Financial Engineering

‘Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason, to pump up or support the stock price. The shareholder who chooses to sell today, of course, is benefited by any buyer, whatever his origin or motives. But the continuing shareholder is penalised by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.’ Buffett '91

A rare occurrence indeed, posting two consecutive weeks in a row and hopefully more to come if time permits. This week the subject will be the unproductive and ineffective type of engineering: financial engineering. The engineering field is very respectable and is efficient in that there is a purpose and a finished product. Often there are issues with the finished product, but most importantly, they come with time. For example, this past week’s tragic collapse of a bridge in Minnesota was a long time in the making. However, because it happened, bridges all over the country will be inspected and engineers will make adjustments to ensure more durable bridges.

Business is about profitable growth, not growth in size (market cap) and the eventual creation of value (for shareholders). Do not be fooled by the voices in the media that tout the record earnings growth because they are a little mythical. First, much of the business world believes that earnings per share (“EPS”) are the most important number to judge a company by. Moreover, Wall Street wants predictable earnings from the many companies that report on a quarterly basis. Thus, the creation of value is given 3 months to blossom! Furthermore, most of the upper management of companies manage earnings as opposed to managing the company.

Second, the fall of the Dollar has allowed many multinational companies that do most of their business outside of the States to record amazing growth in profit. It has certainly been a great currency arbitrage for multinational companies, but it is not their fault, rather it is another smoking sign. A basic example would include a company reporting a 7% increase in net profits for the year, but if the dollar has fallen 8%, profits actually contracted.

So what happened is that most CEO's, CFO's turned to a new field by becoming financial engineers. The end result was to grow EPS at reasonable rate (determined by analysts) to make sure that their stocks didn't plummet. Every quarter, all the analysts estimate of EPS for the next quarter are averaged and that is the "number" that management has to make. Creative accounting is only one of the many tools used. An example includes the case of Cisco, a BW article in 2002 (here) talked about the hype. Here is an excerpt:

"That night, at the company's main San Jose warehouse, employees scrambled to load as many boxed-up machines onto trucks as possible, thus enabling them to be counted as "sold" for accounting purposes before the quarter ran out at midnight. "We had guys running with parts, trying to run them up to the trucks," recalls Larry R. Carter, chief financial officer, who monitored the action from a computer terminal in the warehouse that tallied shipments in real time. One harried staffer, in his haste, fell headlong to the concrete floor in front of Carter. Ten minutes before midnight, Chambers called Carter's cell phone from Davos, Switzerland, where he was speaking at an economic summit. "Did we make it?" Chambers asked. After a few more minutes of watching the numbers come in, Carter had to pass along the bad news: Cisco would undershoot expectations by a penny per share, its first Wall Street miss in 11 years."

"Did we make it?" And so it goes, but make no mistake, every 4 or 5 years a new way of "making it" comes around and exposes the destruction of value. I personally believe that for the past three years the way to "make it" was buybacks. Simply put, net earnings rose at a slower pace than earnings per share and it was an act that was rewarded by Wall Street analysts and media. The upper management figured that by buying shares of their own stock (put in treasury) earnings would increase; it was not organic growth by any means. In fact, the popular saying was that companies were participating in equity arbitrage, the act of dividing the E (earnings) by the P (price) and if the rate was higher than the 10 year treasury, to borrow (debt) and buyback shares of their own stock. Because you can right off the interest of the debt payments, you were rewarded for adding leverage.

"I’ve seen more people fail because of liquor and leverage- leverage being borrowed money. Donald Trump failed because of leverage. He simply got infatuated with how much money he could borrow, and he did not give enough thought to how much money he could pay back." Buffett

The innocent companies were penalized, if they had a solid balance sheet with little to no debt, a corporate raider would buy a small percentage of your company and order you to take on more debt and to use the proceeds by purchasing stock. Furthermore, because corporations are driven by net returns on capital after taxes, the tax write off of interest payments masked the EPS growth. That my friend is how and where the majority of earnings growth was made over the past few years.

Jeremy Grantham of GMO stated, “Corporate tax has always been a tax on efficiency- be less efficient, make less money, and you’ll pay less tax. The more reckless you are, the more you borrow, and the more interest you deduct, the less tax you pay.” It is the equivalent of driving with your seatbelt on and a cop stops you because you are too careful. So you get a ticket and because you obey the law you refuse to put your seatbelt on. The next time you are driving (w/o a seatbelt) the same cop stops you and asks why you have your open while you are driving, so he gives you an eye-patch to cover one of your eyes. This is not an exaggeration by any means, it was the rule in Wall Street until recently when Credit Spreads widened making buybacks too expensive because of a higher cost of capital (“COC”).

Now, I don't want to be misunderstood, there were and are many companies that purchased back their own stock at a discount, and that will create enormous shareholder value. Wally Weitz, fund manager of the Weitz fund in his latest quarterly letter stated, “Generally good ideas are taken too far.” True, he was talking about the idea of mortgage backed securities, but the statement has value.

Earlier this week, Procter and Gamble (“PG”) stated their plan to buy back up to $30 billion of its shares. For a company as safe and sound as PG, I think this will benefit shareholders a great deal. The company is always evolving and has great management that actually manages the company as opposed to managing the earnings.

Today’s post is more of a value-investing type of message than the previous one(s). This will be the order of the day for a while for three reasons:

1). I can’t find any value in the marketplace. Businesses are selling at a price that does not meet my required margin of safety.

2). I want this blog to have some value based on personal ideas/beliefs in order to create a personality towards businesses that we look at in the future. For example, most readers automatically know my views on the economic numbers because of this post.

3). I am still learning, although my un-audited returns for the past three years are above market returns, I want to learn as much as possible. The early posts are the foundation of a young investor’s beliefs and education.

Thank you,

S.K.