Faded Blue Chips, Debt & Buybacks

11/04/2016 10:00 am EST

Focus: STOCKS

Kelley Wright

Managing Editor, Investment Quality Trends

A good chunk of each day at our shop is dedicated to research. I’m constantly looking for stocks that meet our criteria and have well-defined patterns of dividend yield. While it is a labor of love, the pickings, unfortunately, are pretty slim, suggests Kelley Wright, editor of Investment Quality Trends.

When I took the helm at the end of 2002 our roster of Select Blue Chips was well over 300 stocks; since then, 105 stocks no longer meet our criteria for Select Blue Chips.

The simple fact is that the overall level of quality has just disappeared from the stock market. And it’s not just the quality of the companies, it is also the quality of management that has disappeared.

I recently read it is estimated the total payouts for the S&P 500, meaning dividends and stock buybacks, will reach $1 trillion for the first time ever this year. Yes, folks, that’s a trillion with a T.

Now obviously I don’t have a problem with the dividends, they are after all mother’s milk to us value investors. Of that $1 trillion, about $400 billion is dividends and the rest is stock buybacks.

I know, stock buybacks are as old as the hills and when used “properly” they’re not a bad tool for management to keep handy in their toolbox.

As for “properly” though, that train left the station a long time ago. You see, for the last five or six years, a lot of companies have been using stock buybacks to cover up a boat load of deficiencies, such as poor earnings growth and falling profits.

Of course if your compensation is based on meeting certain metrics, say EPS for example, then you’re going to do everything possible to show you are meeting or exceeding your EPS targets.

What a wonderful thing it is then when the current interest rate environment (read QE and zero interest rate policy) allows you to borrow money at dirt-cheap rates.

This cheap money is then allocated toward the buyback of huge chunks of stock, which reduces the number of outstanding shares, and boom - you get EPS growth without actually making or selling anything.

Is this a beautiful deal or what? Based on the above is it any wonder that payouts have ballooned from $500 billion to $1 trillion over the last six years?

Getting back to the issue of quality management though, what gets lost in this discussion is that traditionally, under normal circumstances, high-quality companies invested their cash into new plants, new products and services, or even more importantly into the human capital that is necessary for future growth.

It begs the question then of why would a corporation opt for the easy-fix of financial engineering instead of investing in the long-term growth of profits?

Could it be they have all become lazy, or rather that instead of taking the traditional business risk associated with building new plants, developing new products or services, investing in people etc., it’s just easier to buy back stock, collect their performance bonuses and stock options and kick the can down the road for the next guy to deal with?

Am I being too cynical? Perhaps, but don’t you see a disconnect where according to the government employment is booming, consumer spending is advancing at a healthy clip, both of which suggest a positive economic outlook, yet corporations don’t want to invest in their business?

Clearly we don’t know what we don’t know, but what I do know is that financial engineering with cash derived from sales is one thing, but with borrowed money it is an entirely different thing altogether.

One day this money will have to be paid back, and without having invested in future growth it may become problematic.

As our founder Geraldine Weiss has written a thousand times, “Debt is the albatross that hangs around a company’s neck.”

Now compound that with a rising interest rate environment, which will happen at some point. That folks is ugly with a capital U.

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By Kelley Wright, Editor of Investment Quality Trends

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