International Business Machines (IBM, Financial) 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 (Trades, Portfolio) 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 (Trades, Portfolio), former chairman and president of Duquesne Capital, former portfolio manager of Soros’ 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 –Â you know the story –Â and has spent the last six years deleveraging.
While the consumer was taking down leverage, the U.S. 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 –Â whose core business was basically flat over six years –Â well, you’d never know it from looking at a chart of the stock. (Hint: it went straight up for years.)
continue reading: http://www.mauldineconomics.com/the-10th-man
