Since the end of the Great Recession, management teams of publicly traded companies have increasingly engaged in financial engineering to improve their stock performance metrics.
Specifically, some have borrowed money—usually by issuing bonds—and used the cash to buy shares of their own companies’ stock on public stock exchanges. These stock buybacks have the effect of improving “per share” measures of stock performance. For example, even if a company’s sales are flat, its sales-per-share calculation will increase just by reducing the number of shares outstanding.
Historically, companies have bought back shares as a way to return capital to investors when it is no longer needed for ongoing operations—essentially as a one-time dividend. There’s nothing wrong with that at a general level. But when companies fund the buybacks with debt, it’s not evidence of financial success in the form of surplus cash flows.
Consider IBM as one example. In the past five years, IBM’s sales have decreased 18.2 percent. Net income has fallen 11 percent. But because of share buybacks, earnings per share rose during the same period. To accomplish this feat of financial engineering, IBM added more than $10 billion of new debt—taking on far too much financial risk, in our opinion, for a non-growth company.
What happens to over-indebted companies when it becomes harder to roll over debt at attractive interest rates?
With today’s historically low interest rates bound to eventually move higher, investors are beginning to sour on leveraged balance sheets. Consequently, this financial engineering shortcut to EPS growth may be turning into a dead end. Year-to-date, businesses in the Russell 3000 Index with the most debt have been among the worst performers.
If this trend continues, we believe businesses with low or no debt that have the ability to improve earnings through sales growth will be poised to outperform in the year ahead.
Our approach is to focus on companies with low debt levels, high free cash flow yields and strong company-specific catalysts for improvement. We believe these businesses are uniquely positioned to provide downside protection in a volatile market and benefit from an improving economic outlook.
-Bill Nasgovitz is founder, chairman and chief investment officer of Heartland Advisors Inc. in Milwaukee.
