The Financial Jigsaw – Issue No. 98

My unpublished (100,000 word) book “The Financial Jigsaw”, is being serialised here weekly in 100 Issues by Peter J Underwood, author

Quote of the Week:  “It is not the most intellectual of the species that survives; it is not the strongest that survives; but the species that survives is the one that is able best to adapt and adjust to the changing environment in which it finds itself.” –  Origin of Species. Charles Darwin

NOTE – If anyone would like a free updated, 4th edition, electronic copy of the complete book, I should be pleased to email a free PDF on request to: [email protected].  The book has many footnotes linking to relevant and explanatory Appendices, websites and videos.

            It remains uncertain that the current approach to this pandemic is entirely the correct solution.  Lots of experts have raised concerns and this article lists some of them:

https://off-guardian.org/2020/03/28/10-more-experts-criticising-the-coronavirus-panic

            Gail Tverberg has a good article about what happens after we get back to work: “Once an economy has been shut down, it is extremely difficult for the economy to recover back to the level it had reached previously. In fact, the longer the shutdown lasts, the more critical the problem is likely to be. China can shut down its economy for two weeks over the Chinese New Year, each year, without much damage. But, if the outage is longer and more widespread, damaging effects are likely”

https://ourfiniteworld.com/2020/03/31/economies-wont-be-able-to-recover-after-shutdowns/

            Covid-19’s meant to be a new Black Death, but in Britain no more people are dying than NORMAL. What does this say about the virus? — RT Op-ed

https://www.rt.com/op-ed/484548-coronavirus–people-die-outcome/

Here is the link to last week: Issue 97

Updates about Brexit negotiations with the EU are now suspended for the duration of Covid-19:

            Brexit is definitely off the agenda for the time being so there are unlikely to be any further updates in this area.  “The largest group in the European parliament has urged the UK government to do the “responsible thing” and extend the Brexit transition period, as coronavirus plays havoc with the timetable for an EU-UK deal.”

https://www.theguardian.com/politics/2020/mar/30/extend-brexit-transition-by-years-over-coronavirus-uk-told

UK has now left EUROPE so I will continue to comment on relevant EU – UK events:

            The EU is not getting its act together at present and of course has other more important things to attend to.  “Planned negotiating rounds on the UK’s future relationship with the EU have been abandoned as a result of the coronavirus pandemic, with Boris Johnson’s government still to table a comprehensive legal text for both sides to work on. During a European commission briefing on Thursday, envoys for the EU capitals were told that holding negotiations via video-conferencing had so far proved impossible.”

https://www.theguardian.com/world/2020/mar/26/covid-19-puts-post-brexit-relationship-talks-in-deep-freeze          

            “Just a few words about the EU.  It is no longer the European Union but the European Disunion – ED.   “All the illusions of grandeur have gone and each ED country is now fighting for its own survival. There is no coordination and no cross border assistance in connection with Coronavirus. Italy, Spain and France are on the verge of collapse but are getting no aid from Germany. The European banking systems under massive pressure and will most probably fail or be seriously impaired in the next 6-12 months.  So we are looking at a truly global crisis which will have irreparable repercussions for the world for a foreseeable future.”

https://goldswitzerland.com/dont-wait-for-the-storm-to-pass-learn-to-dance-in-the-rain/

            The official figures for 24 countries across Europe show, not only that overall mortality is not increasing, but – so far – it is actually well below recent averages.

https://off-guardian.org/2020/03/30/covid19-yet-to-impact-europes-overall-mortality/

The 4^th edition of The Financial Jigsaw issued recently includes a Foreword, Preface, Epilogue and Appendices which I will publish here in advance.   Next come the Appendices:

Here is Appendix X – A continuation from last week.

Appendix X

SHARE BUY-BACKS

I have introduced this Appendix because the subject is part of ‘financial engineering’ but does not appear in Chapter 8 in this much detail for reasons of understanding and space allowed.   This is Part 1 of a two part document.

Share buy-backs have only been allowed under company law in the last 15 years in UK and there are positives and negatives associated with these financial instruments.  It is all part of the continued easing of corporate regulation much of which has caused the many distortions in the financial sphere.

This article is from:  The Bear’s Lair • 2019-02-25   by  Martin Hutchinson

The source post is from:  The Bear’s Lair: Senator Rubio’s first good idea appeared first on True Blue Will Never Stain  I have added my own edits for clarity and English spelling

Also false is the corresponding analysis among proponents of share buybacks that they must inevitably raise share prices. They do generally raise earnings per share, if money is borrowed at today’s low interest rates to finance them. If a company can borrow at 4%, and its earnings are taxed at 21%, then the after-tax cost of new debt is only 3.16%.  From the pure earnings point of view, borrowing money to buy back stock is thus earnings-positive provided the stock is trading on a P/E ratio of less than 31.6 times earnings (the reciprocal of 3.16%).

However, by the stock buyback, the company has increased its leverage. Proponents of modern financial theory will tell you this does not matter; if a company can increase its earnings per share by increasing its leverage through borrowing tax-deductible debt it should do so, since it is thereby reducing its cost of capital.

However, this assumes the economy trundles on along an even keel, or that the company is in an extremely non-cyclical industry. In most situations, a company can get caught out, either by being in a cyclical industry when an unexpected recession strikes, or by a sudden technological change that makes its products less attractive and new capital investment essential for survival.  In either of those cases, increased leverage can be fatal.

In any case, there is another way of looking at stock buybacks, and that is by assets.  If a company has $100 of net assets, and its stock is selling at a market capitalization of $200, being 100 shares of $2, then a $50 stock buyback reduces net assets to only $50 (possibly by taking on $50 of debt) while reducing its share count only from 100 to 75. Net assets per share have been reduced from $1.00 to $0.67.  Far from selling at a higher price than $2 after the buyback, if the stock still sells at twice net asset value, it should now sell at only $1.34.

Alternatively, if it continues to sell at $2, then its valuation has risen from twice net asset value to three times. The buyback is thus not a good deal for shareholders, the naïve among who, if they did not sell into the buyback, will be expecting their stock to trade higher, not lower.

The only case in which a stock buyback would increase net assets per share would be if a company was trading in the market at below net asset value. In those cases, provided the company has adequate liquidity and is not over-leveraged, it would favour a stock buyback. The increase in the share price that it would normally produce, based on the higher post-buyback net asset value per share, would be soundly based.  However, in current overvalued stock markets, those cases are very rare indeed.

The above example shows that ordinary shareholders do not benefit significantly from stock buybacks. Their earnings per share may be increased on the reduced share count, but their net asset value per share is reduced, usually more sharply than earnings per share are increased.

However, top management benefits by the reduction in the share count; it can award itself stock option grants, exercise them, and allow the dilution from its issue of shares to itself to be absorbed by the reduction in share count from repurchases.  For management; buybacks are a very good deal indeed; it’s just that nobody else benefits, certainly not the U.S, economy as a whole.

Apart from increasing the risk of corporate bankruptcy, buybacks have an additional, killer defect in forcing shareholders over a business cycle to suffer from the ineptitude of management’s stock market forecasting. When business is good and stock prices are high, management sees the possibility of “returning cash to shareholders” by means of larger buybacks.

Then when recession hits, companies may be forced to do emergency share issues at low prices, even if they do not go bankrupt.  Selling something for $4 and buying it back for $1 is a huge waste of the shareholders’ money – but management gets to cash out its options at the top and award itself new lower-strike-price options at the bottom. Needless to say, given its own “skin in the game,” management is less than averagely competent at forecasting the best times to do share buybacks.

The fad for stock buybacks is yet another ill-effect of the period of [artificial] ultra-low interest rates through which the U.S. economy has suffered for the last decade [Financialisation]. Money has been readily available and cheap for large corporations, so it has gone into this as into other forms of unproductive investment [malinvestment is the result of financial engineering].

Author’s note:

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)

To be continued next Saturday

Click to visit the TBP Store for Great TBP Merchandise

Author: Austrian Peter

Peter J. Underwood is a retired international accountant and qualified humanistic counsellor living in Bruton, UK, with his wife, Yvonne. He pursued a career as an entrepreneur and business consultant, having founded several successful businesses in the UK and South Africa His latest Substack blog describes the African concept of Ubuntu - a system of localised community support using a gift economy model. View all posts by Austrian Peter