Alibaba revisited

 

In my last post on the subject, I reviewed what I believed were the main risks associated with investing in Alibaba.  I know little about China but something about emerging markets and markets in countries ruled by authoritarian regimes.

My conclusion was that Alibaba was “investable”, targeting an entry price for the ADSs of up to $160 and an exit price of $220, unless conditions changed.

I also noted this: A quantum change in risk level would be the entrance of the Chinese state in the share capital of Alibaba.

Over the weekend, the Wall Street Journal ran a story according to which Chinese state investors were looking to take an ownership position in ride-hailing DiDi Global Inc., months after regulators had punished it [for listing in the US against their wishes].

The WSJ went on detailing that the Beijing municipal government was coordinating such project and that the goal was to gain enough voting power to have influence over the company.  It added that DiDi would be merged with a smaller competing rival, Beijing Shouqi Group Inc., itself backed by the city of Beijing.  The same general story was first reported by Bloomberg. 

Didi has denied this story.  Earlier today, the Beijing city government also denied the story.

I don’t know where the truth lies, but the WSJ and Bloomberg are serious news organizations, and they seem to have relied on more than a couple of sources. 

Maybe the WSJ and Bloomberg were fooled, but then whoever planted the story felt that the Chinese government actions had been such that the story would be believed by the likes of Bloomberg and the WSJ.

It may also be that the Beijing city government’s reading of the regulators and president Xi was that an investment in DiDi had a good chance of succeeding.  Or the city of Beijing may have received a green light from above.

Whatever the actual situation, I feel that the yellow light is turning orange.  By that I mean that, at best, Alibaba’s price-earning multiple could decrease, slowly or rapidly, to a range of 12-15 vs. 19-20 now.

Let's remember that Russian state controlled Gazprom, the biggest natural gas producer in the world and a very profitable company, is selling at a price-earnings multiple of under 4.  By comparison, Chevron sells at a p/e multiple of 16.

Alibaba, or the tribulations of a Chinaman in China?

 

August 23, 2021

In Jules Verne’s novel, Kin-Fo, the hero, is a rich oligarch who decides to put an end to his life after learning that his main overseas businesses have collapsed.  Thus, he instructs his mentor to murder him before his life insurance expires.  Meanwhile, for a short while, he will live life to the fullest.  But when he learns that, far from being a pauper, his affairs have prospered greatly, Kin-Fo no longer wants to die; problem is that his mentor is nowhere to be found.  Kin-Fo must now run for his life, and in the process, he learns that life is infinitely precious.

Viewed from afar, Alibaba seems to have been on the run lately, assailed at every turn by faceless bureaucrats intent on hacking away at its fortune, relentless and determined in their pursuit.

As Alibaba runs, foreign shareholders also run, away, and markets wonder if Alibaba will share the fate of the dodos.

I have no special knowledge of how the Chinese government works nor do I have an insight into the Chinese Communist Party’s deliberations.  However, I believe that human nature is universal, driven both by emotions and reason, and that authoritarian regimes have characteristics in common.  That is why, I will try to evaluate the merits on investing in Alibaba and, in the process, try to answer some of the key questions asked by investors.

Basic premise

The Chinese Communist Party (CCP) is a body that controls all levers of power in China.  Since it regroups just 1/15 of the population, it derives its legitimacy not from popular vote but from delivering better standards of living to the 1.4 billion Chinese.

Its leader and Chinese president, Xi JinPing, seems to have accumulated more power than his predecessors and, in the process, has pushed aside political peers and interest groups.  As happens in similar situations, witness Putin in Russia, Chavez in Venezuela, and others, retirement is not an option; staying in power is the only way forward.

This means that, for both the CCP and Xi, survival is the only thing that counts, and everything else either comes second or may be used to that end. 

Reading the world press, the CCP and Xi seem to feel that all is not well in China ahead of next year’s presidential election: Covid-19 continues to have a negative impact on the economy, the rise in standards of living has been uneven and mammoth companies have been accumulating data and financial power on their own (i.e. beyond the tight control of the Party) and to the detriment of the people.

Viewed from this standpoint, the actions of Xi and his administration are logical and understandable.  They appear designed to ensure favorable short-term political goals as well as solving China’s fundamental challenge: how to safeguard a regime founded by Mao Zedong the legitimacy of which is best served by economic free enterprise?

My first conclusion is that the CCP and Xi will go as far as they dare to achieve their goals.  But I also believe that destroying household savings and reverting to economic socialism would imperil their survival.

My second conclusion is that China is not “uninvestable”, rather that it is riskier than initially thought and thus deserving of a wider margin of safety/error.

Let us review some of the risk factors raised in connection with investing in Alibaba, and others.

The VIE structure means that foreign investors own “nothing”

Typically, if foreign company XYZ seeks to list on US exchanges, it will issue ADRs (American Depository Receipts).  ADRs are certificates issued by a US depositary bank and backed by shares of a foreign company (XYZ) held by that US depositary bank abroad.  For example, one Petrobras ADR represents two ordinary Brazilian shares.

The ADSs (American Depositary Shares) issued by Chinese companies have a much weaker structure.  To provide foreigners with an economic participation in its business, Alibaba set up a Variable Interest Entity (VIE) in the Cayman Islands that grants ADS owners a contractual right to a specific percentage of its profits.  Such right is established by a contract between the VIE and Alibaba.  One ADS has a call on the profits accruing to eight Chinese shares of Alibaba.

Put it another way, the holder of an Alibaba ADS owns shares in a Cayman Islands company, the VIE, which in turns has a right to profits generated by Alibaba, such right being instrumented by a contract between the VIE and Alibaba.

Some non-Chinese companies issue preferred shares where the holders have no voting rights but have either preference over holders of ordinary shares in case of liquidation or with regards to the payment of dividends.  Holders of Alibaba ADS have no ownership in the company, no voting right, and for the moment Alibaba pays no dividend.

Clearly, an ADS in a Chinese company offers less than a classic ADR and pricing should reflect this situation.

China can declare null and void the VIE structure

Trying to go around government rules is risky and the track record of those who tried is not good. 

I remember the case of investment banks in Brazil back a few decades ago: foreign investors would enter into side agreements with the controlling local shareholders to gain a say in key decisions, or a right of veto, which the Brazilian laws prohibited.  Sure enough, the side agreements didn’t survive a dispute between shareholders when one case was brought up to a local court.

The 2014 prospectus prepared in connection with the Alibaba ADS issue states that, as per its outside Chinese legal counsel, Alibaba’s VIEs do not violate any applicable law, regulation or rule in the PRC.  However, counsel goes on stating that “there are substantial uncertainties regarding the interpretation and application of current PRC laws, rules and regulations.”  And Alibaba goes on saying that future laws, rules and regulations regarding VIEs could be enacted.

Perhaps a more useful way to look at this issue is to place it within a broader perspective: does the PRC want to have normal business and financial relationships with the rest of the world?

In 2020, Alibaba was the most valuable ADR/ADS stock traded on the NYSE and NASDAQ.  It was not some small outfit flying under everybody’s radar.  Since 2014, there have been many other Chinese IPOs following the same VIE route; the Chinese government had plenty of opportunities to object to these VIEs, and it hasn’t.  That has widely, and rightly, been interpreted as tacit acceptance.

The CCP may want to steer more capital raising and trading towards Chinese exchanges, but it certainly doesn’t want to cut itself from the rest of the world by flouting widely followed international rules.

Yes, there have been instances of governments doing so, but the circumstances and motivations were very different.  In 1917, the Soviet Union reneged on its external debt and, in effect, locked itself out from the rest of the world to rebuild itself as a communist country.  North Korea, Venezuela have defaulted on their debts and have then limited their international dealings with a few sympathetic countries which extract their pound of flesh to help them out.  It is difficult to imagine the CCP wanting to follow the same route.

The trade fights with the Trump administration also showed that, for its great manufacturing prowess, China needed the rest of the world to absorb its industrial output and keep millions employed.  Isolationism brings poverty, not wealth.

My view is that it is very unlikely that China would retroactively nullify the VIE structure.

China could, for all intents, take over Alibaba and ruin it

The CCP has been vocal about its goals of redistributing wealth and cutting Big Tech down to size.  It seems determined to do so, at least for the time being.

There have been examples of government using “cash cows” to advance political or socio-economic causes; the results haven’t been good for shareholders.  They haven’t been good for the governments either, although in at least one case, Gazprom in Russia, the cost has been bearable.

In Russia, Gazprom has been used to exert pressure on Ukraine and on countries that depend on it for a substantial portion of their energy needs.  It has also served domestic priorities by selling its natural gas at a fraction of its export prices.  Despite having a production more than twice that of Exxon and a massive pipeline network, its market value is less than half that of the US company.

The Lula administration pushed its oil giant Petrobras to the edge of bankruptcy by interfering with its business investments and management.  In Venezuela, Hugo Chavez ruined what once was the best oil company in the region, Petroleos de Venezuela S.A., by redirecting its finances and management toward social spending.

Unlike Alibaba, it should be noted that Gazprom, Petrobras and PDVSA are majority or wholly own by the state.  This makes government interference much easier.  The CCP could still tighten the rules and regulations which apply to Big Tech and effectively reduce its profitability by reregulating the use and value of data, by limiting the pricing power of integrated behemoths and by simply pressuring management.  It seems that it will.

I expect Alibaba’s life to become harder and its freedom of action to be constrained.  A quantum change in risk level would be the entrance of the Chinese state in the share capital of Alibaba.

Is Alibaba “investable”?

That is the question, and if so, at what price?  I think that the threats of a Chinese government crackdown are real; therefore, BABA’s stock pricing should reflect that.

The government has already announced the cancellation of several tax and other incentives which made more economic sense when Alibaba and others were startups, not tech giants.  That will have a negative impact, although perhaps not that big.

Regulating the use of personal data could be more damaging.  So will rules taking aim at Alibaba’s sector dominance.

Many commentators have advised investing in sectors now favored by the Chinese government, including high value-added manufacturing, healthcare and the environment.  It is likely that stocks in these sectors will see their prices rise, at least initially. 

But are corporations which are groomed and closely monitored by the government more likely to be profitable and creative?  Will government bureaucrats encourage risk taking, straying from the consensus?  Possibly.  Airbus has been both a technological as well as a business success.  But there are not so many such examples.

Finally, if the end result of government economic planning is a fairer rise in standards of living, why wouldn’t firms dedicated to facilitating consumption not benefit, even if their pricing powers have been clipped?  There are risks to investing in any country. 

My view is that investing in China has proven riskier than perhaps expected, but that it is “investable” at the right price.  The same goes for a well-managed behemoth like Alibaba.

To some extent, Jack Ma’s case reminds me of Mikhail Khodokorvsky’s, the former head of defunct Yukos.  Yukos was the biggest oil producer in Russia.  Like other oligarchs of his days, Khodokorsky gained control and built Yukos up in the years that followed the fall of the Soviet Union.  He then decided to enter the political arena, financing groups opposing Putin.  He was jailed and Yukos was dismembered.

Jack Ma seems to have challenged the management of Xi, but he didn’t enter the political arena.  He created Alibaba from scratch, not via a route as controversial as the privatization via loans-for-shares in Russia.  Finally, he has been out of Alibaba’s leadership since 2018.

So there are enough parallels to be uneasy, but no real equivalence to fear the worst.

Is there a price at which to buy Alibaba ADSs?

I think there is, but I would allocate a modest portion of my stock portfolio to Chinese stocks at this time. 

Value Line finds that its highest historic predictor of Alibaba’s stock price has been a “least square linear” relationship with 28 times cashflows.  Interestingly, it found that for Amazon’s stock price the best predictor has been 27 times cash flows.

While Alibaba may have comparable growth potential, or more, the China country risk should require BABA to trade at a discount to Amazon. If such discount is 30% then a fair price today for the ADS should be about $220.

Another way to look at valuation is multiples of earnings to BABA’s enterprise value, that is its market capitalization + debts – cash holdings.  At today’s closing ADS price of $161, should the company meet UBS analysts profit expectations of Rm161 billion (vs. Rm172 billion for 2020), the enterprise value to net profits multiple is around 14.5.  This looks prudent under most non-catastrophic scenarii.

Finally, a third way to value the company is to relate its enterprise value to its active user base.  At today’s ADS price and at its active user base at 6/30/21, investors put a value of $313/active user.  That is quite low.  By comparison, I estimate Amazon enterprise value per active user at around $4,500/active user (which sounds too high perhaps for undercounting active users) .  Although its business model is different, Google is valued at around $2,000/active user.

The above calculations are very rough: using for example “adjusted earnings” rather than GAAP; the definition of “active user” is not the same for Alibaba, Amazon and Google; China’s wealth per capital is much lower than that of the US or Western Europe, etc.

Rather than representing a benchmark for current valuation, I believe that enterprise value/active user is a more useful indication of what Alibaba could aspire to…if both it and China prosper.

In the end, it is very difficult to come up with a precise valuation of Alibaba as the biggest threats to its business future are non-quantitative in nature.  As discussed above, I believe that Alibaba has a future, albeit a cloudy one for the foreseeable future.

Under current circumstances, $160/share appears to me as a reasonable top price to pay given the circumstances.  But I wouldn’t be shocked if BABA’s ADS price dropped as low as $140.

Inflation: Is it different this time?

 A year ago, 10 year treasurys yielded 1.34% p.a.  After bottoming out at 0.52% in early August, it is now back up to 1.34%.  For the past 5 years or so, treasury yields fluctuated between 2% p.a. and 3% p.a.

After plunging to 0.12% in 2015, US inflation, as measured by the consumer price index, rose to 1.26% in 2016, 2.13% in 2017, 2.44% in 2018, 1.81% in 2019.  Covid-19 knocked inflation back to 0.9% in 2020.  For January 2021, inflation (CPI not seasonally adjusted) rose 0.4% over December 2020.

 Where do we go from there?  The recent rapid rise in 10 year treasury yields suggests that investors are wary of a resurging inflation.  The Federal Reserve and the Biden Administration, on the other hand, seem more concerned with too slow a recovery from the damage caused by Covid-19. Who is right?

Milton Friedman famously said that inflation is a monetary phenomenon: too much money printed resulting in an imbalance between money and output.  Dissenters will point to Japan where the government, for years, has issued massive amounts of debt and the Bank of Japan has created massive amounts of money by buying all sorts of public and private financial instruments.

The thing is that for Friedman’s proposition to work, the money that is created has to be spent.  The vast increase in money created by the Federal Reserve after the Great Recession of 2008 found its way back home in the form of bank reserves and deposits.  Likewise, much of the 2020 financial government assistance went unspent by households, boosting saving rates at one time to over 30%.

Such inclination to save and reluctance to spent have several causes: some may be purely economic such as over indebtedness and wage stagnation, demographic with aging populations, and psychological namely fear of the future.

Japan is a good example of aging population, low economic growth causing low wage growth and, for these and cultural reasons, a proclivity to save.

The US, on the other hand, seem to occupy a very different place: the population is younger (though not overly so), economic and wage growth has been higher and consumerism rather than saving has ruled the land.

Globalization has been a big factor in putting a lid on production costs and thus prices; while it is still prevalent, the US as well as other countries have somewhat cooled down to it.

Finally, the Administration is pushing another very large relief package of up to $1.9 trillion coming on top of the $900 billion stimulus approved last December, hundreds of billions of the original $4.8 trillion which have yet to be disbursed and a yet to be announced infrastructure investing program.  When these items are measured against how much more the economy could produce, it is no wonder that economist L. Summers is concerned that inflation may accelerate and that it will then be politically difficult to throttle the stimuli back.

I for one don’t know if and when excess inflation (over 1%-2%p.a.) will arise, but the creation of money is awe-inspiring, the US are nor Japan, and assets seem very richly priced, whether one looks at stocks or real estate.  Finally, when bitcoin is being preferred over gold as a store of value in uncertain times, one can worry.

 The thing about inflation is that it starts as a monetary phenomenon and becomes a psychological condition: producers raise prices, just in case, and invest only in short-term projects; consumers buy and often finance their purchases with loans; unions and investors push for indexation of wages and fixed-income instruments respectively.  Pretty soon, indexation makes it very difficult to return to normal and years of efforts are needed to overcome past fears and mistrust.

I will finish with a graphic example of brutal inflation in Brazil during the 1970s and 1980s.  The first bill is one of 100,000 cruzeiros, by then not worth much.  In 1986, the cruzeiro was replaced by the crusado in the ratio of 1000:1.  It was in circulation until 1989 when it was replaced by the crusado novo in the ratio, you guessed it, of 1000:1.  Brazil did overcome hyperinflation, but it took many years, a lot of efforts and extracted a very high cost on the population, mostly on the poor who didn’t have savings and couldn’t protect themselves.

I am not implying that the US will fall into hyperinflation, but Brazil didn’t expect it would either. 

Were the US to have an inflation rate of 5% p.a., by no means in hyper territory, the impact on the economy and our way of life would be profound: pensioners on fixed annuities would lose 25% of their purchasing power after 4-5 years; mortgage rates would likely by in the 7% p.a. range; stocks would likely lose 40% of their value.

Better not get close to it.

 

 

 

 

 

 

 

Ice Age: the Post Covid-19 New World

Six months into the Covid-19 crisis, many of us feel like Manny, Diego and Sid: hurtling through a world on the edge of life-changing cataclysms, not sure what tomorrow will look like.

Nowhere has this angst been clearer than in the stock market.  Cruise lines have tanked, which is understandable given the industry very high fixed costs, high debt leverage and its inability to operate (in the US, as per the No Sail Order).  Airlines are likewise in an existential crisis for similar reasons.  At the other end of the spectrum, Zoom Video Communications (ZM) has experienced a massive rise in both customer usage and stock price.  Generally speaking, companies involved in physical activities have suffered while those that are associated with at-home or virtual activities have flourished.

But the stock market is supposed to look ahead, to discount future cashflows; monoclonal antibody treatments are proving useful, vaccines are expected to start being distributed by next spring, and the second wave of infection has so far been much less lethal than the first.  Trillions in savings remain on the sidelines which, at some point, will either be spent on Main Street or invested on Wall Street.

Why is it that the stock market seems to believe that we are and will remain mired in the Ice Age, confined at home, watching streaming videos and leaving home only for quick dashes to the supermarket?  Or are the fears of a change in the White House and the Senate so great as to stamp any feeling of hope and optimism?

Are we entering a new era where, among other changes:

·        No one flies for vacations or business reasons?

·        No one shops for clothes, be they fashion or sports oriented?

·        Alternative energy sources quickly take the place of oil and natural gas?

 

I don’t think so.  The question then is (a) which company to invest in and (b) when?

There is no magic recipe.  Logically, in times of stress and uncertainty about the future, it pays to be selective.  We will not give up flying, but we may fly less (at least for a while); in this case, only the strongest might survive; why invest in the #5 airline stock which could return 150% if investing in the #1 could return 50% over the same horizon but with a lot less risk?

In the fashion sector, uncertainly is the nature of the business.  I would ask myself: ”what is a reasonable value for this brand and does the enterprise value of the company (market value + debt - cash) reflect it?” There is no set formula but a commonsense approach (looking at comparable products and companies, historical data, likely future earnings, etc.) should yield a range of values to work with.

Energy, being the single most important factor for economic growth, has strategic, political and social dimensions in addition with concerns about global warming.  While it is reasonable to assume that oil and gas will fade as energy sources just like coal did, such transition will likely take 20 to 30 years:  the demand for energy keeps increasing, solar and wind power are both expensive and not easily scalable, nuclear fission is unpopular in the US and Western Europe and nuclear fusion is still at the experimental stage.  Fossil fuels are widely used because they have several big economic advantages (such as energy density, ease of transport and storage, scalability, cost) which solar and wind lack, and will continue to lack.

In all of these sectors, given their depressed valuations, investors willing to take the plunge should stick to the top companies: those that have enduring market positions, the riskier the sector the more reason to stick to the #1 firm.  Targeted companies should also enjoy very strong financials to carry them through extended periods of volatility or low growth, and high quality management; it is worth emphasizing that high quality management usually translates into a strong company culture which facilitates good execution and overcoming hard times.

The other question is when to get in.  Picking a good entry price is the most important decision in an investment cycle.  It is easier to determine if a good company is selling at an attractive price than to try and guess when market bottoms may be reached.  Finally, in times of stress and volatility, picking realistic goals is key: a stock which may rise by at least 30% over the next 3-4 years while paying a 2.5% dividend would return around 40% over that period while a US treasury would return 4% at best.  Why be greedy? 

The Madness of Crowds

 

In 1841, Charles McKay wrote his famous book “Extraordinary Delusions and the Madness of Crowds”.  Its first volume dealt with economic manias and bubbles, the most famous of which, to that date, had been the Dutch tulip mania.

Manias, being born from mass human behavior, have endured as exemplified by the Internet and “eyeballs” stock craze at the turn of last century.  Over the last decade, another one has flourished and while its cost has already been high, we likely haven’t paid the full bill yet.  I am talking about stock buybacks.

This mania is insidious and rarely makes headlines: after all, it is easier to laugh at hapless retail investors riding the latest wave of euphoria for Covid-19-proof stocks or for cloud-centric IPOs.  Large companies are managed by cooler heads, have carefully crafted operating procedures and vigilant boards of directors to rein in overly optimistic CEOs, or do they?

The truth is many companies have bought back their stock, and over the last 30 years, those that did have seen, in the aggregate, their share price perform better than those that didn’t.  In part, this is explained by the fact that the better companies generate more cashflows (with which to buyback shares) and their better share performance also reflects their better businesses.

The stock buyback movement has accelerated over the years.  While the ratio of buyback value to market (S&P500) hasn’t changed much since 2004 at around 3% p.a., the timing of these buybacks has been poor: companies backed the truck as market indices soared (see below) but stepped back when valuations were attractive. 

Furthermore, more and more buybacks are funded by debt as opposed to free cashflows (see below).

 

The table below maps the trends in shares outstanding (in millions)/long-term debt outstanding (in billions of US$)/net worth (in billions of US$) for a cross section of US blue-chips.

	2010	2012	2014	2016	2020 (e)
American Airlines			697/16.2/2	461/22.5/3.8	515/30/(4.5)
Boeing	735/11.5/2.8	756/9/5.9	707/8.1/8.7	617/9.6/0.8	566/60/(13)
Corning	1,561/2.3/19.4	1,470/3.4/21.5	1,271/3.2/21.6	926/3.6/17.9	761/7.5/13.3
Emerson Electric	753/2.5/9.8	724/3/10.3	697/2.4/10.1	643/1.9/7.6	595/1.2/8.5
McDonald	1,054/11.5/14.6	1,003/13.6/15.3	963/15/12.9	819/25.9/(2.2)	744/35/(10.5)
Microsoft	8,668/4.9/46.2	8,381/10.7/66.4	8,239/20.6/89.8	7,808/40.8/72	7,571/59.6/118.3
Regeneron	87/0/0.5	95/0.3/1.2	102/0.1/2.5	106/0.4/4.5	105/0.7/12

 

Source: Valueline.

 

The above table deserves a few comments.  First, shares outstanding reflect the issuance of new shares and corporate buybacks, so that annual buybacks are generally higher than the difference in year-end outstandings.  Second, the table shows long-term debt outstandings with no mention of cash holdings which reduce net debt levels.

As to the companies listed: American Airlines filed for Chapter XI in December of 2011 and emerged from bankruptcy in December of 2013.  Nevertheless, in 3 years (2014-2016) it repurchased at least 1/3 of its common shares outstanding and despite generating an aggregate of $13 billion in earnings and $17 billion in cashflows, it increased it long-term debt by 39% or $6.3 billion.

On the surface, although Boeing share count was reduced by 16% through 2016 and 41% through 2019, the company seemed to have acted reasonably since its long-term debt actually decreased over the 2010-2016.  Not so.  By the end of 2019, debt had risen by 73% from 2010 levels, and by the end of 2020 it is expected to rise another 200%!  Worse, to support its massive share buybacks and the payment of dividends, the company diverted funds which normally would go to investments in new products and manufacturing excellence.

This is apparent in the table below.  Over the 2016-18 period, Boeing used 88% of its cashflows to buyback stocks and pay dividends, leaving very little for productive investments.

 

Boeing	Cashflow from Operations	Dividends + Stock Buybacks	End of Year Cash	Cumulative use of cashflows for dividends and buybacks
2016	$10.5 bn	($9.4 bn)		($9.4 bn)
2017	$13.3 bn	($12.3 bn)		($21.7 bn)
2018	$15.3 bn	($12.8 bn)		($34.5 bn)
2019 Q1.[1]			$6.8 bn

McDonald pushed the envelope even further, spending 158% of its operating cashflows on dividends and buybacks over the 2016-2018 period.   From 2010 to 2020, its share count will have dropped by 29% and its long-term debt will have tripled!  It almost paid the price when Covid-19 wrecked financial markets this last March.  Had the Fed not injected trillions in liquidity, McDonald could have faced real difficulties.  Unlike Boeing though, its capital investment needs follow a shorter cycle and are more discretionary in nature.

 

McDonald	Cashflow from Operations	Dividends + Stock Buybacks	End of Year Cash	Cumulative use of cashflows for dividends and buybacks
2016	$6.3 bn	($14.2 bn)		($14.2 bn)
2017	$5.8 bn	($7.8 bn)		($22 bn)
2018	$7.2 bn	($8.5 bn)	$2.7 bn	($30.5 bn)

Microsoft on the other hand is one of the few companies which could afford large buybacks yet did them in a measured way (12% over the 2016-2020 period); its net worth more than doubled, unlike the others which shrank.  Finally, while its long-term debt grew exponentially to $60 billion, it held $134 billion in cash on 6/30/19.

 

Microsoft	Cashflow from Operations	Dividends + Stock Buybacks	End of Year Cash	Cumulative use of cashflows for dividends and buybacks
2017	$39.5 bn	($22.8 bn)		($22.8 bn)
2018	$43.8 bn	($22.4 bn)		($45.2 bn)
2019[2]	$52.2 bn	($32.2 bn)	$133.8 bn	($77.4 bn)

Last, but not least in the first table, is Regeneron, a biotech company which has famously focused on R&D and been dismissive of short-term move in its stock prices.  This strategy has probably impacted its market valuation, but rock-solid financials allowed Regeneron to sail through the recent crisis and to keep putting money where it has great expertise, i.e. the discovery of new drugs[3].

This buyback mania is dangerous in many ways.  First, it represents an apparently easy and safe way to boost financial results by reducing the number of shares outstanding and boosting earnings per share.  The problem is that this fix is difficult to abandon once used a few times.

It reinforces management’s focus on short term results, with the danger that a transparent result-booster like buybacks may incentivize management to look for other financial performance levers in accounting, purchasing, etc. which can become questionable.

Another problem with buybacks is that they tend to detract management from an essential responsibility, that of assessing the risk-reward of long-term investment decisions and making such decisions.  This was, I believe, an issue with Boeing and its 737 Max: massive stock buybacks funded by starving new product development provided immediate financial benefits while the development of a new airplane was fraught with risks (even if these risks were in a field where Boeing was an expert and world leader).

Besides diverting funds, excessive reliance on buybacks eventually affect a company culture: short-termism, avoidance of risks and eventually responsibilities.  Once this sets in, reforming a corporate culture can take very long and be quite disruptive: bringing in a new CEO from outside is easy, changing the rest of senior management takes time, can be operationally costly and doesn’t insure that lower rank employees will trust, accept or understand what is now expected from them.

Extremely low interest rates have been a huge factor in this buyback mania.  As they remain low, companies pile on debt which they can easily service.  But even if interest rates don’t rise any time soon, these last few months have shown that a sudden crisis can abruptly zap fixed-income investors’ appetite for anything but risk-free US treasurys.

The smartest financial minds can’t successfully time their buybacks.  Last year, Liberty Global tendered for $2.5 billion of its own shares, repurchasing them at around $27. The stock price never reached that level since and stands at $20.50 today.  During the first quarter of this year, Liberty bought back $500 million at around $16.50 per share.  $3 billion in buybacks which, so far, have been value destructive.

For the foreseeable future, the Fed seems able and willing to cast a wide safety net.  But the draw of near-zero interest rates is still alive, as is the desire to beat short-term earnings per share expectations.  Caveat emptor.

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[1] Last trimester before the massive raising of fresh funds due to the problems of the 737 Max.

[2] Fiscal year ends in June.

[3]  In the interest of disclosure, I own shares in Microsoft and Boeing.