How Recessions and Interest Rate Changes Affect Stocks

Knowing how stocks have performed in the past in the context of recessions and changes in interest rates provides us with possible paths that stocks could take in the future.

After years of investing in stocks, I’ve noticed that stock market participants place a lot of emphasis on how recessions and changes in interest rates affect stocks. This topic is even more important right now for investors in US stocks, given fears that a recession could happen soon in the country, and the interest rate cut last month by the Federal Reserve, the country’s central bank. I have no crystal ball, so I have no idea how the US stock market would react if a recession were to arrive in the near future and/or the Federal Reserve continues to lower interest rates.

What I have is historical context. History is of course not a perfect indicator of the future, but it can give us context for possible future outcomes. I’ve written a few articles over the years in this blog discussing the historical relationships between stocks, recessions, and movements in interest rates, some of which are given below (from oldest to the most recent):

I thought it would be useful to collect the information from these separate pieces into a single place, so here goes!

The history of recessions and stocks

These are the important historical relationships between recessions and stocks:

It’s not a given that stocks will definitely fall during a recession. According to a June 2022 article by Ben Carlson, Director of Institutional Asset Management at Ritholtz Wealth Management, there have been 12 recessions in the USA since World War II (WWII). The average return for the S&P 500 (a broad US stock market benchmark) when all these recessions took place was 1.4%. There were some horrible returns within the average. For example, the recession that stretched from December 2007 to June 2009 saw the S&P 500 fall by 35.5%. But there were also decent returns. For the recession between July 1981 and November 1982, the S&P 500 gained 14.7%.
Holding onto stocks in the lead up to, through, and in the years after a recession, has mostly produced good returns. Carlson also showed in his aforementioned article that if you had invested in the S&P 500 six months prior to all of the 12 recessions since WWII and held on for 10 years after each of them, you would have earned a positive return on every occasion. Furthermore, the returns were largely rewarding. The worst return was a total gain of 9.4% for the recession that lasted from March 2001 to November 2001. The best was the first post-WWII recession that happened from November 1948 to October 1949, a staggering return of 555.7%. After taking away the best and worst returns, the average was 257.2%.
Avoiding recessions flawlessly would have caused your return to drop significantly. Data from Michael Batnick, Carlson’s colleague at Ritholtz Wealth Management, showed that a dollar invested in US stocks at the start of 1980 would be worth north of $78 around the end of 2018 if you had simply held the stocks and did nothing. But if you invested the same dollar in US stocks at the start of 1980 and expertly side-stepped the ensuing recessions to perfection, you would have less than $32 at the same endpoint.
Stocks tend to bottom before the economy does. The three most recent recessions in the USA prior to COVID-19 would be the recessions that lasted from July 1990 to March 1991, from March 2001 to November 2001, and from December 2007 to June 2009. During the first recession in this sample, data on the S&P 500 from Yale economist Robert Shiller, who won a Nobel Prize in 2013, showed that the S&P 500 bottomed in October 1990. In the second episode, the S&P 500 found its low 15 months after the end of the recession, in February 2003. This phenomenon was caused by the aftermath of the dotcom bubble’s bursting. For the third recession, the S&P 500 reached a trough in March 2009, three months before the recession ended. Moreover, after the December 2007 – June 2009 recession ended, the US economy continued to worsen in at least one important way over the next few months. In March 2009, the unemployment rate was 8.7%. By June, it rose to 9.5% and crested at 10% in October. But by the time the unemployment rate peaked at 10%, the S&P 500 was 52% higher than its low in March 2009. Even if we are right today that the economy would be in worse shape in the months ahead, stocks may already have bottomed or be near one – only time can tell.
The occurrence of multiple recessions has not stopped the upward march of stocks. The logarithmic chart below shows the performance of the S&P 500 (including dividends) from January 1871 to February 2020. It turns out that US stocks have done exceedingly well over these 149 years (up 46,459,412% in total including dividends, or 9.2% per year) despite the US economy having encountered numerous recessions. If you’re investing for the long run, recessions are nothing to fear.

*Figure 1; Source: Robert Shiller* *data; National Bureau of Economic Research*

The history of interest rates and stocks

These are the important historical relationships between interest rates and stocks:

Rising interest rates have been met with rising valuations. According to Robert Shiller’s data, the US 10-year Treasury yield was 2.3% at the start of 1950. By September 1981, it had risen to 15.3%, the highest rate recorded in Shiller’s dataset. In that same period, the S&P 500’s price-to-earnings (P/E) ratio moved from 7 to 8. In other words, the P/E ratio for the S&P 500 increased slightly despite the huge jump in interest rates. It’s worth noting too that the S&P 500’s P/E ratio of 7 at the start of 1950 was not a result of earnings that were temporarily inflated. Yes, there’s cherry picking with the dates. For example, if I had chosen January 1946 as the starting point, when the US 10-year Treasury yield was 2.2% and the P/E ratio for the S&P 500 was 19, then it would be a case of valuations falling alongside rising interest rates. But this goes to show that while interest rates have a role to play in the movement of stocks, it is far from the only thing that matters.
Stocks have climbed in rising interest rate environments. In a September 2022 piece, Carlson showed that the S&P 500 climbed by 21% annually from 1954 to 1964 even when the yield on 3-month Treasury bills (a good proxy for the Fed Funds rate, which is the key interest rate set by the Federal Reserve) surged from around 1.2% to 4.4% in the same period. In the 1960s, the yield on the 3-month Treasury bill doubled from just over 4% to 8%, but US stocks still rose by 7.7% per year. And then in the 1970s, rates climbed from 8% to 12% and the S&P 500 still produced an annual return of nearly 6%.
Stocks have done poorly in both high and low interest rate environments, and have also done well in both high and low interest rate environments. Carlson published an article in February 2023 that looked at how the US stock market performed in different interest rate regimes. It turns out there’s no clear link between the two. In the 1950s, the 3-month Treasury bill (which is effectively a risk-free investment, since it’s a US government bond with one of the shortest maturities around) had a low average yield of 2.0%; US stocks returned 19.5% annually back then, a phenomenal gain. In the 2000s, US stocks fell by 1.0% per year when the average yield on the 3-month Treasury bill was 2.7%. Meanwhile, a blockbuster 17.3% annualised return in US stocks in the 1980s was accompanied by a high average yield of 8.8% for the 3-month Treasury bill. In the 1970s, the 3-month Treasury bill yielded a high average of 6.3% while US stocks returned just 5.9% per year.
A cut in interest rates by the Federal Reserve is not guaranteed to be a good or bad event for stocks. Josh Brown, CEO of Ritholtz Wealth Management, shared fantastic data in an August 2024 article on how US stocks have performed in the past when the Federal Reserve lowered interest rates. His data, in the form of a chart, goes back to 1957 and I reproduced them in tabular format in Table 1; it shows how US stocks did in the next 12 months following a rate cut, as well as whether a recession occurred in the same window. I also split the data in Table 1 according to whether a recession had occurred shortly after a rate cut, since eight of the 21 past rate-cut cycles from the Federal Reserve since 1957 took place without an impending recession. Table 2 shows the same data as Table 1 but for rate cuts with a recession; Table 3 is for rate cuts without a recession. What the data show is that US stocks have historically done well, on average, in the 12 months following a rate-cut. The overall record, seen in Table 1, is an average 12-month forward return of 9%. When a recession happened shortly after a rate-cut, the average 12-month forward return is 8%; when a recession did not happen shortly after a rate-cut, the average 12-month forward return is 12%. A recession is not necessarily bad for stocks. As Table 2 shows, US stocks have historically delivered an average return of 8% over the next 12 months after rate cuts that came with impending recessions. It’s not a guarantee that stocks will produce good returns in the 12 months after a rate cut even if a recession does not occur, as can be seen from the August 1976 episode in Table 3.

Conclusion

Knowing how stocks have performed in the past in the context of recessions and changes in interest rates provides us with possible paths that stocks could take in the future. But it’s also worth bearing in mind that anything can happen in the financial markets. Things that have never happened before do happen, so there are limits to learning from history. Nonetheless, there’s a really important lesson from all the data seen above that I think is broadly applicable even far into the future, and it is that one-factor analysis in finance – “if A happens, then B will occur” – should be largely avoided because clear-cut relationships are rarely seen.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have no vested interest in any company mentioned. Holdings are subject to change at any time.

The Federal Reserve Has Much Less Power Over Financial Markets Than You Think

It makes sense to mostly ignore the Federal Reserve’s actions when assessing opportunities in the stock market.

Last week, the Federal Reserve, the USA’s central bank, opted to lower the federal funds rate (the key interest rate controlled by it) by 50 basis points, or 0.5%. The move, both before and after it was announced, was heavily scrutinised by market participants. There’s a wide-held belief that the Federal Reserve wields tremendous influence over nearly all aspects of financial market activity in the USA.

But Aswath Damodaran, the famed finance professor from New York University, made an interesting observation in a recent blog post: The Federal Reserve actually does not have anywhere close to the level of influence over America’s financial markets as many market participants think.

In his post, Damodaran looked at the 249 calendar quarters from 1962 to 2024, classified them according to how the federal funds rate changed, and compared the changes to how various metrics in the US financial markets moved. There were 96 quarters in the period where the federal funds rate was raised, 132 quarters where it was cut, and 21 quarters where it was unchanged. Some examples of what he found:

A median change of -0.01% in the 10-year Treasury rate was seen in the following quarter after the 96 quarters where the federal funds rate increased, whereas a median change of 0.07% was seen in the following quarter after the 132 quarters where the federal funds rate was lowered. Put another way, the 10-year Treasury rate has historically tended to (1) decrease when the federal funds rate increased, and (2) increase when the federal funds rate decreased. This means that the Federal Reserve has very little control over longer-term interest rates.
A median change of -0.13% in the 15-year mortgage rate was seen in the following quarter after the quarters where the federal funds rate increased, whereas a median change of -0.06% was seen in the following quarter after the quarters where the federal funds rate was lowered. It turns out that the Federal Reserve also exerts little control over the types of interest rates that consumers directly interact with on a frequent basis.
A median change of 2.85% in US stocks was seen in the following quarter after the quarters where the federal funds rate increased, a median change of 3.07% was seen in the following quarter after the quarters where the federal funds rate was lowered, and a median change of 5.52% was seen in the following quarter after the quarters where the federal funds rate was unchanged. When discussing the stock-market related data, Damodaran provided a provocative question and answer:

“At the risk of disagreeing with much of conventional wisdom, is it possible that the less activity there is on the part of the Fed, the better stocks do? I think so, and stock markets will be better served with fewer interviews and speeches from members of the FOMC and less political grandstanding (from senators, congresspeople and presidential candidates) on what the Federal Reserve should or should not do.”

I have always paid scant attention to what the Federal Reserve is doing when making my investing decisions. My view, born from observations of financial market history* and a desire to build a lasting investment strategy, is that business fundamentals trump macro-economics. Damodaran’s data lends further support for my stance to mostly ignore the Federal Reserve’s actions when I assess opportunities in the stock market.

*A great example can be found in Berkshire Hathaway, Warren Buffett’s investment conglomerate. Berkshire produced an 18.7% annual growth rate in its book value per share from 1965 to 2018, which drove a 20.5% annual increase in its stock price. Throughout those 53 years, Berkshire endured numerous macro worries, such as the Vietnam War, the Black Monday stock market crash, the “breaking” of the Bank of England, the Asian Financial Crisis, the bursting of the Dotcom Bubble, the Great Financial Crisis, Brexit, and the US-China trade war. Damodaran’s aforementioned blog post also showed that the federal funds rate moved from around 5% in the mid-1960s to more than 20% in the early-1980s and then to around 2.5% in 2018. And yet, an 18.7% input (Berkshire’s book value per share growth) still resulted in a 20.5% output (Berkshire’s stock price growth).

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. We currently have no vested interest in any company mentioned. Holdings are subject to change at any time.

The Buyback Endemic

Buying back stock at unreasonably high valuations is not a good use of capital and can destroy shareholder value.

Buybacks can be a good way for companies to enhance shareholder value. Share buybacks reduce the number of shares outstanding, allowing companies to pay a higher dividend per share in the future.

But not all buybacks are good. Done at the wrong price, buybacks can actually be a bad use of capital. In fact, I have seen so many companies do buybacks recklessly and without consideration of the share price.

The problem probably arises from a few reasons.

Wrong mindset

First, some executives do not have a good grasp of what buybacks are. Take this statement from Tractor Supply’s management in its 2024 second-quarter earnings report for example:

“The Company repurchased approximately 0.5 million shares of its common stock for $139.2 million and paid quarterly cash dividends totaling $118.5 million, returning a total of $257.7 million of capital to shareholders in the second quarter of 2024.”

The issue with this statement is that it lumps dividends and share repurchases in the same bracket. It also implies that share repurchases are a form of returning capital to shareholders. The truth is that share repurchases is not returning cash to long-term shareholders but only to exiting shareholders. If management mistakes repurchases as capital return, it may lead them to do buybacks regularly, instead of opportunistically.

Although I am singling out Tractor Supply’s management, they are just one out of many management teams that seem to have the wrong mindset when it comes to buybacks.

Incentives

Additionally, executive compensation schemes may encourage management to buy back stock even if it is not the best use of capital.

For instance, Adobe’s executives have an annual cash remuneration plan that is determined in part by them achieving certain earnings per share goals. This may lead management to buy back stock simply to boost the company’s earnings per share. But doing so when prices are high is not a good use of capital. When Adobe’s stock price is high, it would be better for management to simply return dividends to shareholders – but management may not want to pay dividends as it does not increase the company’s earnings per share.

Again, while I am singling out Adobe’s management, there are numerous other companies that have the same incentive problem.

Tax avoidance

I have noticed that the buyback phenomena is more prevalent in countries where dividends are taxed.

The US, for instance, seems to have a buyback endemic where companies buy back stock regardless of the price. This may be due to the fact that US investors have to pay a tax on dividends, which makes buybacks a more tax-efficient use of capital for shareholders. On the contrary, Singapore investors do not need to pay taxes on dividends. As such, Singapore companies do not do buybacks as often.

However, simply doing buybacks for tax efficiency reasons without considering the share price can still harm shareholders. Again, management teams need to weigh both the pros and cons of buybacks before conducting them.

Final thoughts

There is no quick fix to this problem but there are some starting points that I believe companies can do to address the issue.

First, fix the incentives problem. A company’s board of directors need to recognise that incentives that are not structured thoughtfully can encourage reckless buybacks of shares regardless of the share price.

Second, management teams need to educate themselves on how to increase long-term value for shareholders and to understand the difference between buybacks and dividends.

Third, management teams need to understand the implications of taxes properly. Although it is true that taxes can affect shareholders’ total returns when a company pays a dividend, it is only one factor when it comes to shareholder returns. Executive teams need to be coached on these aspects of capital allocation.

Only through proper education and incentives, will the buyback endemic be solved.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Adobe and Tractor Supply. Holdings are subject to change at any time.

Assessing Different Share Buyback Strategies

Buying back stock is a great way to drive shareholder value but only if it is done at the right price.

Over the past few years, I have observed the different ways that companies conduct their share buybacks. This made me realise that the way a company conducts its share buybacks can have a profound impact on the long term returns of its stock.

Here are some share buyback strategies and what they mean for shareholders.

Opportunistic

The best way to conduct share buybacks is what I term as opportunistic buybacks. This means buying back shares aggressively when shares are undervalued and vice versa.

An example of a company that does this very well is the US-listed company Medpace, which helps drugmakers run drug trials.

In 2022, when markets and its own stock price were down, Medpace took the opportunity to buy back its shares aggressively. The company tapped the debt markets to procure more capital to buyback shares, to the extent that its net-cash position of US$314 million at the end of 2021 flipped to a net-debt position of US$361 million as of 30 June 2022.

But as its stock price went up, Medpace became less enthusiastic about buying back shares and instead started to pay off the debt it incurred; the company ended 2022 with a lower net-debt position of US$180 million

This type of opportunistic buyback strategy is the most efficient buyback strategy in my opinion.

The plot below shows the amount spent by Medpace on buy backs over the last 3 years.

With its stock price now at a much higher level, Medpace has not conducted buybacks for the last four quarters. Medpace’s management team is likely waiting for its shares to fall to a lower valuation before they conduct buybacks again.

Regular buybacks

Another way to conduct buybacks is to do it on a regular basis. The parent of Google, Alphabet, is one such company that has conducted very regular buybacks. In the past 10 quarters, Alphabet has consistently spent close to US$15 billion a quarter on buybacks. This includes quarters when the company’s free cash flow was less than US$15 billion.

Although I prefer opportunistic buybacks, regular buybacks may be best suited for a company such as Alphabet which has to deploy large amounts of capital. Alphabet’s shares have also consistently traded at a reasonable valuation over the last few years, making regular buybacks a decent strategy.

The chart below shows the amount that Alphabet spent on buybacks in each quarter for the last 10 quarters.

Poor timing

At the other end of the spectrum, some companies try to time their buybacks but end up being aggressive with buybacks at the wrong time.

Take Adobe, the owner of Photoshop, for example.

Adobe seems to change the level of aggressiveness in its share buybacks from quarter to quarter.

In the first quarter of 2022 , Adobe’s stock price was close to all-time highs, but the company was very aggressive with buybacks and spent more than US$2 billion – or 143% of its free cash flow in the quarter – to repurchase its shares.

When its stock price started falling later that year, instead of taking advantage of the lower price, Adobe surprisingly cut down on its buybacks to slightly over US$1 billion a quarter, less than what it generated in free cash flow during those periods. So far in 2024, Adobe has again increased its buybacks after its stock price increased.

The optimum strategy would have been to do more buybacks when its stock price was low and less buybacks when its stock price was high.

Bottom line

Buybacks can be a great way to add value to shareholders. However, it is vital that companies conduct buybacks at low valuations to maximise the use of their capital to generate long term returns for shareholders.

Medpace is an excellent example of great capital allocation, even going so far as to tap the debt markets to be even more aggressive with buybacks when its stock price is low. In the middle, we have companies such as Alphabet that consistently buyback shares. But on the other end of the spectrum is Adobe that seems to become more aggressive with buybacks at the wrong times.

Hopefully, more companies can follow in the footsteps of Medpace and make sure they put their capital to use only when the time is right.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I have a vested interest in Adobe, Alphabet, and Medpace. Holdings are subject to change at any time.

The Expensive Weighing Machine

Stocks and business fundamentals can diverge wildly in the short run, only to then converge in the long run.

In Pain Before Gain, I shared Walmart’s past business growth and corresponding stock price movement (emphases are new):

“From 1971 to 1980, Walmart produced breath-taking business growth. The table below shows the near 30x increase in Walmart’s revenue and the 1,600% jump in earnings per share in that period. Unfortunately, this exceptional growth did not help with Walmart’s short-term return… Walmart’s stock price fell by three-quarters from less than US$0.04 in late-August 1972 to around US$0.01 by December 1974 – in comparison, the S&P 500 was down by ‘only’ 40%. But by the end of 1979 (when inflation in the USA peaked during the 1970s), Walmart’s stock price was above US$0.08, more than double what it was in late-August 1972 (when inflation was at a low in the 1970s)…

…At the end of 1989, Walmart’s stock price was around US$3.70, representing an annualised growth rate in the region of 32% from August 1972; from 1971 to 1989, Walmart’s revenue and earnings per share grew by 41% and 38% per year…

…It turns out that in late-August 1972, when its stock price was less than US$0.04, Walmart’s price-to-earnings (P/E) ratio was between 42 and 68… This is a high valuation… at Walmart’s stock price in December 1974, after it had sunk by 75% to a low of around US$0.01 to carry a P/E ratio of between 6 and 7 the easy conclusion is that it was a mistake to invest in Walmart in August 1972 because of its high valuation. But as can be seen above, Walmart’s business continued to grow and its stock price eventually soared to around US$3.70 near the end of 1989. Even by the end of 1982, Walmart’s stock price was already US$0.48, up more than 10 times where it was in late-August 1972.”

In When Genius Failed (temporarily)*, I explored a little-discussed aspect of Teledyne’s history (emphasis is from the original passage) :

“Warren Buffett once said that Singleton “has the best operating and capital deployment record in American business… if one took the 100 top business school graduates and made a composite of their triumphs, their record would not be as good.”

Singleton co-founded Teledyne in 1960 and stepped down as chairman in 1990… According to The Outsiders, a book on eight idiosyncratic CEOs who generated tremendous long-term returns for their shareholders, Teledyne produced a 20.4% annual return from 1963 to 1990, far ahead of the S&P 500’s 8.0% return. Distant Force, a hard-to-obtain memoir on Singleton, mentioned that a Teledyne shareholder who invested in 1966 “was rewarded with an annual return of 17.9 percent over 25 years, or a return of 53 times his invested capital.” In contrast, the S&P 500’s return was just 6.7 times in the same time frame…

…based on what I could gather from Distant Force, Teledyne’s stock price sunk by more than 80% from 1967 to 1974. That’s a huge and demoralising decline for shareholders after holding on for seven years, and was significantly worse than the 11% fall in the S&P 500 in that period. But even an investor who bought Teledyne shares in 1967 would still have earned an annualised return of 12% by 1990, outstripping the S&P 500’s comparable annualised gain of 10%. And of course, an investor who bought Teledyne in 1963 or 1966 would have earned an even better return…

…But for the 1963-1989 time frame, based on data from Distant Force, it appears that the compound annual growth rates (CAGRs) for the conglomerate’s revenue, net income, and earnings per share were 19.8%, 25.3%, and 20.5%, respectively; the self-same CAGRs for the 1966-1989 time frame were 12.1%, 14.3%, and 16.0%. These numbers roughly match Teledyne’s returns cited by The Outsiders and Distant Force”

My article The Need For Patience contained one of my favourite investing stories and it involves Warren Buffett and his investment in The Washington Post Company (emphasis is from the original passage):

“Through Berkshire Hathaway, he invested US$11 million in WPC [The Washington Post Company] in 1973. By the end of 2007, Berkshire’s stake in WPC had swelled to nearly US$1.4 billion, which is a gain of over 10,000%. But the percentage gain is not the most interesting part of the story. What’s interesting is that, first, WPC’s share price fell by more than 20% shortly after Buffett invested, and then stayed in the red for three years”

Buffett first invested in WPC in mid-1973, after which he never bought more after promising Katherine Graham (the then-leader of the company and whose family was a major shareholder) that he would not do so without her permission. The paragraph above showed that Berkshire’s investment in WPC had gains of over 10,000% by 2007. But by 1983, Berkshire’s WPC stake had already increased in value by nearly 1,200%, or 28% annually. From 1973 to 1983, WPC delivered CAGRs in revenue, net income, and EPS of 10%, 15%, and 20%, respectively (EPS grew faster than net income because of buybacks).

Walmart, Teledyne, and WPC’s experience are all cases of an important phenomenon in the stock market: Their stock price movements were initially detached from their underlying business fundamentals in the short run, before eventually aligning with the passage of time, even when some of them began with very high valuations. They are also not idiosyncratic instances.

Renowned Wharton finance professor Jeremy Siegel – of Stocks for the Long Run fame – penned an article in late-1998 titled Valuing Growth Stocks: Revisiting The Nifty-Fifty. In his piece, Siegel explored the business and stock price performances from December 1972 to August 1998 for a group of US-listed stocks called the Nifty-Fifty. The group was perceived to have bright business-growth prospects in the early 1970s and thus carried high valuations. As Siegel explained, these stocks “had proven growth records” and “many investors did not seem to find 50, 80 or even 100 times earnings at all an unreasonable price to pay for the world’s preeminent growth companies [in the early 1970s].” But in the brutal 1973-1974 bear market for US stocks, when the S&P 500 fell by 45%, the Nifty-Fifty did even worse. For perspective, here’s Howard Marks’ description of the episode in his book The Most Important Thing (emphasis is mine):

“In the early 1970s, the stock market cooled off, exogenous factors like the oil embargo and rising inflation clouded the picture and the Nifty Fifty stocks collapsed. Within a few years, those price/earnings ratios of 80 or 90 had fallen to 8 or 9, meaning investors in America’s best companies had lost 90 percent of their money.”

Not every member of the Nifty-Fifty saw their businesses prosper in the decades that followed after the 1970s. But of those that did, Siegel showed in Valuing Growth Stocks that their stock prices eventually tracked their business growth, and had also beaten the performance of the S&P 500. These are displayed in the table below. There are a few important things to note about the table’s information:

It shows the stock price returns from December 1972 to August 1998 for the S&P 500 and five of the Nifty-Fifty identified by Siegel as having the highest annualised stock price returns; December 1972 was the peak for US stocks before the 1973-1974 bear market
It shows the annualised earnings per share (EPS) growth for the S&P 500 and the five aforementioned members of the Nifty-Fifty
Despite suffering a major decline in their stock prices in the 1973-1974 bear market, members of the Nifty-Fifty whose businesses continued to thrive saw their stock prices beat the S&P 500 and effectively match their underlying business growth in the long run even when using the market-peak in December 1972 as the starting point.

You may have noticed that all of the examples of stock prices first collapsing then eventually reflecting their underlying business growth that were shared above – Walmart, Teledyne, WPC, and members of the Nifty-Fifty – were from the 1970s. What if this relationship between stock prices and business fundamentals no longer holds now? It’s a legitimate concern. Economies change over time. Financial markets do too.

But I believe the underlying driver for the initial divergence and eventual convergence in the paths that the companies’ businesses and stock prices had taken in the past are alive and well today. This is because the driver was, in my opinion, the simple but important nature of the stock market: It is a place to buy and sell pieces of a business. This understanding leads to a logical conclusion that a stock’s price movement over the long run depends on the performance of its underlying business. The stock market, today, is still a place to buy and sell pieces of a business, which means the market is still a weighing machine in the long run. This also means that if you had invested a few years ago in a stock with an expensive valuation and have seen its stock price fall, it will likely still be appropriately appraised by the weighing machine in the fullness of time, if its fundamentals do remain strong in the years ahead.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I do not have a vested interest in any companies mentioned. Holdings are subject to change at any time.

Have Apple’s Share Buybacks Been Good For Shareholders?

Apple has used a staggering amount of cash to buyback shares. Has it been a good use of capital for shareholders?

Apple has spent a whopping US$651.4 billion on share repurchases from September 2011 to December 2023.

For perspective, Broadcom, the 9th largest company listed on the US stock market, currently has a market cap of US$617 billion. Apple could have bought the 9th largest listed company in the US using the cash it spent on buybacks. This brings us to the question, were Apple’s share buybacks the best use of its cash?

How much return did the buybacks create?

To judge if Apple made the right decision, we need to look at how much earnings per share growth the buybacks achieved.

Back in September 2011, Apple had roughly 26 billion shares outstanding on a split-adjusted basis. As of 20 October 2023, the date of the regulatory report for the fiscal year ended 30 September 2023 (FY2023), Apple had 15.55 billion shares outstanding. This is a 40% drop in shares outstanding. The lower share count, achieved through buybacks, has had a profound impact on Apple’s earnings per share.

In FY2023, Apple generated US$97 billion in net income and US$6.13 in diluted earnings per share. If the buybacks didn’t happen and Apple’s shares outstanding remained at 26 billion for FY2023 – instead of 15.55 billion – its diluted earnings per share would only be US$3.73 instead of US$6.13. Said another way, if Apple opted not to reduce its share count, the company would have needed its net income in FY2023 to be higher by US$62 billion in order to generate a similar diluted earnings per share figure.

So, Apple’s US$651 billion investment in share buybacks has created US$62 billion in “annual net income” to the company, and possibly more in the future as Apple’s net income continues to climb.

Could it have done better?

Although it’s clear now that Apple’s buybacks have had a positive impact on its diluted earnings per share, the next question is if the buybacks were the best use of the company’s capital.

Broadcom, the company whose market cap is close to the cumulative amount Apple has spent on buybacks, generated net income of US$14 billion in its most recent fiscal year.

If Apple had bought Broadcom instead, it would only have generated US$14 billion more in net profit, far less than the implied US$62 billion growth achieved from buying back its own shares. This would have resulted in substantially less earnings per share growth than the buybacks. In comparison, Apple’s buybacks seem like a good investment decision.

I know that using Broadcom as an example may not be the best comparison as Apple could have bought Broadcom for much less in 2012. Nevertheless, it gives some perspective on the different possible uses of capital.

Conclusion

Was buybacks the single best use of cash for Apple? Probably not. But was it a bad investment? Definitely not. The return on investment through Apple’s buyback program has resulted in a large jump in its earnings per share. The US$62 billion “increase” in annual earnings could also continue to rise if Apple’s earnings grows over time. Although there could possibly have been better investments, I think Apple made a decent decision to focus on buybacks over the past few years.

But should Apple continue buying back shares? This is the question on everyone’s lips right now, especially with Apple recently announcing a new US$110 billion buyback authorisation.

Buybacks provide a good return only if shares are trading at cheap valuations. Apple’s management needs to continue evaluating the company’s valuation when making future buyback decisions. With Apple’s valuation increasing in the past few years, management will need to decide if conducting buybacks today still provides good value for shareholders or if other forms of investments will be more impactful.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I currently have a vested interest in Apple Inc. Holdings are subject to change at any time.

What The USA’s Largest Bank Thinks About The State Of The Country’s Economy In Q1 2024

Insights from JPMorgan Chase’s management on the health of American consumers and businesses in the first quarter of 2024.

JPMorgan Chase (NYSE: JPM) is currently the largest bank in the USA by total assets. Because of this status, JPMorgan is naturally able to feel the pulse of the country’s economy. The bank’s latest earnings conference call – for the first quarter of 2024 – was held two weeks ago and contained useful insights on the state of American consumers and businesses. The bottom-line is this: Economic indicators in the US continue to be favourable and American consumers are in good shape, but there are a number of risks on the horizon, so JPMorgan’s management is preparing for a wide range of outcomes.

What’s shown between the two horizontal lines below are quotes from JPMorgan’s management team that I picked up from the call.

1. Management sees economic indicators in the USA as favourable, but there are many risks on the horizon (including geopolitical conflicts, inflationary pressures, and the Fed’s quantitative tightening) so they want to be prepared for a range of outcomes; the economy always looks healthy at the inflection point; management thinks the US economy will be affected even if problems happen elsewhere

Many economic indicators continue to be favorable. However, looking ahead, we remain alert to a number of significant uncertain forces. First, the global landscape is unsettling – terrible wars and violence continue to cause suffering, and geopolitical tensions are growing. Second, there seems to be a large number of persistent inflationary pressures, which may likely continue. And finally, we have never truly experienced the full effect of quantitative tightening on this scale. We do not know how these factors will play out, but we must prepare the Firm for a wide range of potential environments to ensure that we can consistently be there for clients…

…But what I caution people, these are all the same results [referring to the comments in Point 2 and Point 6 below about consumers and businesses being in good shape] of a lot of fiscal spending, a lot of QE, et cetera. And so we don’t really know what’s going to happen. And I also want to look at the year, look at 2 years or 3 years, all the geopolitical effects and oil and gas and how much fiscal spending will actually take place, our elections, et cetera. So we’re in good — we’re okay right now. It does not mean we’re okay down the road. And if you look at any inflection point, being okay in the current time is always true. That was true in ’72, it was true in any time you’ve had it. So I’m just on the more cautious side that how people feel, the confidence levels and all that, that doesn’t necessarily stop you from having an inflection point. And so everything is okay today, but you’ve got to be prepared for a range of outcomes, which we are…

…I think that when we talk about the impact of the geopolitical uncertainty on the outlook, part of the point there is to note that the U.S. is not isolated from that, right? If we have global macroeconomic problems as a result of geopolitical situations, that’s not only a problem outside the U.S. That affects the global economy and therefore the U.S. and therefore our corporate customers, et cetera, et cetera.

2. Management is seeing consumers remain healthy with overall spend in line with a year ago, and although their cash buffers have normalised, they are still higher than pre-COVID levels; management thinks consumers will be in pretty good shape even if there’s a recession; the labour market remains healthy with wages keeping pace with inflation

Consumers remain financially healthy, supported by a resilient labor market. While cash buffers have largely normalized, balances were still above pre-pandemic levels, and wages are keeping pace with inflation. When looking at a stable cohort of customers, overall spend is in line with the prior year…

… I would say consumer customers are fine. The unemployment is very low. Home price dropped, stock price dropped. The amount of income they need to service their debt is still kind of low. But the extra money of the lower-income folks is running out — not running out, but normalizing. And you see credit normalizing a little bit. And of course, higher-income folks still have more money. They’re still spending it. So whatever happens, the customer’s in pretty good shape. And they’re — if you go into a recession, they’d be in pretty good shape.

3. Auto originations are down

And in auto, originations were $8.9 billion, down 3%, while we maintained healthy margins and market share.

4. Net charge-offs (effectively bad loans that JPMorgan can’t recover) rose from US$1.1 billion a year ago, mostly because of card-related credit losses that are normalising to historical norms; management expects consumer-spending on credit/debit cards to have strong growth in 2024

In terms of credit performance this quarter, credit costs were $1.9 billion, driven by net charge-offs, which were up $825 million year-on-year predominantly due to continued normalization in Card…

…And in Card, of course, while charge-offs are now close to normalized, essentially, we did go through an extended period of charge-offs being very low by historical standards, although that was coupled with NII also being low by historical standards…

….Yes, we still expect 12% card loan growth for the full year.

5. The level of appetite that companies have for capital markets activity is uncertain to management

While we are encouraged by the level of capital markets activity we saw this quarter, we need to be mindful that some meaningful portion of that is likely pulling forward from later in the year. Similarly, while it was encouraging to see some positive momentum in announced M&A in the quarter, it remains to be seen whether that will continue, and the Advisory business still faces structural headwinds from the regulatory environment…

…Let me take the IPO first. So we had been a little bit cautious there. Some cohorts and vintages of IPOs had performed somewhat disappointingly. And I think that narrative has changed to a meaningful degree this quarter. So I think we’re seeing better IPO performance. Obviously, equity markets have been under a little bit of pressure the last few days. But in general, we have a lot of support there, and that always helps. Dialogue is quite good. A lot of interesting different types of conversations happening with global firms, multinationals, carve-out type things. So dialogue is good. Valuation environment is better, like sort of decent reasons for optimism there. But of course, with ECM [Equity Capital Markets], there’s always a pipeline dynamic, and conditions were particularly good this quarter. And so we caution a little bit there about pull-forward, which is even more acute, I think, on the DCM [Debt Capital Markets] side, given that quite a high percentage of the total amount of debt that needed to be refinanced this year has gotten done in the first quarter. So that’s a factor.

And then the question of M&A, I think, is probably the single most important question, not only because of its impact on M&A but also because of its knock-on impact on DCM through acquisition financing and so on. And there’s the well-known kind of regulatory headwinds there, and that’s definitely having a bit of a chilling effect. I don’t know. I’ve heard some narratives that maybe there’s like some pent-up deal demand. Who knows how important politics are in all this. So I don’t know.

6. Management is seeing that businesses are in good shape

Businesses are in good shape. If you look at it today, their confidence is up, their order books drop, their profits are up.

7. Management thinks that the generally accepted economic scenario is nearly always wrong and that no one can accurately predict an inflection point in the economy

And the other thing I want to point out because all of these questions about interest rates and yield curves and NII and credit losses, one thing you projected today based on what — not what we think in economic scenarios, but the generally accepted economic scenario, which is the generally accepted rate cuts of the Fed. But these numbers have always been wrong. You have to ask the question, what if other things happen? Like higher rates with this modest recession, et cetera, then all these numbers change. I just don’t think any of us should be surprised if and when that happens. And I just think the chance of that happen is higher than other people. I don’t know the outcome. We don’t want to guess the outcome. I’ve never seen anyone actually positively predict a big inflection point in the economy literally in my life or in history.

8. Management thinks the US commercial real estate market is fine, at least when it comes to JPMorgan’s portfolio; management thinks that if interest rates rise, it could be roughly neutral or really bad for the real estate market, depending on the reason for the increase in interest rates

First of all, we’re fine. We’ve got good reserves against office. We think the multifamily is fine. Jeremy can give you more detail on that if you want.

But if you think of real estate, there’s 2 pieces. If rates go up, think of the yield curve, the whole yield curve, not Fed funds, but the 10-year bond rate, it goes up 2%. All assets, all assets, every asset on the planet, including real estate, is worth 20% less. Well obviously, that creates a little bit of stress and strain, and people have to roll those over and finance it more. But it’s not just true for real estate, it’s true for everybody. And that happens, leveraged loans, real estate will have some effect.

The second thing is the why does that happen? If that happens because we have a strong economy, well, that’s not so bad for real estate because people will be hiring and filling things out. And other financial assets. If that happens because we have stagflation, well, that’s the worst case. All of a sudden, you are going to have more vacancies. You are going to have more companies cutting back. You are going to have less leases. It will affect — including multifamily, that will filter through the whole economy in a way that people haven’t really experienced since 2010. So I’d just put in the back of your mind, the why is important, the interest rates are important, the recession is important. If things stay where they are today, we have kind of the soft landing that seems to be embedded in the marketplace, everyone — the real estate will muddle through.

9. Consumers whose real incomes are down are slowing their spending, but they account for only a small proportion of the overall population, and they are not levering up irresponsibly

And there are some such people whose real incomes are not up, they’re down, and who are therefore struggling a little bit, unfortunately. And what you observe in the spending patterns of those people is some meaningful slowing rather than what you might have feared, which is sort of aggressive levering up. So I think that’s maybe an economic indicator of sorts, although this portion of the population is small enough that I’m not sure the read-across is that big. But it is encouraging from a credit perspective because it just means that people are behaving kind of rationally and in a sort of normal post-pandemic type of way as they manage their own balance sheets.

Disclaimer: The Good Investors is the personal investing blog of two simple guys who are passionate about educating Singaporeans about stock market investing. By using this Site, you specifically agree that none of the information provided constitutes financial, investment, or other professional advice. It is only intended to provide education. Speak with a professional before making important decisions about your money, your professional life, or even your personal life. I don’t have a vested interest in any company mentioned. Holdings are subject to change at any time.

Debunking An Investment Myth

Instead of fretting over stock prices, it is better to focus on how much cash the company can generate and return to shareholders.

There are some investing beliefs that are widely accepted but may not be entirely true. One such belief is the idea that a company has a “common” intrinsic value.

When investors think of investing in stocks, the thought is often that a stock has the same intrinsic value for everyone, and eventually the stock price will gravitate toward that intrinsic value. But this may not be the case.

Intrinsic value is dependent on the circumstances of an investor.

Imagine a stock that consistently and predictably pays out $1 per share in dividends every year for eternity. An investor who seeks to find investments that will give a return of 10% a year will be willing to pay $10 per share. In other words, $10 is the “intrinsic value”. On the other hand, another investor may be highly connected and can find high-return investments that gives him 20% a year. This investor will only pay $5 for the above company. His intrinsic value is thus $5 per share.

As you can see, the intrinsic value for the same share is very different.

Intrinsic value changes with rates

Besides the circumstances of each investor, the intrinsic value of a stock can also change when the risk-free rate changes. If the risk free rate goes up, theoretically, investors will gravitate towards the now higher-yielding bonds. As such, stocks will require a higher rate of return and hence their intrinsic value falls.

As the last couple of years have shown, interest rates can have a very big impact on stock prices.

While all this is happening, the company in question is still the same company.

So despite being the same company, it can have different intrinsic values to different people and may also have different intrinsic values on a day-to-day basis based on the risk-free rate at the time.

So what?

This naturally leads to the question, what price will a stock trade at if its intrinsic value differs from person to person and from day to day?

I believe that it’s impossible to know what price a stock should or would trade at. There are too many factors in play. It depends on the market as a whole and with so many market participants, it is almost impossible to know how the stock will be priced.

Given this, instead of focusing on price, we can focus on the dividends that will be distributed to the investor in the future. This means we do not need to predict price movements and our returns are based on the returns that the company will pay to shareholders. Doing this will ensure we are not beholden to fluctuations in stock prices which are difficult to predict.

What’s more predictable is how a company will perform and whether it can generate cash flows and dividends to the shareholders. As such, I prefer focusing my efforts on looking for types of companies with predictable earnings and paying a price that fits my personal investing returns requirement.

A Radical Idea To Improve Stock-Based Compensation

Here’s a radical idea to improve stock-based compensation so that employees are inclined to drive long term shareholder value.

The idea of giving stock-based compensation is to turn employees into partners. In theory, giving employees stock will make them part-owners of a business and drive them to think and act like a business owner.

However, the reality is that the way SBC programmes of many companies are designed today actually does not motivate employees to think or act like business owners.

In today’s world, SBC is predominantly given in the form of RSUs or options that vest over three to four years. This means that employees are given a fixed number of shares/options every month over a three to four year period. Although this turns employees into shareholders, it may not adequately motivate them to think like owners of a business.

The reason is that employees can sell the stock as soon as they receive them. Many employees are also not inclined to hold the stock for a long period of time, instead opting to sell the stock when the prices go up. Employees may also consider their contribution to the company as too small to make any difference to the stock price.

As such, this form of SBC does not make employees think like shareholders at all. In fact, I would argue that cash-based compensation would be a better motivator for employees.

Complete lock up

One way that companies try to get around this is to have a lock-up period. In this way, employees are not allowed to sell the shares they receive for a number of years. The lock up period can range from months to years.

But, I think that this is still not enough. Employees need to think like perpetual shareholders where returns are driven by cash flows and ultimately dividends paid to shareholders.

As such, my radical proposal is for SBC to have perpetual lock ups. This means that employees who receive SBC are never allowed to sell unless they are forced to sell via a buyout.

By having perpetual lock ups, employees become true long-term shareholders whose returns are tied to how much cash flow a company is able to return to shareholders.

In this way, employees really think hard about how to maximise cash flow to the company so that the company can pay them a growing stream of dividends in the future instead of just fretting over stock prices. Stock prices are also not entirely in the control of a company as stock prices can also fluctuate based on sentiment and interest rates. Cash flow on the other hand is entirely influenced by management decisions and employee actions.

Although perpetual lock ups may not seem enticing to employees at first, if the company is able to grow and pay dividends in the future, the employee is entitled to a new stream of regular and growing cash income.

Possible push backs

I know there are many possible push backs to this proposal.

For one, some employees may not want to wait so long to receive dividends as an early stage company may take years, if not decades, to start paying dividends. Such a long lock up will not be attractive to employees who want to get rich quick. But that’s the reality of being a long-term shareholder of a business. True business owners are not here to flip the business to someone else but to reap the growing cash flows that the business builds over time. These are patient business builders and that is exactly what we want from employees.

Another pushback would be that it would encourage management to pay dividends instead of investing in other higher return investments. Although this is possible, management who have received shares and are long-term thinkers should be willing to forego some cash dividends today to earn a much larger stream of future cash dividends. Ultimately, a perpetual lock up should drive management to maximise dividend cash flow to themselves over the entire life cycle of the business and not just maximise dividend payment for the near term.

Final words

A perpetual lock-up sounds like a radical idea but it may make employees really think like long-term business partners.

The current model for stock-based compensation via vesting periods and short lock-ups just do not have the same effect in my view. Employees end up focusing on how to drive short term price movements or they just aren’t motivated at all to think like a business owner. In this case, cash incentives and the current form of SBC is not much different.

The only true way to make employees act and think like long-term shareholders is to make them one. And perpetual lock ups probably are the best way to do this.

Beware of This Valuation Misconception

Don’t value your shares based on cash flow to the firm, value it based on cash flow to the shareholder.

How should we value a stock? That’s one of the basic questions when investing. Warren Buffett answers this question extremely well. He says:

“Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”

While seemingly straightforward, a lot of investors (myself included) have gotten mixed up between cash flow that a company generates and cash that is actually taken out of a business.

While the two may sound similar, they are in fact very different.

Key difference

Extra cash flow that a firm generates is termed free cash flow. This is cash flow that the company generates from operations minus any capital expenditure paid.

But not all free cash flow to the firm is distributed to shareholders. Some of the cash flow may be used for acquisitions, some may be left in the bank, and some may be used for other investments such as buybacks or investing in other assets. Therefore, this is not cash that a shareholder will receive. The cash flow that is taken out of the business and paid to shareholders is only the dividend.

When valuing a stock, it is important that we only take cash that will be returned to the shareholder as the basis of the valuation.

Extra free cash flow that is not returned to shareholders should not be considered when valuing a stock.

Common mistake

It is a pretty big mistake to value a stock based on the cash flow that the company generates as it can severely overstate the value of a business.

When using a discounted cash flow model, we should not take free cash flow to the firm as the basis of valuation but instead use future dividends to value a business.

But what if the company is not paying a dividend?

Well, the same should apply. In the case that there is no dividend yet, we need to account for that in our valuation by only modelling for dividend payments later in the future.

Bottom line

Using discounted cash flow to the firm to value a business can severely overstate its value. This can be extremely dangerous as it can be used to justify extremely unwarranted valuations, leading to buying overvalued stocks.

To be accurate, a company should be valued based only on how much it can return to shareholders.

That said, free cash flow to the firm is not a useless metric in valuation. It is actually the basis of what makes a good company.

A company that can generate strong and growing free cash flows should be able to return an increasing stream of dividends to shareholders in the future. Free cash flow to the firm can be called the “lifeblood” of sustainable dividends.

Of course, all of this also depends on whether management is able to make good investment decisions on the cash it generates.

Therefore, when investing in a company, two key things matter. One, how much free cash flow the firm generates, and two, how good management is in allocating that new capital.