Robbing Peter To Pay Paul

The 10th Man: The Financial Engineering Market

By Jared Dillian

IBM went down hard on its quarterly earnings report this week. This made a splash in the news because, well, it’s IBM, and also Warren Buffett owns it, so it was a rare moment of human fallibility for him. But there is a lot more to the story than that. Very sophisticated people have been keeping an eye on IBM for some time.In particular, Stanley Druckenmiller—former chairman and president of Duquesne Capital, former portfolio manager of Soros’s Quantum Fund, and, honestly, one of the greatest investors in modern times—went public about a year ago saying that IBM was his favorite short (which says a lot) and that it was the poster child for, well, the type of stock market we have nowadays.

What was Druckenmiller referring to?

Some Quick History

Ten years ago, during the housing boom, the consumer was the most leveraged entity, taking out negative amortization mortgages, cashing out home equity, things like that. The consumer got a margin call, which was ugly—you know the story—and has spent the last six years deleveraging.

While the consumer was taking down leverage, the US government was adding leverage, taking the deficit to over 10% of GDP at one point. But even the government is deleveraging (for the moment), and now it is America’s corporations that have been adding leverage, at a furious pace. We’ve had trillions of dollars in corporate bond issuance in the last few years.

So when corporations sell bonds, what do they typically use the proceeds for?

In theory, the proper use for debt is to finance capital expenditures. Growth. But in this last cycle, that’s not what the money has been used for. It’s primarily been used for stock buybacks and dividends.

Robbing Peter to Pay Paul

Now, there are good corporate finance reasons to lever up a balance sheet and conduct stockholder-friendly actions, like buying back stock or paying dividends. You can read about it in the corporate finance textbooks. For any company, there is an optimal amount of leverage. It’s even possible to be underleveraged.

But you see (and this is the important thing), when you take out debt to buy back stock, leveraging the balance sheet in the process, you may be increasing the optics of how profitable the business is by increasing earnings per share—but you are not actually changing the fundamentals of the business.

You are not actually increasing profitability. You are just rewarding one tranche of the capital structure (common stockholders) at the expense of another one (bondholders).

IBM just happened to be a particularly egregious example. IBM—whose core business was basically flat over six years—well, you’d never know it from looking at a chart of the stock. (Hint: it went straight up for years.)

What happened?

They tripled their debt over time, retiring stock, taking the share count under a billion, ramping up the earnings per share. The goal was to get it over $20, which they abandoned on the last earnings call.

Financial Engineering Works, to a Point

So what can we learn about financial engineering? It works, up to a point. In the short term, you can conceal from investors the fact that your business model is broken and you don’t have a plan. You can conceal it for a number of years, in fact. That is the thing about finance: you can suspend the laws of economics in the short term. But not forever. It will always come back to haunt you.

IBM is by no means alone. There are dozens, even hundreds of buybacks going on as we speak. One of my favorites is GameStop (NYSE:GME). It is an open secret that GME is the next Blockbuster, now that the technology exists for games to be downloaded over the Internet with no interruption of play. Everyone knows that unless there is a radical change in strategy, GME is doomed. But you couldn’t short the stock because of… a buyback.

So with a good portion of the S&P 500 buying back stock, it’s no surprise that it wants to keep going up, and hindsight being what it is, it has been very foolish to try and short it.

This Can’t Go On Forever

There is good news, though (or bad news, depending on your point of view). IBM might be the canary. Put another way, there is a limit to how many bonds can be issued, and for sure, the credit markets have been less accommodative lately. Maybe that is how it ends—the credit markets shut down, no more bonds, no more buybacks.

People kind of forget what it’s like when the credit door slams shut. I remember writing bullishly on Gannett (NYSE:GCI) back in 2008. The stock was in the low single digits. The market was very worried that the company would not be able to refinance an existing bond issue maturing in 2009. GCI did manage to refinance, and stockholders have been rewarded. But it was looking very sketchy there for a moment.

The credit markets are kind of my hobby horse, and it is the right of anyone with a hobby horse to ride that thing as long as possible. There’s been so much debt issued—at such unfavorable terms and at such low interest rates—that the credit markets are more vulnerable than at any point in history. A mild recession, and we are looking at 20% default rates. All it takes is a push.

Just last week, it looked like we were going to get it. A hint of QE4, and the market seems to have changed its mind. We shall see. I tend not to use phrases like “smoke and mirrors” to describe the stock market, because that is very tinfoil-hatty.

Put more thoughtfully, I would say that much of this 200% move in the stock market off the lows has been divorced from economic fundamentals, and based solely on financial engineering, which can be ephemeral.

It’s a self-reinforcing process that has worked for a while, but I don’t want to be around when it stops working.
Jared Dillian