No one knows for sure the real earnings of American corporations.

In Q1 2009, according to the Federal Reserve flow of funds table F.102, after-tax profits of US non-financial, non-farm corporations, on an annual basis, were about $589.9 billion.

However, about 50% of these after-tax earnings were disbursed through stock buybacks, primarily to support prices and give value to executive options. See: Stock buybacks refusing to die live on!

The “cost” of employee stock options, according to FAS Rule 123 of March 2004 must be “disclosed but not recognized” by issuers in their financial reports.

There is no easy way of knowing whether or by how much the earnings behind S&P price-earnings-per-share figures have been adjusted for executive stock options.

However, it is certain that, whatever the adjustment, it is far less than the cost to long-term shareholders in terms of cash no longer available for dividends or corporate reinvestment.

Investor monkeys contemplating the unknown
Investor monkeys contemplating the unknown

FAS Rule 123 vastly understates the real cost of stock options

Ever since 1982 when the US Securities and Exchange Commission granted “safe harbor” to corporations using stock buybacks to manipulate prices in order to give value to executive stock options, a increasing portion of corporate earnings have been diverted from dividends that would benefit ordinary shareholders to stock buybacks for the benefit of corporate executives.

While accountants argue technicalities as to whether the Black-Scholes model or the Binomial model best represents the “cost” of executive options that should be disclosed, the fact is that the true cost to shareholders is far greater than the actual benefit to executives, since it takes more money to manipulate prices upwards by using buybacks than executives actually receive as profits when exercising their options.

In other words, the buyback fraud lives on. See: The Great Misleading.

Money for dividends that would benefit long-term shareholders is diverted for manipulative purposes and is not registered as a cost at all, but, according to Generally Accepted Accounting Practices, is posted directly to the capital accounts of the company.

If buybacks were only a tiny portion of the market — as was the case in, say, 1980 — we might ignore this accounting foible.

However, in Q1 2009, despite the shortage of credit and the need to conserve cash to get through hard times, corporate executives, in general, supported by subservient boards of directors, continue to recklessly misuse stock holders funds to support prices for their own benefit through the use of buybacks. See: Stock Buybacks: A Simple Fable.

And the US SEC commissioners continue to avert their gaze from this shameful practice.

Is the real S&P 500 price-earnings ratio 18 or 36? — no one knows

If the S&P 500 PE ratio was 18, as now appears in the newspapers, one might conclude that stocks, although over-priced, were still a reasonable investment.

However, if the real PE ratio was closer to 36 — but hidden by the loopholes in GAAP, the current market “recovery” would appear to be a mere bounce in a bear market heading for further losses.

It would seem that it is a little early to break out the champagne and to start celebrating economic recovery.


Heroic solitary security analysts, like Warren Buffett and Benjamin Graham are figures of the past — vestiges of forgotten times when capital markets were much, much simpler than today.

The solitary, heroic security analyst is long gone

Actually, Messrs Buffett and Graham moved away from classic securities analysis about two generations ago, as bond yields began to surpass stock yields and as control of most public corporations began to slip from individual shareholders and owner-managers, passing to mutual fund administrators and hired executives.

Mr. Buffett continued in finance in the holding company business (Berkshire Hathaway), while Professor Graham entered academia and life as a financial guru.

What changed since the time of Graham & Dodd?

Security analysts in the Buffett mold spent their days analyzing financial statements.

Most companies were relatively simple, with few subsidiaries and a single line of business.

A business an analyst could understand

One could tear into a financial statement, rip out some critical ratios (turnover of receivables and inventories, net working capital, return on equity, dividend payout, etc.) and then visit the company.

Touring the factory floor, chatting with workers on the assembly line, and having lunch with the sales manager, a good analyst could ascertain whether the balance sheet appeared to reflect reality, while gaining an insight into the future of the venture. With a little commonsense and willingness to go against the crowd, the solitary hero financial analyst could do quite well.

This was before the days of off-balance sheet financing, outsourcing of production to distant lands, just-in-time inventories and supply-chain management, and the subordination of individual companies to extremely complicated groups of interlocking financial interests.

Why financial statements have become less relevant

Although the SEC and the US Congress have not yet caught on, the organization of modern economic endeavors has far out-stripped the ability of accountants to present easily comprehensible financial statements that provide sufficient information to understand the strengths and weaknesses of a particular security.

The following diagram, is a vast simplification of the actual structure of many major international corporations traded on world stock exchanges today.

Economic groups easily confound modern accounting

It shows how willy-nilly interlocking relationships, often ultimately circular in nature, based on equity holdings, service contracts, off-balance sheet agreements, and memoranda of understanding, transcending international boundaries, with legal ties passing through non-disclosing offshore financial centers, can easily turn the financial statement of a single unit in the network (say the green box), into an irrelevancy.

A chart showing the myriad contractual and ownership relationships of a major international institution, like Citicorp, would likely cover an entire football field in a spider-web carpet of infinitely complex ownership and contractual relationships that defy attempts of accountants to present a “consolidated” statement of what, in essence, is beyond the capabilities of dual entry bookkeeping.

A decade ago, when I was advising securities regulators in Southeast Asia, my clients would come to me with charts far more complicated than the diagram above, with questions like, “Is Mr. A an affiliated person of Mr. B”, or “If Mrs C gives information about company X to Mr. D, is this insider information?” The answers were never obvious. Complexity can quickly trump the best regulation intended to protect investors.

The criticality of non-accounting information

Although, in the wake of a financial catastrophe, like the failure of Enron, Worldcom, the Crash of 2008, or the Madoff Ponzi scheme, the US Congress likes to call for tighter accounting standards or more effective oversight by market regulators, the truth is that those inclined towards bad behavior in securities markets can dream up complex schemes faster than regulators can write rules.

Complexity of design may amount to deception

Until a law is passed banning complex financial arrangements or requiring approval for new products and financial operations — as is done in the pharmaceutical industry — accounting information will become ever less central to the task of analysis of investment opportunities.

  • Auction rate securities: Analysts at Standard & Poor’s gave most issues of auction rate bonds investment grade ratings because they were asking the wrong question, “What is the risk of default of this bond?”. The better question would have been, “What is the risk that this bond will become illiquid?”, but the analysts were not being paid to answer that question and investors lost billions.
  • Behavior of investment management: Billions of dollars were lost in the Ponzi scheme because neither the SEC nor advisors channeling client funds to Bernard Madoff asked the simple question, “Is it reasonable for one man to have sole custody and discretion over billions of dollars of other people’s money, with the oversight of only a tiny auditing firm operating out of a store front in a New York suburb?”
  • Rogue operations: The failure of Barings Bank a decade ago and the crisis at AIG following the Market Crash of 2008, both illustrate the fact that in large complex organization, a rogue operator or unit, a tiny part of the whole, can put an entire huge organization at risk. Details that escape the auditor, like a break-down in internal controls in a far off banking unit in Singapore, or unclear, non-standard terms of over-the-counter derivative contracts, not mentioned in the annual report to shareholders, can be instrumental is collapsing a giant financial institution.

Rethinking the analyst’s job

The old-fashioned, heroic security analyst, working alone in a dark room with a stack of annual reports, in a snow-bound house in Omaha, far from Wall Street, is less likely to solve investment riddles today, than fifty years ago.

The first problem of today’s analyst is the sheer volume of information that is freely available over the Internet.

A search for the term “Citicorp” in the SEC files turns up over one thousand documents. The same term on Google, turns up almost one million hits.

Somewhere in this vast sea of information may be the “smoking gun” that either reveals a security as an outstanding opportunity or unacceptable risk.

It is clear that this data should be “mined”, and that the task is greater than any individual can handle alone.

Capital Market Wiki --- a work in progress

The analyst of the 21st century must be ready to engage in collaborative research. The solitary hero-analyst can not handle the job alone, anymore.

The solution to the problem lies in modern knowledge handling technology, including OSINT techniques, crowdsourcing, wiki software, and capital market taxonomy.

Capital Market Wiki is a project that addresses this issue.

I’ve written on this a bit in previous articles:

See: Crowdsourcing investment research: opportunities in OSINT and Free information and the Efficient Market Hypothesis and Crowdsourcing investment research: Capital Market Taxonomy and Innovation in investment research; dealing with free information and Modern technology for institutional investment research and New technology in open source investment intelligence

This topic is extensive.

I’ll have more to say, later.


Despite a seemingly fatal blow from the Crash of 2008, stock buybacks live on, like the creature at the end of a horror film, whose sinister claws rises from the muck, just as the good guys are celebrating victory over evil.

Corporate buybacks ... back from the dead!

So, my earlier article heralding the end of the buyback era seems to have been a bit premature.

Federal Reserve flow of funds statistics for Q1 2009 show that the rise in equity prices in the first quarter of 2009 was due almost entirely to stock buybacks, rather than investor confidence in the future.

The harsh criticism of executive remuneration by the Obama administration and the public in general has thrown fear into boardrooms that this might be the last chance to transfer stockholder funds into their own pockets before pay reforms are introduced.

Stock buybacks dominate a thin market

The Fed flow of funds data for corporate equities show the primary purchasers of equities in Q1 2009 were the Federal government and corporate buyback programs, domestic and foreign.

The Federal government equity purchases were directed mainly to financial institutions — absorbing over 70% of stock issued by this sector.

Corporate stock buybacks were sufficient to support a market rally during the quarter, but volumes were down significantly, compared to prior years.

Furthermore, the market faced significant selling pressure from pension and retirement funds, mutual funds, exchange-traded funds, and broker-dealers.

US Corporate Equity Net Flow of Funds (yearly basis)

US$ billions 2007 Q4
Sales of equities
Financial sector new issues 178.0 1123.1 480.8 -942.3
Households (mainly executive stock options) 800.4 -96.2 217.8 314.0
Property-casualty insurance companies -0.5 -69.1 0.2 68.9
Private pension funds 239.3 295.1 149.8 -145.3
State and local govt. retirement funds 35.3 -5.3 3.7 9.0
Federal govt. retirement funds -2.7 2.4 3.2 0.8
Mutual funds -91.3 110.4 158.0 47.6
Exchange traded funds -137.2 -270.7 58.0 328.7
Brokers and dealers -25.4 54.4 73.3 18.9
Purchases of equities
Non-financial corporate buybacks 831.2 386.0 297.0 -89.0
Non-domestic corporate buybacks -118.0 158.7 3.0 -155.7
State & local governments 2.4 34.3 18.4 -15.9
Federal government 0.0 1025.4 347.5 -677.9
Foreign investors 176.2 13.2 0.9 -12.3
Commercial banks 1.6 -0.5 18.0 18.5
Savings institutions -0.1 4.7 1.5 -3.2
Life insurance companies 71.4 23.2 18.0 -5.2
Closed end funds 18.7 -9.0 4.9 13.9

How buybacks were financed in Q1 2009

Net corporate profits after taxes and dividends in Q1 2009 were only $30 billion on an annual basis. (Federal Reserve Flow of Funds Table F.102)

First quarter corporate buybacks of $297 billion (annual basis) were financed at least 90% by depreciation reserves and by substantial new corporate bond issues.

In view of economic hard times, the de-leveraging of banks, and the wisdom of harboring assets to ride out the current storm, the return of financed buybacks in the midst of the most serious recession in over fifty years, signals an abysmal lack of fiduciary responsibility on the part of American corporate directors and executives.

At the same time, despite talk of regulatory reform, the US SEC has not taken steps to revoke the 1983 Rule 10b-18, granting executives safe harbor from charges of stock manipulation and fraud in connection with stock buybacks.

No signs of a return of investor confidence

Substantial net sales of equities by mutual funds, exchange traded funds, and pension funds during Q1 2009, into a rising market, suggest that although the buyback movement might not be entirely dead yet, its vital signs are, at least, not favorable.

Buyback volume is down at least two-thirds from 2007 levels.

Since even at these reduced levels, buybacks are not supported by corporate profits, but by depreciation reserves and borrowing — one might conclude that the fiscal profligacy of the Obama administration is well matched by the lack of fiduciary responsibility of US corporate boards.

These are indeed interesting times.


copyright | privacy | home

Powered by WordPress | Entries (RSS) | Comments (RSS)