Stock Buyback— Intrinsic Value Matters
Stock buyback has become an increasingly popular choice for companies to return money to their shareholders tax-efficiently. In a buyback, the repurchased shares will go into inventory and reduce the outstanding share count in the open market, benefiting shareholders by raising the per-share value and, potentially, the stock price. In recent years, concerns have been raised about the true beneficiaries of stock buybacks. Skeptics argue that buybacks primarily manipulate the stock price and benefit the wealthy executives, many of whom get stock-based compensation or hold options on their own stock, rather than mid-class workers who play a key role in the company’s growth. They view it as a misuse of available money for short-sighted goals while giving up the potential long-term interest by investing elsewhere to boost employee benefits, and based on that, the politicians have introduced laws to propose a tax on the process, hoping to restrict or reduce the buyback actions.
However, Warren Buffett has described such critics as ‘economic illiterate’ in the recent Berkshire Hathaway annual letter and defended that stock buybacks will benefit all owners as long as they are made at value-accretive prices. It is true that in most successful cases, such as Oracle, by the end of 2020, buyback reduces the supply and shows a signal of undervalued, thus boosting the stock price in the following period of time. But while the ‘Oracle of Omaha’ strongly supports the concept, it is critical to understand the “value-accretive price” that he’s conditional on. Actually, the man explicitly stated as early as in his 2012 letter that “value is destroyed when purchases are made above intrinsic value.” One such example can be AIG, which decided to repurchase an additional $8 million of its stocks at the end of 2007 but did not save its stock price from crashing in 2008.
Is Another Fed Misstep Ahead?
The Fed has announced its intention to continue raising rates to lower inflation. The model the Fed has embraced requires a reduction of the rate of growth of output to lower inflation. Raising rates is part of the effort to lower the growth rate of output. The Fed Chairman has argued real growth is too high and driving inflation. However, there are signs he has misread the state of the economy, While raising the Fed Funds rate, the Fed has brought about a reduction in the growth rate of the money supply. The current rate of growth of M2 is negative, and growth at this level is consistent with a substantial slowdown in economic activity. A sustained further reduction in the growth rate will almost certainly produce negative economic growth. Ironically, due to the SVB bailout, the Federal Reserve loosened its borrowing guidelines for banks to encourage lending and, in effect, boosted the money supply – analogous to Quantitative Easing 5.0. The year-over-year percent change for real disposable personal income has just become positive. During the period from April 2021 to January 2023, real disposable personal income declined. If the change does not remain positive, it will be difficult to sustain economic growth. In addition, stocks of companies in the consumer durables sector will likely face challenges while trying to generate growth in profits. Consumer confidence could be more robust, and the current level is consistent with the weak real disposable income data. There has been some improvement in confidence, but should the economy slow down in response to the Fed’s efforts, confidence will surely diminish. Existing home sales have declined from about 6,300,000 annually to approximately 4,000,000 over the last year. This decline is evidence that a resumption in economic growth at or near the long-term average of 3% is unlikely in the near term. Slowing housing sales typically lead to a slowdown in demand for consumer durables. If the damage from the SVB bankruptcy cannot be contained, then all bets are off.
SVB Collapse Shakes Markets
What was initially viewed as this week’s market overreaction to Chair Powell’s congressional testimony on monetary policy was replaced by the left-field pandemonium from the collapse and FDIC seizure of Silicon Valley Bank. Although the S&P 500 sustained a major loss of 4.53% in a short period of a week, Financial stocks were shaken and dropped 8.17% by the news of Silicon Valley Bank’s fall, dropping 63% before the stock was halted from trading. Due to contagion fears, regional banks measured by KRE (SPDR S&P Regional Bank ETF) sank 16.05% in a week. In reaction to recession fears and the Fed tightening monetary policy, the bond market had the opposite reaction as yields narrowed and gained 1.2% while long Treasuries gained 3.6% during the week. It is a modest week ahead for earnings releases. As the fallout from Silicon Valley Bank continues to unfold this week, the market will tread on understanding the widespread impact to the bank’s corporate customers and many tech start-ups. Sentiment will initially focus on the CPI and Industrial Production report being released this week, but angst will likely center around the banking sector and liquidity fears until the U.S. Treasury Department reassures the market as they determine bailout options. On Sunday, Treasury, Federal Reserve, and FDIC issued a joint statement that the U.S. Government would protect all SVB’s deposits to assure the global market’s confidence in the U.S. banking system. However, special mention was made to shareholders and debtholders they will not be protected.
Mortgage Rates Peak at 7% as Home Values Drop
A recent February report from Redfin confirmed that higher mortgage rates had slowed home sales growth and even started declining home prices. This result is not too unexpected, as high inflation has forced the Federal Reserve to raise interest rates dramatically. However, recently in December, the Redfin article noted that mortgage rates at 6.36% are off the peak of 7.08%. As in the past, these housing market gyrations give color to the submarkets and cities around the nation and the relative price action in these regions. This time, the report shows that the Florida housing market has been stable for the last year, and this may be due to the continued influx of people, affordable prices, and well-known zero state income tax. On the other hand, the tech-heavy San Francisco Bay area has taken the biggest hit. The Redfin study found that the total value of San Francisco homes has fallen by 6.7% over the past year, leading all U.S. cities in declines. That said, it seems like a small price to pay in an environment of high inflation and what might be viewed as extreme interest rate hikes by the FED. In fact, most other declines were minimal and compared to the dramatic boom in housing during the pandemic, this seems surprising if not palatable.
Beyond FAANG: Invest in Businesses
Over the last five years, most investors have been bombarded with the constant hype around the FANG names, Facebook, Apple, Netflix, and Google. To be straight, there is no argument that these companies are generational and have products or businesses that are more than apparent in their impact and success. In fact, these FANG names represent very well the “market,” and anyone holding the S&P 500 should feel comforted that they didn’t miss out, and these names and others of the same ilk represent upwards of 25%+ of the index. However, over the last five years, companies like United Rentals (URI) have outpaced FANG with a 175% approximate return as the world’s largest equipment rental business. Equipment used for construction, heavy and light, and other tools and services for the massive construction and infrastructure markets hold almost 13% market share generating about $12 billion in revenues and $5.4 billion in EBITDA. More importantly, a company like this brings diversification and elements of value with a Forward P/E of 10.4x and a modest dividend to a portfolio. We see the value prop of renting versus owning large equipment as a huge benefit. Companies benefit by conserving capital and increasing profitability by paying for equipment only when needed. Throw in the cost of carry like maintenance and insurance, and renting becomes quite compelling. URI has grown through acquisition and offers high free cash flow. Investors might see this as a name to sink their fangs or teeth into for the future.
EV Stocks Offer Bright Spot
The bright spot for the week were gains in electric vehicle-related stocks boosted by Biden’s Administration Infrastructure Law to sponsor $7.5 bn in building 500,000 EV chargers nationwide: Tesla (TSLA 5.8%), Lucid (LCID 8.97%), Rivian (RIVN 7.27%), and General Motors (GM 4.4%). Stocks and bonds stalled for another week awaiting the latest annual CPI report slowed modestly to 6.4%. At the same time, the Core CPI, excluding food and energy, rose slightly above Wall Street’s consensus estimate to 5.6%. Investor sentiment previously in disbelief of the Fed’s hawkish rhetoric has finally come to terms with the Fed’s view that interest rates have some ways to go. Meanwhile, investors can look forward to their email inboxes awaiting the subject line: “Good news, savings rates are going up!” The housing market, in light of high-interest rates, continues to show softening signs to more normal levels, as new housing starts slowed to 1.3 million buildings, below consensus estimates combined with Redfin reporting home purchases for the 4th quarter fell 45.8% year over year, the largest decline since 2008s subprime mortgage crisis. This week, a short week in celebration of Presidents Day, all gauges will continue to focus on the state of the economy and inflation as GDP, Housing, and Consumer Spending reports release. Highly anticipated industry heavyweights will also report earnings and forward guidance: Berkshire Hathaway, Home Depot, NVIDIA, and Walmart.
ChatGPT, do my homework!
Does this week’s news about ChatGPT remind you of when pocket calculators first launched in the 1970s and the development of technology since then? How many of you already regularly say Ok Google, Alexa, or Hey Siri in your daily vocabulary?
So what is ChatGPT? Well, let’s ask it! Here’s its answer. “ChatGPT is a pre-trained language model developed by OpenAI, an artificial intelligence research laboratory based in San Francisco, California. It is a powerful tool for natural language processing, allowing users to generate human-like responses to a wide range of questions and prompts. ChatGPT can be used by various organizations and individuals, including businesses for customer service, developers building chatbots and virtual assistants, and even creative writers. The model’s ability to understand and generate text in a human-like manner makes it a versatile tool for a wide range of applications. ChatGPT works by using a deep neural network trained on a massive dataset of internet text. The model has been trained to predict the next word in a sequence of text, allowing it to generate coherent and contextually relevant responses. The model can generate answers to many questions and prompts, making it a highly advanced tool for natural language processing.” Private company OpenAI owns ChatGPT, but the big news was that Microsoft has already cut a deal to invest $10 billion in OpenAI on top of the $3 billion.
Reports Point to Slowing Housing Market
Last week’s economic reports pointing to a slowing housing market with a -0.5% price decline, -0.4% decline in construction spending, and the widely expected Fed rate hike of 25 bps helped support the S&P 500 index gaining 1.64%, at least initially. But a careful analysis of the FOMC’s forward statement points to the Fed’s expectation for ongoing rate hikes, albeit at a slower pace, better than expected jobs reports, and disappointing earnings releases from Apple and Google gave back some of the week’s earlier gains. The carefully watched ISM survey for factory orders fell to 47.4%, trending lower month after month, raising concerns of a recession. Bond yields, currently inverted, ended the week flat, confused by the strong jobs report and the implication of the Fed’s next steps. The week ahead will largely focus on the wholesale inventory report, the state of U.S. manufacturing, and speeches by the Fed regarding future interest rate guidance. Markets will be concerned with the Fed getting too far ahead with its hawkish rhetoric, risking bursting the market gains YTD and further risking a recession.
Market Momentum Advances
Positive earnings reports from AT&T, GE, Microsoft, Tesla, and Visa continued to advance the market momentum for the major stock indexes squashing any concerns about Congress’s need to raise the national debt ceiling debate and the Fed’s upcoming interest rate decision at least for now. Market momentum was also helped Market momentum was also helped by last week’s economic reports confirming a slowdown in the overall economy and indication that the Fed has reached its restrictive policy limit: U.S. Leading Index reported for the month -1%; Personal spending declined by 0.20%; Albeit, U.S. GDP report of 2.9% was better than expected furthering confirming although the economy is slowing down, it’s not in a recession. With improvement in the inflation front weakening the economy, all eyes and ears will again be on the Fed’s interest rate guidance this Wednesday. Investors expect nothing more than a 25 bps rise in the policy rate by the Fed.
Core Segments Point to Contracting Economy
Core segments of the market are pointing to a contracting economy. Last week’s economic report on Retail Sales and Industrial Production was weaker than consensus forecasts. Capacity utilization, the gauge for production capacity in the U.S., was lower than expected. In addition, regional markets for Philly and NY Empire State are all reflecting worse-than-expected declines. The one bright spot is Housing Starts and the Mortgage Market Index, showing improving fundamentals with moderating mortgage rates.
After last week’s core banks earnings, this week will spotlight prominent earnings across a broad spectrum of industrials, including core Dow companies highlighting the strength of the overall economy alongside U.S. GDP ranging from AT&T, Boeing, Chevron, J&J, Microsoft, Verizon, and Visa. Further, Thursday’s report on GDP, Inventories, and Durable Goods will shed light on the heartland of manufacturing.