Hitchhikers’ guide to instant wealth

A penny saved is a penny earned. It is especially usuful when companies are struggling to generate higher earnings during recessions, when demand and market expension are scarce commodity. Fortunately, nowadays it only takes four letters to achive higher returns: WACC. (Weighted Average Cost of Capital)

Thanks to cheap credit many of the hedge funds and activist investors could buy firms (usually using some credit in the first place), replace some equity with cheaper loans, and get the money out of the company while earnings numbers have been boosted too.  However, higher leverage or gearing on the balance sheet should make the investment more risky and cheap, higher earnings and multipliers compensate for the effect. Veni, vidi, vici; too good to be true.

The eye-watering returns seen on stock markets recently are fueled by these takeovers, or as a metter of fact, why would the management wait until the takeover, they can initiate share buyback programs too. Financial engineering within and higher multipliers outside the firms.

Luckily, we can not say that the market went full nuts. The widening spread between equity and debt returns reflects the understanding of this situation, and also indicates some kind of market efficiency. But back to the original question…

Is this kind of financial engineering essentially wrong? Boosting the ‘wealth-effect’ or decreasing savings through buying back equity could be beneficial for a troubled economy. Could be…

The problems with the argument is that it is superficial. First of all, the majority of these shares are held by higher income classes, whose marginal propensity to consume is naturally lower. Secondly, the lack of interpretable interest payments demolish the effect of compounded interest.For example, since the low interest policy savings rate has actually risen in the US. Low interests not only increase the NPV of assets, but also liabilities… pensions for instance. Last but not least, the combined effect of the last two factors can easily lead to overvaluation (let’s not overuse the ‘B’ word). After the buyback it is plausible that our investor would like to buy more shares using the returned money. The real economy would not see a dime before the prices of financial instruments are over the roof.

Why is it important now? Recently the S&P 500 buyback index once again surpassed its older brother. With a US fiscal expension on the horizon monetary policy could pass the baton to the fiscal policy, and switch into tightening mode. Taking away the punch-bowl would certainly hurt today’s valuations and ratios. There are no instant riches, and there is no free lunch. The tailwind of cheap credit can easily turn into a headwind.



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