Conserve cash, don't buy back shares

As stocks plummet, corporates should not make big buybacks to defend their share price

A simplistic distinction often made between Western and traditional Chinese medicine is that the former uses scientifically proven methods to treat disease symptoms, while the latter goes for a broader approach to address root causes.

From this perspective, swooning stock markets are just symptoms. It is foolish to attempt to support share prices using artificial means, in the hope that underlying diseases go away.

With valuations at lows, the Singapore Exchange (SGX) has seen a raft of share buyback activity, with around 1,500 such announcements made by companies in the past six months.

However, corporates should resist the temptation. Many of them are better served conserving their money to survive a business downturn, rather than attempting to address the symptom of falling prices.

Ironically, it was the Chinese who tried, a year ago, to address their economic problems by attempting to treat the symptoms.

Policymakers had a misguided dream to talk up share prices to such an extent that a mad bull rush ensues. Once companies were enjoying inflated valuations, the line of argument went, they could place out expensive shares to raise capital to rescue their ailing, debt-laden businesses.

The situation quickly got out of hand, fuelled by market commentators believing in their own hype. Traders borrowed massive amounts of money to pump share prices up, which drew in increasing numbers of retail investors. When the inevitable crash came in June and August 2015, the Chinese government formed a "national team" of state firms to keep prices up.

Yet this week, the Shanghai Composite Index had fallen below the depths reached in last August's crash. To add insult to injury, circuit breakers meant to calm the market's swings ended up exacerbating them, and were withdrawn from use.

Treating the symptoms has failed spectacularly.

The key lessons from the Chinese experience are two-fold.

First, propping up stock prices work only when valuations linger at absolutely unjustified troughs. In this situation, the institutions buying stocks become value investors that aim to profit from panicked sellers - usually external - while providing liquidity.

That was not the case when the "national team" started buying last year, when Chinese stocks have already rallied significantly from their 2014 lows.

Neither is it necessarily the case now for the Singapore market. Certain companies are trading at low valuations because their earnings have been plummeting. Others might be valued at over 30 times earnings. Both types of companies are buying back shares.

Meanwhile, expecting sovereign wealth fund GIC to start buying stakes in listed companies, as some business leaders have suggested recently, is wishful thinking at best.

Ultimately, forces at play in a market can be stronger than what the government, or any company can do.

The market can stay irrational longer than the companies themselves have the cash to keep buying back stock. And what then? Mr Market has the propensity to administer rude shocks to over-optimistic managers. Cheap can always become cheaper, and a better entry price be found.

Second, debt should be treated with the utmost care.

The root disease in the Chinese economy is bad debt. What is happening there thus far is similar to how sub-prime mortgages are packed and repackaged in the years leading to the 2008-9 global financial crisis.

In China, debt is also similarly repackaged, sold as wealth management products offering enticing yields, or even used as collateral for companies to attract lending from others. Commercial banks are enticed, or forced, to bail out possibly-bust local governments. This is through the banks buying longer term bonds issued by the local governments, in exchange for the banks being able to count the bonds as collateral to get financing from the central bank.

Bad deal for banks

The deal is a bad one for banks, as they are getting low-quality assets at low yields. Swapping debt for bonds is like kicking the can down the road. The crisis is merely postponed while local governments await a growth spurt to bail them out that might never come.

Debt causes crises. With the Chinese experience in mind, corporates that already hold debt should have no business using precious cash to buy back their shares in a downturn, especially if the cash was obtained from lenders.

Corporates might not be as indebted as the Chinese. They might think their fundamentals are sound. Even then, they should preserve their resources to deal with unexpected events, or even to snap up distressed assets. There is always debt to repay.

If there is really no good use for their cash, there is always the option to give a special dividend to shareholders. It is one thing for major shareholders to buy more shares using their own money, and another to use company money to do a share buyback. Let minority shareholders decide what to do with their money.

Like economies, companies have to look at their competitive fundamentals and figure out how to grow revenues and improve profitability.

Trying to prop up stock prices is trying to treat symptoms instead of root causes.

Once the fundamentals are right, healthy valuations will assuredly follow.

haoxiang@sph.com.sg

This article was first published on JAN 22, 2016.
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