Equity Evaporation
Insight NewsletterIssue #16
As the second quarter enters its final act we see a difficult environment in some ways, an easy one in other ways.
It’s a difficult environment because the noise of different viewpoints is loud.
It’s easy because if we can turn off the noise, we see supply and demand balance that which is creating a benign environment for investors of many different asset classes, particularly equities.
What is the BIG picture?
The below chart shows that WORLD stock markets have de-coupled from the rising trend line. When this happens, it is natural for the average to return to the rising trend line sooner, or later. That’s our question of the day, will it be sooner (2007) or later (2008/09)?
One of the most important factors in this equation is the supply of equity shares. The number of equity shares outstanding is shrinking. In fact, some estimate that the global supply of equity will decrease 5% this year, representing $1.75 trillion of invested assets will need to be re-allocated to other securities.
There are four factors driving this trend of equity evaporation.
1) Private Equity: Private equity is removing billions of shares from portfolios. Just this week, two groups announced an 8.2B buyout of Avaya, the Telecom Equipment maker.
2) Cash Mergers. Cash Acquisitions by public corporations are also reducing share count such as the $18 Billion in cash that Freeport McMoran’s ponied up for Phelps Dodge, the largest US copper producer, earlier this year.
3) Corporate Buy-Backs. The third cause of equity shrinkage is corporate share repurchase programs, otherwise known as “buy-backs”. Financially strong companies have always had repurchase programs in place, but what used to be an occasional event, has turned into a massive re-allocation of capital out of corporate treasuries and into an ever-rising stock market.
You see, buy-backs are bids for common stock that emanate from a company’s treasury. Quite a lot of the rising earnings per share of the S&P 500 can be attributed to share repurchases. IBM for instance, has reduced its outstanding shares by 255 million (15%) since 2000.
4) Fewer IPO’s. Historically, any extended period of declining equity shares has been met by Wall Street Investment bankers, eager to bring to Joe Public, a host of new and exciting companies in alleged growth industries. The investment bankers do this well (remember Ethanol a year ago?). The resulting new supply of low-quality stocks brings new supply into frothy markets and sets the stage for market declines. Indeed, it was the investment bankers that brought every bright idea to the public (do you remember theglobe.com?) that eventually imploded a stock index filled with such companies (Nasdaq 5000).
Given the 60% rise in the US Stock market since 2003, it is surprising that there are so few IPO’s. But something out of the ordinary transpired over the last five years. In the wake of the 2001-2002 crash, the mutual fund scandals, 9/11, and Sarbanes-Oxley legislation, the cost to becoming a public company has dramatically increased. At the same time, retail investors focused on the real estate sector as the go-to place to make fast money. New public companies have not come anywhere close to fulfilling their traditional role of adding equity supply to the public markets.
Bulging corporate coffers have only acerbated the equity evaporation problem with their stingy dividend payouts. Due to tax advantages of buy-backs, the poor record of acquisition strategies, and the general disdain that public companies and their shareholders have shown for high dividend payout ratios, corporate treasuries have chosen to put their cash back into their own shares, reducing outstanding shares by millions and billions of shares.
Meanwhile, the retail public partied at the real estate trough and shunned active participation in IPO’s and any “new economy” concepts fewer new public companies were brought to market. In this back drop, the overall stock gains have been solid indeed as Global demand for shares outstripped supply and the DOW has ascended 5000 points since 2003. We don’t expect this to end anytime soon, because not only are corporate treasuries a driver of global demand for common stocks, but there are also many global factors, more so than ever before (these include the recycling of petro-dollars (oil profits) from the Middle East and Russia, as well as the balance of trade with China ($1 billion per day), much of which is finding its way into common stock investments). So we believe that this is actually a market in which solid equities will perform well. But we are still cautious and therefore recommending for our clients only the most solid companies with stated policies growing their dividends for their shareholders.
Our View
Let’s start with our conclusion. Contrary to some of our peers, we expect buy-backs and higher barriers for companies wishing to go public, to persist for the foreseeable future. This is significant and was a factor that motivated our shift to a less defensive stance three months ago.
We believe we must provide our readers with both sides of the picture. Yes, stocks look as though they want to go higher. Yes, the forces of supply and demand favor higher prices. And yes, stocks, based on historical measurements, are expensive.
So we remain cautious, because with such thin margins for error, we’d really rather be in higher quality companies that offer less upside, but also less downside: namely robust dividend paying companies that believe in sharing their success with their shareholders.
Blessings,
Daniel A. Barnes, CFA