the results of a simulation that I did, allowing expected revenue growth, operating margin and cost of capital to be drawn from distributions, rather than using point estimates.
Simulation Results
The finding the value falls within a tight range, with the first decile at about $26 and the ninth at close to $47 should not surprise you, since the ranges on the inputs are also not wide. As an investor, here are the actions that would follow this valuation. 
  • If you owned Kraft Heinz prior to the earnings report (and I thankfully did not), selling now will accomplish little. The damage has been done already, and the stock as priced now, is a fair value investment. I know that 3G sold almost one quarter of its holding in September 2018, good timing given the earnings report, but any attempts to sell now will gain them nothing. (I made a mistake in an earlier version of the post, and I thank those of you who pointed it out.)
  • If you don’t own Kraft Heinz, the valuation suggests that the stock is fairly valued, at today’s price, but at a lower price, it would be a good investment. I have a limit buy on the stock at a $30 price (close the 25th percentile of the distribution), and if it does hit that price, I will be a Kraft Heinz stockholder, notwithstanding the fact that I think its future does not hold promise. If it does not drop that low, there are other fish to catch and I will move on.
There are two concerns, though, that investors looking at this stock have to consider. The first is that when companies claim that they have discovered accounting irregularities, but that they have cleaned up their act, they are often dissembling and that there are more shocks to come. With Kraft Heinz, the magnitude of the irregularity is small, and given that they have no history of playing accounting games, I am willing to given them the benefit of the doubt. The second is that the company does carry $32 billion in debt, and while that debt has no toxic side effects today, that is because the company is perceived to have stable and positive cash flows. If the margin decline that I forecast becomes a margin rout, the debt will expose the company to a clear and present danger of default. Put simply, it will make the bad case scenarios that are embedded in the simulation worse, and perhaps threaten the company’s existence. 

The Lessons
There are lessons in the Kraft-Heinz blow-up, but I will tread carefully, since I risk offending some, with talk that you may view as not just incorrect but sacrilegious:
  1. It is human to err: At the risk of stating the obvious, Warren Buffett and 3G’s key operators are human, and are prone to not only making mistakes, like the rest of us, but also to have blind spots in investing that hurt them. In fact, Buffett has been open about his mistakes, and how much they have cost him and Berkshire Hathaway shareholders. He has also been candid about his blind spots, which include an unwillingness to invest in businesses that he does not understand, a sphere that only grows as he gets older and the economy changes, and an excessive trust in the managers of the companies that he invests in. While he is, for the most part, an excellent judge of character, his investments in Wells Fargo, Coca Cola and Kraft-Heinz show that he is not perfect. The fault, in my view, is not with Buffett, but with the legions of investors, analysts and journalists who treat him as an investment deity, quoting his words as gospel and tarring and feathering anyone who dares to question them. 
  2. Stocks are not bonds: In my data posts, I looked at how companies in the United States have moved away from dividends to buybacks, as a way of returning cash. That trend, though, has not been universally welcomed by investors, and there remains a significant subset of investors, with strategies built around buying stocks with big dividends. One reason that stocks like Kraft  Heinz become attractive conservative value investors is because they offer high dividend yields, often much higher than what you could earn investing in treasury or even safe corporate bonds. In effect, the rationale that investors use is that by buying these shares, they are in effect getting a bond (with the dividends replacing coupons), with price appreciation. From the Dogs of the Dow to screening based upon dividend yields, the underlying premise is that investors can count more on dividends than on buybacks. While it is true that dividends are stickier than buybacks, with many companies maintaining or increasing dividends over time, these dividend-based strategies become delusional when they treat dividends as obligated payments, rather than expected ones. After all, much as companies do not like to cut dividends, they are not contractually obligated to pay dividends. In fact, when a stock carries a dividend yield that looks too good to be true, it is usually almost always an unsustainable dividends, and it is only a question of time before dividends are cut (or even stopped) or the company drives itself into a financial ditch. 
  3. Brand Names last a long time, but nothing lasts forever: A major lodestone of conventional value investing is that while technology, cost efficiencies and new products are all competitive advantages that can generate value, it is brand name that is the moat that has the most staying power. Again, that statement reflects a truth, which is that brand names last long, often stretching over decades, but even brand name benefits fade, as customers change and companies seek to become global. The troubles at Kraft-Heinz are part of a much bigger story, where some of the most recognized and valued brand names of the twentieth century, from Coca Cola to McDonalds, are finding that their magic fading. Using my life cycle terminology, these companies are aging and no amount of financial engineering or strategic repositioning is going to make them young again. 
  4. Cost cutting can take you far, but no further: For the last few decades, we have cut a great deal of slack for those who use cost cutting as their pathway for creating value, with many leveraged buyouts and restructurings built almost entirely on its promise. Don’t get me wrong! In firms with significant cost inefficiencies and bloat, cost cutting can deliver significant gains in profits, but even with these firms, those gains will be time limited, since there is only so much fat to cut out. Worse, there are firms that find themselves in trouble for a myriad of reasons that have little to do with cost inefficiencies and cutting costs as these firms is a recipe for disaster. It is true that 3G did a masterful job, cutting costs and increasing margins at Mexico's Grupo Modelo, the Mexican brewer that they acquired through Inbev, but that was because Modelo’s problems lent themselves to a cost-cutting solution. It may even have worked at Kraft-Heinz initially, but at this point, the company’s problems may have little to do with cost inefficiencies, and much to do with a stable of products that is less appealing to customers than it used to be, and cost cutting is the wrong medicine for whatever ails them.
I hope that you do not read this as a hit piece on Warren Buffett and/or 3G. I admire Buffett’s adherence to a core philosophy and his willingness to be open about his mistakes, but I think he is ill served by some of his devotees, who insist on putting him on a pedestal and refuse to accept the reality that his philosophy has its limits, and that like the rest of us, he has an ego and makes mistakes. If you have faith in value investing, you should be willing to have that faith tested by the mistakes that you and the people you admire make in its pursuit. If your investment views are dogma, and you believe that your path is only the correct one to success, I wish you the best, but your righteousness and rigidity will only set you up for more disappointments like Kraft Heinz.

YouTube Video


Friday, February 22, 2019

January 2019 Data Update 9: The Pricing Game

In my last eight posts, I looked at aspects of corporate behavior from investments to financing to dividend policy, using the data that I collected at the start of 2019, to examine what companies share in common, and what makes them different. In summary, I found that the rise in risk premiums in both equity and bond markets in 2018 have pushed up costs of equity and capital, that companies across the globe are finding it difficult to generate returns on their investments that exceed their costs of funding, and that many of them, especially in mature businesses, are returning more cash, much of it in the form of buybacks. Since all of the companies in my data set are publicly traded, there is one final number that I have not addressed directly in my posts so far, and that is the market pricing of these companies. In this post, I  complete my data update series, by looking at how pricing varies across companies, sectors and geographies, and what lessons investors can draw from the data.

Value versus Price: The Difference
I have posted many times on the between the value of an asset and its' pricing, but I don't think it hurts to revisit that difference. The determinants of value are simple, although not always easy to estimate. Whether you are valuing start-up businesses, emerging market firms, or commodity companies, the values are driven by expected cash flows, growth, and risk. Although a discounted cash flow valuation is often the tool that we used to give form to these fundamentals, in the form of cash flows, growth rates in these cash flows, and discount rates, it is not the only pathway to intrinsic value.  The determinants of price are demand and supply, and while fundamentals do affect both, mood and momentum are also strong forces in pricing. These “animal spirits,” as behavioral economists might tag them, can not only cause price to diverge from value, but also require different tools to be used to assess the right pricing for an asset. With many assets and businesses, pricing an asset usually involves standardizing a price (a multiple), finding similar or comparable assets that are already priced in the marketplace, and controlling for differences. The picture below, which I have used many times before, captures the two processes:

The reason that I reuse this picture so much is because, to me, it is an all-encompassing snapshot of every conceivable investment philosophy that exists in the market:
  1. Efficient Marketers: If you believe that markets are efficient, the two processes will generate the same number, and any gap that exists will be purely random and quickly closed.
  2. Investors: If you are an investor, whether value or growth, and you truly mean it, your view is that the pricing process, for one reason or the other, can deliver a price different from your estimate of value and that the gap that exists will close, as the price converges to value. The difference between value and growth investors lies in where you think markets are most likely to make mistakes (in valuing existing assets or growth opportunities) and correct them. In essence, you are as much a believer in efficient markets as the first group, with the only difference being that you believe markets become efficient after you have taken your position on a stock. 
  3. Traders: If you are a trader, you start off with either the presumption that there is no such thing as intrinsic value, or that it exists, but that no one can estimate it. You play the pricing game, effectively using your skills at gauging momentum and forecasting the effects of corporate news on prices, to buy at a low price and sell at a high price.
Market participants are most exposed to danger when they are delusional about the game that they are playing. Many portfolio managers, for instance, claim to be investors, playing the value game, while using pricing screens (PE and growth, PBV and ROE) and adding to their holdings of momentum stocks. Many traders seem to think that they will be viewed as deeper and more accomplished if they talk the value talk, while using charts and technical indicators in the closet, to make their stock picks.

The Pricing Process
The essence of pricing is attaching a number to an asset or company, based upon how similar assets and companies are being priced in the market. To get insight into how to price an asset, a business or a company, you should break down the pricing process into steps:

You may be a little puzzled by the first step in the process, where I standardize the price, but the reason is simple. You cannot compare price per share across companies, since it is a function of the share count, which can be changed overnight in a stock split. To standardize prices, you scale them to some variable that all of the assets in the peer group share. With real estate properties, you divide the price of each property by its square footage to arrive at a price/square foot that can be compared across properties. With businesses, you scale pricing to an operating variable, with earnings being the most obvious choice, but it can be revenues, cash flows or book value. Note that any multiple that you find on a stock or company is embedded in this definition, ranging from PE ratios to EV/EBITDA multiples to revenue multiples, and even beyond, to market price per subscriber or user. The second step in the process, i.e., finding similar assets and companies, should make clear the fact that this is a process that requires subjective judgments and is open to bias, just as is the case in intrinsic valuation. If you are pricing Nvidia, for instance, you determine how narrowly or broadly you define the peer group, and which companies to deem to be "similar".  The third step int he process requires controlling for differences across companies. Put simply, if the company that you are pricing has higher growth or lower risk or better returns on its investments on it projects that the companies in the peer group, you have to adjust the pricing to reflect it, either subjectively, as many analysts do, with story telling, or objectively, by bringing in key variables into the estimation process.

Pricing the Markets in January 2019
Rather than taking you through multiple after multiple, and overwhelming with pictures and tables on each one, I will list out what I learned by looking at the pricing of all publicly traded stocks around the world, in early 2019, in a series of pricing propositions.

Pricing Proposition 1: Absolute rules don't belong in a relative world!
Paraphrasing Einstein, everything is relative, if you are pricing companies. Is a PE ratio of five low? Not if half the stocks in the market trade at less than five. Is an EV/EBITDA of forty high? Perhaps in some sectors, but not if you are comparing high growth companies in a highly priced sector. Old time value investing is filled with rules of thumb, and many of these rules are devised around absolute values for PE or PEG ratios or Price to Book, at odds with the very notion of pricing. If you want to make pricing statements about what comprises cheap or expensive, you should be looking at the distribution of the multiple across the market. Thus, to form pricing rules on US stocks at the start of 2019, I looked the distribution of current, forward and trailing PE ratios for US stocks on January 1, 2019:

At the start of 2019, a low trailing PE ratio for a US stock would have been 6.09, if you used the lowest decile or 10.36, if you moved to the first quartile, and a high PE ratio, using the same approach, would have been 27.31, with the third quartile, or 53.70, with the top decile. Lest I be accused of picking on value investors, they are not the only or even the biggest culprits, when it comes to absolute rules. Private equity investors and LBO initiators have built their own set of screens. I have lost count of the number of times I have heard it said that an EV to EBITDA less than six (or five or seven) must mean that a company is not just cheap, but a good candidate for leverage, but is that true? To answer the question, I looked at the EV to EBITDA multiples across companies, across regions of the world.
If you wield a pricing bludgeon and declare all companies that trade at less than six times EBITDA to be cheap, you will find about half of all stocks in Russia to be bargains. Even globally, you should hav no trouble finding investments to make with this rule, since almost one quarter of all companies trade at less than six times EBITDA.  My point is not that that you cannot have rules of thumb, since they do exist for a reason, but that those rules, in a pricing world, have to be scaled to the data. Thus, if you want to define the first decile as your measure of what comprises cheap, why not make it the first decile? That would mean that an EV to EBITDA multiple less than 5.16 would be cheap in the US on January 1, 2019, but that number would have to recalibrated as the market moves up or down.

Pricing Proposition 2: Markets have a great deal in common, when it comes to pricing, but the differences can be revealing!
Much is made about the differences across global equity markets, and especially about the divide between emerging and developed market companies, when it comes to pricing, with delusions running deep on both sides. Emerging market analysts are convinced that stocks are priced very differently, and often more irrationally, in their local markets, leaving them free to devise their own rules for their markets. Conversely, developed market analysts often bring perspectives about what comprises high, low or average pricing ratios, built up through decades of exposure to US and European markets, to emerging markets and find them puzzling. The data tells a different story, with pricing ratios around the world having distributional characteristics that are surprisingly similar across different parts of the world:

While the levels of PE ratios vary across regions, with Chinese stocks having the highest median PE ratios (20.63) and Russian and East European stocks the lowest (9.40), they all have the same asymmetric look, with a peak to the left (since PE ratios cannot be lower than zero) and a tail to the right (there is no cap on PE ratios). That asymmetry, which is shared by all pricing multiples, is the reason that you should always be cautious about any pricing argument that is built on comparisons to the average PE or PBV, since those numbers will be skewed upwards because of the asymmetry.  While it is true that markets share common characteristics, when it comes to pricing, the differences in levels are also worth paying attention to, when investing. A global fund manager who ignores these differences, and picks stocks based upon PE ratios alone, will end up with a portfolio that is dominated by African, Midde East and Russian stocks, not a recipe for investing success.

Pricing Proposition 3: Book value is the most overrated metric in investing
I have never understood the reverence that some investors seem to hold for book value, as revealed in the number of investing adages built around it. Stocks that trade at less than book value are considered cheap, and companies that build up book value are considered to be value creating. At the root of the "book value" focus are two assumptions, sometimes stated but often implicit. The first is that the book value is a measure of liquidation value, an estimate of what investors would get if they shut down the company today and sold its assets. The second is that accountants are consistent and conservative in estimating asset value, unlike markets, which are prone to mood swings. Both assumptions are built on foundations of sand, since book value is not a good measure of liquidation value in most sectors, and accountants are both inconsistent and slow-moving, when it comes to estimating and adjusting book value. Again, to get perspective, let's look at the price to book ratios around the world, at the start of 2019:
If you believe that stocks that trade at less than book value are cheap, you will again find lots of bargains in the Middle East, Africa and Russia, but even in markets like the United States, where less than a quarter of all companies trade at less than book value, they tend to be clustered in industries that are in capital intensive (at least as defined by accountants) and declining businesses.
PBV by Industry (US)
Note that among the US industries with the fewest stocks that trade at less than book value are a large number of technology and consumer product companies, with utilities and basic chemicals being the only surprises. On the list of US industry groups with the highest percentage of stocks that trade at less than book value are oil companies (at different stages of the business), old time manufacturing companies and life insurance. If you pick your stocks based upon low price to book, in January 2019, your portfolio will be weighted with companies in the latter group, a prospect that should concern you.

Pricing Proposition 4: Most stocks that look cheap deserve to be cheap!
There are traders who have little time for fundamentals, arguing that they have little or no role to play in day to day movements of stock prices. That is probably true, but fundamentals do have significant explanatory power, when it comes to why some companies trade at low multiples of earnings or book value and others are high multiples. To understand the link, I find it most useful to go back to a simple intrinsic value model, and with simple algebraic manipulation, make it a model for a pricing multiple. The picture below shows the paths you would take with an equity multiple (Price to Book) and an enterprise value (EV/Sales) to arrive at their determinants:

Now what? If you buy into the intrinsic view of a price to book ratio, it should be higher for firms that earn high returns on equity, have higher growth and lower risk, and lower for firms that earn low returns on equity, have lower growth and higher risk. Does the market price in fundamentals? For the most part, the answer is yes, as you can see even in the tables that I have provided in this post so far. Russian stocks have the lowest PE ratios, but that reflects the corporate governance concerns and country risk that investors have when investing in them. Chinese stocks in contrast have the highest PE ratios, because even with stepped down growth prospects for the country, they have higher expected growth than most developed market companies. Looking at stocks with the lowest price to book ratios, Middle Eastern stocks have a disproportionate representation because they earn low returns on equity and the industry groupings with the lowest price to book (oil industry groups, steel etc.) also share that feature. Pricing, done right, is therefore a search for mismatches, i.e., companies that look cheap on a pricing multiple without an obvious fundamental that explains it. This table captures some of the mismatches:

MultipleKey DriverValuation Mismatch
PE ratioExpected growthLow PE stock with high expected growth rate in earnings per share
PBV ratioROELow PBV stock with high ROE
EV/EBITDAReinvestment rateLow EV/EBITDA stock with low reinvestment needs
EV/capitalReturn on capitalLow EV/capital stock with high return on capital
EV/salesAfter-tax operating marginLow EV/sales ratio with a high after-tax operating margin

Pricing Proposition 5: In pricing, it is not about what "should be" priced in, but "what is" priced in!
In the last proposition, I argued that markets for the most part are sensible, pricing in fundamentals when pricing stocks, but there will be exceptions, and sometimes large ones, where entire sectors are priced on variables that have little to do with fundamentals, at least on the surface. This is especially true if the companies in a sector are early in their life cycles and have little to show in revenues, very little (or even negative) book value and are losing money on every earnings measure. Desperation drives investors to look for other variables to explain prices, resulting in companies being priced based upon website visitors (at the peak of the dot com boom), numbers of users (at the start of the social media craze) and numbers of subscribers.

I noted this phenomenon, when I priced Twitter ahead of its IPO in 2013, and argued that to price Twitter, you should look at its user base (about 240 million at the time) and what markets were paying per user at the time (about $130) to arrive at a pricing of $24 billion, well above my estimate of intrinsic value of $11 billion for the company at a time, but much closer to the actual pricing, right after the IPO.  It is therefore neither surprising nor newsworthy that venture capitalists and equity research analysts are more focused on these pricing metrics, when assessing how much to pay for stocks, and companies, knowing this, play along, by emphasizing them in their earnings reports and news releases.

I do believe in intrinsic value, and think of myself more as an investor than a trader, but I am not a valuation snob. I chose the path I did because it works for me and reflects my beliefs, but it would be both arrogant and wrong for me to argue that being a trader and playing the pricing game is somehow less worthy of respect or returns. In fact, the end game for both investors and traders is to make money, and if you can make money by screening stocks using PE ratios or technical indicators, and timing your entry/exit by looking at charts, all the more power to you! If there is a point to this post, it is that a great deal of pricing, as practiced today, is sloppy and ignores, or throws away, data that can be used to make pricing better.

YouTube Video

Data Links
  1. PE ratios by industry grouping: USEuropeEmerging MarketsJapanAustralia & CanadaIndia and China
  2. Book Value Multiples by industry grouping: USEuropeEmerging MarketsJapanAustralia & CanadaIndia and China
  3. EV to EBIT & EBITDA by industry grouping: USEuropeEmerging MarketsJapanAustralia & CanadaIndia and China
  4. EV to Sales by industry grouping: USEuropeEmerging MarketsJapanAustralia & CanadaIndia and China
  5. Pricing Multiples, by country

Friday, February 8, 2019

January 2019 Data Update 8: Dividends and Buybacks - Fact and Fiction

In my series of data posts, I had always planned to get to dividends and buybacks, the two mechanisms that companies have for returning cash to stockholders, at this point, but an op ed on buybacks by Senators Schumer and Sanders this week, in the New York Times, will undoubtedly make this post seem reactive. The senators argue that the hundreds of billions of dollars that US companies have expended buying back their own shares could have been put to better use, if it had been reinvested back in their businesses or used to increase wages for their employees, and offer a preview of legislation that they plan to introduce to counter the menace. Like the senators, I am concerned about the declining manufacturing base and income inequality in the US, but I believe that their legislative proposal is built on premises that are at war with the data, and has the potential for making things worse, not better.

The Buyback Effect: Benign Phenomenon, Managerial Short-termism or Corporate Malignancy?
'The very mention of buybacks often creates heated debate, because people seem to have very different views on its causes and consequences. All too often, at the end of debate, each side walks away with its views of buybacks intact, completely unpersuaded by the arguments of the other. The reason, I believe is that our views on buybacks are a function of how we think companies act, what the motives of managers are and what it is that investors price into stocks.

a. Buybacks are benign
If companies are run sensibly, the cash that they return to shareholders should reflect a residual cash flow, making the cash return decision, in terms of sequence, the final step in the process. 

If companies follow this process, buybacks are just another way of returning cash to stockholders, benign in their impact, because they are not coming at the expense of good investments, at least with good defined as investments that generate more than their hurdle rates. In fact, putting restrictions on how much cash companies can return, can harm not only stockholders (by depriving them of their claim on residual  cash flows) but also the economy, because capital will now be tied up in businesses that don't need them, rather than find its way to good ones.

b. Buybacks are short term
The benign view of stock buybacks is built on the presumption that managers make decisions at publicly traded companies with an eye on maximizing value, and since value is a function of expected cash flows over the life of the company, that they have a long term perspective. That view is at odds with evidence that managers often put short term gains ahead of long term value, and if investors are also short term, in pricing stocks, you can get a different picture of what drives buybacks and the consequences:

In effect, managers buy back stock, often with borrowed money, because it reduces share count and increases earnings per shares, and markets reward the company with a higher stock price, because investors don't consider the impact of lost growth and/or the risk of more debt. The argument that buybacks are driven by short term interests is strengthened if management compensation takes the form of equity in the company (options or restricted stock), because managers will be personally rewarded then for buybacks that, while damaging to the company's value (which reflects the long term), push up stock prices in the short term. With this view of the world, buybacks can create damage, especially at companies with good long term projects, run by managers who feel the need to meet short term earnings per share targets.

c. Buybacks are malignant
There is a third view of buybacks, where buybacks are not just motivated by the desire to push up earnings per share and stock prices, but become the central purpose of the firm. With this view, companies try to do whatever they can to generate more cash for buybacks, including crimping on worker wages, turning away good investments and borrowing more, even if that borrowing can put their survival at risk.

This picture captures almost all of the arguments that detractors of buybacks have used, including the ones that Senators Schumer and Sanders present in their article. If buybacks are the drivers of all other corporate actions, instead of being a residual cash flow, the “buyback binge” can be held responsible for a trifecta of America's most pressing economic problems: stagnant wages for workers, the drop in capital expenditures at US companies and the rise in debt on balance sheets. If this buyback shift is being driven by activist shareholders and a subset of "short term" institutional investors, as many argue that it is, you have a populist dream cast of good (workers, small stockholders, consumers) and evil (activists, wealthy shareholders and bankers). If you buy into this description of corporate and investor behavior, and it is not an implausible picture, it stands to reason that restricting or even stopping companies from buying back stock should alleviate and even solve the resulting problems. 

Picking a perspective
The reason debates about buybacks very quickly bog down is because proponents not only come in very different perspectives of corporate behavior, but they use anecdotal evidence, where they point to a specific company that behaves in a way that backs their perspective, and say "I told you so". The truth is that the real world is a messy place, with some companies buying back stocks for the right reasons (i.e., because they have no good investments and their stockholders prefer cash returns in this form), some companies buying back stock for short term price gains (to take advantage of markets which are myopic) and some companies focusing on buying back stock at the expense of their employees, lenders and own long term interests. 

Moneyball with Buybacks

The question of which side of this debate you will come down on, will depend on which of the perspectives outlined above comes closest to describing how companies and markets actually behave. Since that is an empirical question, not a political, idealogical or a theoretical one, I think it makes sense to look at the numbers on dividends and buybacks, not just in the US, but across the world, and I will do so with a series of data-driven statements.

1. More companies are buying back stock, and more cash is being returned in buybacks

Are US companies returning more and more cash in the form of buybacks? Yes, they are, and it represents a trend that saw its beginnings, not ten years ago, but in the 1980s. In the graph below, I look at the aggregate dividends and buybacks from firms in the S&P 500 since 1986, and also report on the percentage of cash returned that takes the form of buybacks, each year:

Starting at a base in the early 1980s, where buybacks were uncommon and dividends represented almost all cash return, you can see buybacks climb through the 1980s and 1990s, both in dollar value terms and as a percentage of overall cash return. That trend has only accelerated in this century, with the 2008 crisis putting a brief crimp on it. In 2018, more than 60% of the cash returned by S&P 500 companies was in the form of buybacks, amounting to almost $700 billion.

2. Cash Returns are rising as a percent of earnings, and it looks like companies are reinvesting less back into their own businesses
If you look at the graph above, you can see that the rise in buybacks has been accompanied by a stagnation in dividends, with growth rates in dividends substantially falling short of growth in buybacks. This shift has had consequences for two widely used measures of cash return, dividend yield, which looks at dividends as a percent of market capitalization or stock prices and the dividend payout ratio, a measure of the proportion of earnings as dividends. The declining role of dividends, as a form of cash return, has meant that a more relevant measure of cash return has to incorporate stock buybacks, resulting in a broader definition of cash yield and cash payout ratio measures:
  • Cash Yield = (Dividends + Buybacks) / Market Capitalization
  • Cash Payout Ratio = (Dividends + Buybacks)/ Net Income
The push back that you will get from dividend devotees that while dividends go to all shareholders, buybacks put cash only in the pockets of those stockholder who sell back, but that argument ignores the reality that the it is still shareholders who are getting the cash from buybacks. (As a thought experiment, imaging that you own all of the shares in a company and consider whether you notice a difference between dividends and buybacks, other than for tax purposes.) Calculating both dividend and cash measures of yield and payout over time, we observe the following for the companies in the S&P 500:
S&P 500: Dividends, Buybacks, Mkt Cap and Net Income
This table reinforces the message from the previous graph, which is that both dividends and buybacks have to be considered in any assessment of cash return. That is why I think that the handwringing over how low dividend yields have become over the last two decades misses the point. The cash yield for US companies, which includes both dividends and buybacks, is much more indicative of what companies are returning to shareholders and that  number has remained relatively stable over time. Using the same logic that I used to argue that cash yields were better indicators of cash returned to shareholders than dividend yields, I computed cash payout ratios, by adding buybacks to dividends, before dividing by net income in the table in the last section, and it does show a disquieting pattern. In fundamental analysis, analysts give weight to the payout ratio and its twin measure, the retention ratio (1- payout ratio) as a measure of how much a company is reinvesting into its own business, in order to grow.  The cash returned to shareholders exceeded net income in 2015 and 2016, and remains high, at 92.12% of net income, and that statistic seems to support the proposition that US companies are reinvesting less.

3. The drop in reinvestment may be real, but it could also be a reflection of accounting inconsistencies and failure to see the full picture on cash return
It is true that companies are returning more of their net income, as measured by accountants, to stockholders in dividends and buybacks, with the latter accounting for the lion's share of the return. Before we conclude that this is proof that companies are reinvesting less, there are two flaws in the numbers that need fixing:
  1. Stock Issuances: If we count stock buybacks as returning cash to shareholders, we should also be counting stock issuances as cash being invested by these same shareholders. Thus, the more relevant measure of cash return would net out stock issuances from stock buybacks, before adding dividends. While this is a lesser issue with the S&P 500 companies, which tend to be larger and more mature companies, less dependent of stock issuances, it can be a larger one for the entire market, where initial public offerings can augment seasoned equity issues, especially for smaller, higher growth companies.
  2. Accounting Inconsistencies: Over the last few decades, the percentage of S&P 500 companies that are in technology and health care has risen, and that rise has laid bare an accounting inconsistency on capital expenditures. If a key characteristic of capital expenditures is that money spent on them provide benefits for many years, accounting does a reasonable job in categorizing capital expenditures in manufacturing firms, where it takes the form of plant and equipment, but it does a woeful job of doing the same at firms that derive the bulk of their value from intangible assets. In particular, it treats R&D, the primary capital expenditure for technology and health care firms, brand name advertising, a key investment for the long term for consumer product companies, and customer acquisition costs, central for growth in subscriber/user driven companies as operating expenses, depressing earnings and rendering book value meaningless. In effect, companies on the S&P 500 are having their earnings measured using different rules, with the earnings for GM and 3M reflecting the correct recognition that money spent on investments designed to create benefits over many years should not be expensed, but the earnings for Microsoft and Apple being calculated after netting those same types of investments. As with the treatment of leases, I refuse to wait for accountants to come to their senses on this question, and I have been capitalizing R&D for all companies and adjusting their earnings accordingly. 
In the table below, I bring in stock issues and R&D into the picture, looking across all US stocks, not just the S&P 500:
All US publicly traded companies; S&P Capital IQ
While the trend towards buybacks is still visible, bringing in new stock issuances tempers some of the most extreme findings. In 2018, for instance, the net cash return (with issuances netted out from dividends and buybacks) represented about 46% of adjusted net profit (with R&D added back), well below the gross cash return.  In fact, there is no discernible decline in reinvestment over time, barring 2008 and 2009, the years around the last crisis. Capital expenditures have grown slowly, but an increasing percentage of reinvestment, especially in the last 5 years, has taken the form of R&D and acquisitions. 

4. Buybacks cut across sectors, size classes and growth categories, but the biggest cash returners are larger, more mature companies.

Before we decide that buybacks are ravaging the economy and should be restricted or even banned, it is also worth taking a look at what types of companies are buying back the most stock.  Staying with US stocks, I looked at buybacks and dividends of companies, broken  down by industry grouping. The full table is at the end of this post, but based upon the dollar value of buybacks, the ten industries that bought back the least stock and the ten that bought back the most are highlighted below:
Dividends and Buybacks: By Industry for US
It should come as no surprise that the industries where you see buybacks used the least tend to be industries which have a history of large dividend payments, with utilities, metals and mining and real estate making the list. Looking at the industries that are the biggest buyers of their own stock, the list is dominated by companies that derive their value from intangible assets, with technology and pharmaceuticals accounting for seven of the ten top spots. While that may surprise some, since these are viewed as high growth businesses, some of the biggest players in both technology and pharmaceuticals are now middle aged or older, using my corporate life cycle structure.

Given that there are often wide differences in size and growth, within each industry grouping, I also broke companies down by market cap size, to see if smaller companies behave differently than larger ones, when it comes to buybacks:
Market capitalization, as of 12/31/18
It is not surprising that the largest companies account for the bulk of buybacks, but you can also see that they return far more in buybacks, as a percent of their market capitalizations, then smaller firms do. 

Finally, I categorized companies based upon expected growth in the future, to see if companies that expect high growth behave differently from ones that expect low growth.
Expected revenue growth in the next two years
While companies in every growth class have jumped on the buyback bandwagon, the biggest buybacks in absolute and relative terms are for companies that have the lowest expected growth in revenues, returning 4-5% of their market capitalization in buybacks each year. Companies in the highest growth class, in contrast, return only 0.95% of their buybacks. That said, there are companies in higher growth classes that are buying back stock, when they should not be, perhaps for short term pricing reasons, but they represent only a small portion of the market, accounting collectively for only 10.56% of overall market capitalization.

I may be guilty of letting my priors guide my reading of these tables, but as I see it, the buyback boom in the United States is being driven by large non-manufacturing firms, with low growth prospects. If you restrict buybacks, expecting that this to unleash a new era of manufacturing growth and factory jobs, I am afraid that you will be disappointed. The workers at the firms that buy back the most stock, tend to be already among the better paid in the economy, and tying buybacks to higher wages for these workers will not help those who are at the bottom of the pay scale.

5. Investing back into businesses is not always better than returning cash to shareholders, when it comes to jobs, economic growth and prosperity.
Implicit in the Schumer-Sanders proposal to restrict buy backs is the belief that while shareholders may benefit from buybacks, the economy overall will be more prosperous, and workers will be better served, if the cash that is returned to shareholders is invested back in the businesses instead. Incidentally, this seems to be a shared delusion for both ends of the political spectrum, since one of the biggest sales pitches for the tax reform act, passed in 2017, was that the cash trapped overseas by bad US tax law, would, once released, be invested into new factories and manufacturing capacity in the US. I believe that both sides are operating from a false premise, since investing money back into bad businesses can make both economies and workers worse off. In a prior post, I defined a bad business as one where it is difficult to generate a return that is higher than the risk adjusted rate that you need to make to break even on your investment. 
Data Update 6 on excess returns
Using the return on capital, a flawed but still useful measure, as a measure of return and the cost of capital, with all of the caveats about measurement error, I found that approximately 60% of companies, both globally and in the US, earn less than their cost of capital. Forcing these companies to reinvest their earnings, rather than letting them pay it out, will only put more more money into bad businesses and create what I call "walking dead" companies, tying up capital that could be used more productively, if it were paid out to shareholders, who then can find better businesses to invest in. 

6. Some companies may be funding buybacks with debt, but the bulk of buybacks are still funded with equity cash flows
The narrative about stock buybacks that its detractors tell is that US companies have borrowed money and used that debt to fund buybacks, creating, at least in the narrative, sky-high debt ratios and  rising default risk. While there is certainly anecdotal evidence that you can offer for this proposition, there is evidence that we have looked at already that should lead you to question this narrative. Looking across sectors, we noted that the technology and pharmaceutical companies are on the list of biggest buyers of their own stock, and neither group is in the top ten or even twenty, when it comes to debt ratios.

Taking the naysayers at their word, I broke US companies down, based upon their debt loads, using Debt/EBITDA as the measure, from lowest to highest, to see if there is a relationship between buybacks and debt loads:
Debt to EBITDA at the end of 2018
The bulk of the buybacks are coming from firms with low to moderate debt ratios, falling in the second and third quintiles of debt ratios.  It is true that the firms with the highest debt load, buy back the most stock, at least as a percent of their market capitalization. As with the growth data, you can view this as evidence of either short-term thinking or worse, but note that the second and third quintiles together account for 61% of overall market capitalization, suggesting that if buybacks are skewing debt upwards at some firms, it is more at the margins than at the center of the market. 

7. Buybacks are now a global phenomenon
It is true that stock buybacks, at least in the form that you see them today, as cash return to stockholders, had their origins in the United States in the 1980s and it is also true that for a long time after that, much of the rest of the world either stayed with dividends and many countries had severe constraints on the use of buybacks. In the last decade, though, the dam seems to have broken and stock buybacks can now be seen in every part of the world, as can be seen in the table below:

US companies still lead the world in buybacks, but Canadian companies are playing catch up and you are seeing buybacks pick up in Europe. Asia, Eastern Europe and Latin America remain holdouts, though it is unclear how much of the reluctance to buy back stock is due to poor corporate governance. 

The Follow Up

I agree that wage stagnation and an unwillingness to invest into the industrial base are significant problems for US companies, but I think that buybacks are more a symptom of global economic changes, than a cause. In particular, globalization has made it more difficult for companies to generate sustained returns on investments,  and has made earnings more volatile for all businesses.  The lower returns on investments has led to more cash being returned, and the fear of earnings volatility has tilted companies away from dividends, which are viewed as more difficult to back out of, to buybacks. In conjunction, a shift from an Industrial Age economy to the economies of today has meant that our biggest businesses are less capital intensive and more dependent on investments in intangible assets, a trend that accounting has not been able to keep up with.  You can ban or restrict buybacks, but that will not make investment projects more lucrative and earnings more predictable, and it certainly is not going to create a new industrial age.

If you came into this article with a strong bias against buybacks it is unlikely that I will be able to convince you that buybacks are benign, and it is very likely that you will be in favor, like Senators Schumer and Sanders, on restricting not just buybacks, but cash returns (including dividends), in general. Playing devil’s advocate, let’s assume that you succeed and play out what the effects of these restrictions will be on how much companies invest collectively and employee wages.
  • On the investment front, it is true that companies that used to buy back large numbers of their own shares will now have more cash to invest, but in what? It could be in more internal investments or projects, but given that many of these companies were buying back stock because they could not find good projects in the first place, it would have to be in projects that don’t earn a high enough returns to cover their hurdle rates. Perhaps, it will be in acquisitions, and while that will make M&A deal makers happy, the corporate track record is woeful. In either case, you will have more reinvestment in the wrong segments of the economy, at the expense of investments in the segments that need them more.
  • On the wage front, the consequences will be even messier. It is possible that tying buybacks to employee wages, as Senators Schumer and Sanders propose, will cause some companies to raise wages for existing employees, but with what consequences? Since they will now be paying much higher wages than their competitors, my guess is that these same companies will  be quicker to shift to automation and will have smaller workforces in the future, and that those at the low end of the pay scale will be most hurt by this substitution. 
Illustrating my point about anecdotal evidence, the senators use Walmart and Harley Davidson to make their case, arguing that both companies should not have expended the money that they did on buybacks, and taken investments or raised wages instead. 
  • Assuming that Walmart had followed their advice and not bought back stock and invested instead, it is unlikely that Walmart would have opened more stores in the United States, a saturated market, but would have opened them instead in other countries, and I don’t believe that the senators would view more stores being built in Indonesia or India as the outcome they were hoping for. As for Harley Davidson, a company that serves a loyal, but niche market, building another factory may have created more jobs for the moment, but it is not at all clear that the demand exists for the bikes that would roll out.
  • Would Walmart have raised wages, if they had not bought back stock? In a retail landscape, where Amazon lays waste to any competitor with a higher cost structure, that would have been suicidal, and accelerated the flow of customers to Amazon, allowing that company to become even more dominant. In a world where people complain about how the FANG stocks are taking over the world, you would be playing into their hands, by handcuffing their brick and mortar competitors, with buyback legislation.
In short, restricting buybacks may lead to more reinvestment, but much of it will be in bad businesses, acquisitions of existing entities and often in other countries. Tying buybacks to employee wage levels may boost the pay for existing employees, but will lead to fewer new hires, increasing automation and smaller workforces over time. In short, the ills that the Schumer-Sanders bill tries to cure will get worse, as a result of their efforts, rather than better.

I believe that the shift to buybacks reflects fundamental shifts in competition and earnings risk, but I don't wear rose colored glasses, when looking at the phenomenon. There are clearly some firms that are buying back stock, when they clearly should not be, paying out cash that could be better used on paying down debt, especially in the aftermath of the reduction of tax benefits of debt, or taking investments that can generate returns that exceed their hurdle rates. You may consider me naive, but I believe that the market, while it may be fooled for the moment, will catch on and punish these firms. Also, the data suggests that these bad players are more the exception than the rule, and banning all buybacks or writing in restrictions on buybacks for all companies strikes me as overkill, especially since the promised benefits of higher capital investment and wages are likely to be illusory or transitory. If you are tempted to back these restrictions, because you believe they are well intentioned, it is worth remembering that history is full of well intentioned legislation delivering perverse results. 

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