Hello reader, welcome to the latest issue of HX Weekly!

Two years ago, we ran a series of notes titled "The Dynamics of Shareholder Capital."

In the series, we ran through the different implications of actions companies can take with their capital structure including stock splits, buybacks and dividends.

For this week's HX Weekly we are sharing all four of those notes together, along with market wisdom from Bob Farrell. We think this is a good comprehensive - and real world - conversation about what companies can do with their capital.

Now, let's dive in!

The Dynamics of Shareholder Capital – Part I

Do Stock Splits Matter?

(Note - This post originally ran on June 3, 2024)

For the last six months, there has been one stock that has dominated the conversation – NVIDIA Corporation (NASDAQ: NVDA)

This is justified as NVDA has seen growth in revenues and profitability at an almost unprecedented pace and scale.

This has also resulted in an incredible performance for the stock. We are sure you know what the stock had done, but just in case…

In the last year, the stock has been up almost +200%.

It also dominates the conversation about the markets in an unprecedented way.

It is not unusual for the stock to make up 10% or more of the TOTAL dollar volume traded in S&P 500 stocks. Some days, it has been as much as 25%!

Again, there have been very few (if any) situations like this…

The company announced a "10-for-1" stock split with their recent blow-out earnings.

Many of you may be familiar with this concept, but let’s go through it for those unfamiliar.

Right now (according to Bloomberg), there are 2.489 billion shares of NVDA stock outstanding. This should include the appropriate adjustments to give us an actual number.

Each share trades at roughly $1100 – giving the company a market capitalization of almost $2.7 trillion.

With the "10-for-1" stock split, what is going to happen is that for every outstanding share, they will issue 9 more additional shares.

If you own 100 shares today (a $110k position), then you would own 1000 shares after the split. The share price, however, will also be adjusted, and instead of $1100 per share, it will be reduced to $110 per share.

Economically, nothing will have changed. The value of your stake in NVDA will remain precisely the same.

You simply will own more shares at a lower price.

The stock market took this as good news. If no economic value is created, why would there be a positive response?

A few years ago, there was an argument to be made about the affordability of buying stocks with very high share prices.

Way back in the day, you could only buy in 100 shares lots. That would mean you would have to have a minimum of $100k to be able to buy NVDA shares. That would eliminate a lot of potential retail shareholders.

Over the years, though, buying smaller lots of stock became possible—as little as even ONE share.

Most recently, "fractional" shares were also invented. Fractional shares are new, but a shareholder could participate in NVDA stock with as little as $100.

With reductions in transaction costs to almost $0, there are now few barriers for retail investors to buy the stock.

Does a lower stock price make you more likely to be involved in a stock or its options?

Then why do it? What value does it add?

There are a couple of technical areas where it could create additional demand and liquidity for the stock.

For the options markets, a lower stock price means that each contract is cheaper. It also means that you would need to maintain less money in your brokerage account to be able to trade the options.

This should increase the demand and liquidity in the options. Does this create more demand for the shares?

Not necessarily, and it may increase volatility as if NVDA needed that!

Another potential positive could be an inclusion in the Dow Jones Industrial Average.

That index is calculated on a “price-weighted” basis. This means that they take the 30 components and take one share of each to calculate the index.

Currently, the index's most significant component is UnitedHealth Group (NYSE: UNH), with an 8.5% weighting. This is because it has a $495 share price.

UNH isn't a small company with a $450 billion market capitalization.

However, Walmart Inc. (NYSE: WMT) only has a 1.12% weighting with its $65 stock price and a $530 billion market capitalization.

In our view, the Dow Jones Industrial Average doesn’t make much sense and is not particularly useful.

Could a $110 stock price versus $1100 make it more likely that NVDA gets included in this index? Maybe.

Would that create more demand for the stock? Not very much in our view.

Honestly - we don't think very much, but it is a positive sentiment for big companies.

We subscribe to a research service called Bespoke Investment Group. They do some great analysis, and you should check them out!

They recently published some data on stock splits by S&P 500 companies. The tables are below…

You can see that stock splits are now relatively uncommon in the S&P 500 compared to twenty years ago. We think company boards now understand that they don't add much value.

Looking at the performance of the split stocks does share some insight.

Usually, an S&P 500 stock that splits has gone up a lot! +74% in one year is crazy good performance, and very few companies ever see that kind of one-year return…

After the split, the stocks don’t seem to do all that much. That shouldn’t be surprising.

Stocks that go up +74% in one year usually need a breather.

From there, though, they exhibit strong performance—+19 % in the next year, or roughly double the performance of the S&P 500.

This is likely because whatever combination of positive dynamics that led the stock to be +74% in the previous year persisted in the following year. Strength begets strength.

We don't think that stock splits matter for a company's economic value. They may not matter much for the stock, but they are not a negative.

The Dynamics of Shareholder Capital – Part II

The Value of Share Buybacks

(Note - This post originally ran on June 4, 2024)

During my career in the financial markets, it has been fascinating to see obscure financial concepts become part of mainstream discourse.

One of the biggest debates in recent years has been about share buybacks.

Before we go further, let's go through the definition of a share buyback...

Companies have a defined number of shares outstanding (for our example, let's say 100), and for publicly traded companies, those are usually free to trade.

If a company has cash it wants to spend – no matter where that cash comes from – it could go into the open market and buy some of those shares.

Let's say the stock is at $10 per share, and the company wants to buy ten shares. It would spend $100 on "buying back" those shares. The company can then "retire" these shares, leaving it with 90 shares outstanding.

The big question is, does this create any economic value?

Like most of these types of questions, there are several factors to consider...

In theory (and mostly in practice), if there's a constant demand for the shares, the share price should go higher.

Per our example, let's say 100 investors are willing to pay $10 per share, but now, there are only 90 shares available. Do the ten investors who now can't get a share (because of the retired shares) offer a higher price?

The reduction of the share count is called "shrinking the float," historically, companies that have aggressively shrunk their share floats have been outstanding stocks.

A notable example is the stock of auto repair retailer AutoZone (AZO). Look at the stock price since 1991…

Since June 1991, the company's stock price has compounded at +20.5%. This is significantly better than the S&P 500 and is a total return of 47,535%!

Next, look at AutoZone's net income since 1998…

The company has an impressive track record, growing net income more than tenfold from $228 million to almost $2.7 billion. 

Still, that's far short of the stock's growth over the same time.

However, if we look at its share count, we can see how aggressively AutoZone has been buying back the stock...

Across the period where it grew earnings by ten-fold, AutoZone also reduced its share count by almost 90%!

The net result is that its earnings per share ("EPS") soared! Look...

As you can see, EPS has gone from $1.48 to almost $144 per share or nearly +10,000%!

AZO has taken a decent growth business and harnessed its cash flow to buy back a crazy amount of stock and amplify EPS growth. This has been well rewarded in the stock market.

This is an example of a buyback that has been great for shareholders. It's one of the most successful in financial history.

But is this the norm? Therein lies the problem...

The first question is whether the company would have been better off investing in its business instead. Would the stock have gone even higher with even higher earnings power?

This is hard to argue because AutoZone grew its earnings tenfold in a mature U.S. automobile market.

The argument that companies are better off investing in the business is the most common criticism of buybacks. Still, it suffers from one of the greatest fallacies we see in financial analysis: that outsiders can make better judgments than management teams regarding running the business.

Management teams could be better, but most did not get there by accident. They are skilled professionals who also have much more information than any outsider.

Honestly, it is galling that financial analysts and politicians who criticize them are entirely unqualified to make these determinations. Most have never run anything, much less a large publicly traded company.

One of the best aspects of our financial system is that these companies also have a board of directors, with several of them being independent of management. Significant laws and regulations also govern these boards.

The system isn't perfect, as mistakes and even fraud sometimes occur, but overall, it works well.

"Checks and balances" are in place to ensure the interests of shareholders – and, increasingly, employees – are appropriately served.

Almost always, a company that's buying back stock would rather invest more in the business if it had the opportunity. The share buyback, however, is an accurate view of its investment opportunities.

Another criticism is that share buybacks are "financial engineering" and don't create "real" value.

Frankly, this doesn't make sense. Most aspects of running a company's balance sheet – issuing shares, issuing debt, paying debt down, etc. – are "financial engineering." And the argument about "real" value runs into our discussion above about the demand for shares.

Also, remember something that I've said repeatedly here at HX Research. Stocks are just pieces of paper. Sure, shareholders technically own the business's cash flows, but those cash flows are seldom paid to shareholders.

Shareholders see companies that successfully buy back their stock as shrinking the supply, feeding into a relatively constant demand. This should (and most often does) create buyers who are willing to pay more for the stock, and as a result, the shares go higher.

This has undoubtedly been the case with AutoZone's stock...

When properly executed, share buybacks are great for shareholders and are a strong net positive for the stock market and economy.

The Dynamics of Shareholder Capital – Part III

When Share Buybacks Don’t Work

(Note - This post originally ran on June 5, 2024)

Earlier, we discussed the – sometimes controversial – topic of share buybacks.

We went through a scenario where a company has utilized a consistent policy of share buybacks across thirty years, creating a tremendous amount of shareholder value.

The example we used – AutoZone Inc. (NYSE: AZO) – is likely the most successful use of share buybacks ever. Few (if any) other companies have repurchased as many shares or seen the same share price performance.

Mostly, we believe companies add value with their share buybacks.

It might be an unpopular opinion, but as we said yesterday, we think that management teams and their boards of directors know what they are doing and add value.

Sometimes, though, the share buybacks do NOT add value. Occasionally, they can even lead to disaster.

Some of the most well-known instances are the large share buybacks that were done by the major banks going into the collapse of Lehman Brothers and the Global Financial Crisis in 2008.

The biggest banks bought back a vast amount of stock but then needed financial aid from the government. Citigroup Inc. (NYSE: C) bought back over $20 billion of shares from 2004 through 2008 but required a roughly $45 billion government bailout.

Lehman Brothers bought back $2.6 billion of stock in 2007 and another $1.5 billion in the first half of 2008. All this just six months before going bankrupt!

Clearly, these buybacks did not produce value for their shareholders.

However, given the financial leverage involved, financial companies are a very particular group. We think they can be used positively by financial companies, but there is always going to be a unique risk associated with them.

A better example of a failed share buyback is the now-bankrupt retailer Bed, Bath and Beyond – formerly listed on NASDAQ as BBBY.

BBBY shared some commonalities with AZO. Both were successful retailers servicing a relatively mature and stable area of the economy. AZO was in the automobile business, and BBBY sold houseware, furniture, and specialty items for the home.

One could argue that BBBY had the better end market when you look at annual growth over time.

In 2004, BBBY decided to deploy a strategy similar to AZO's to buy back shares aggressively. Here is a table showing the diluted shares outstanding from 2004 through 2023…

Across 20 years, they reduced the share count by almost two-thirds. 

At the time, it made sense as they had no debt and had been growing revenue very nicely. Here are those tables…

From 2004 to 2015, the company saw revenue grow from $4.5 billion to almost $12 billion.

From that period onward, though, their revenue growth began to stall. This is despite a decent economy and housing market.

As its growth began to stall, the company decided to layer on debt for the first time and continue – if not accelerate – the share buyback.

We don't think there was necessarily anything wrong with this strategy. We didn't share AZO's revenue and debt charts, but they have also seen periods of muted revenue growth and used debt to buy back shares.

Like AZO, BBBY also saw decent share price performance. Here is the stock price chart from 2004 until going bankrupt in 2023…

The stock doubled over the decade from 2004 to 2014. Then, it stalled along with sales despite the continued share buybacks. This might have been a message to management.

The big difference between the two companies is how their end markets eventually played out.

COVID-19 impacted AZO, but it is relatively immune to online purchasing. Folks just aren’t used to ordering automotive replacement parts and accessories online.

Unfortunately for BBBY, the same was not valid for housewares. COVID was a particularly damaging situation for them…

Although they had a robust online business, their stores were closed. This was when people began to spend a ton of money on their homes. They were stuck there and – if they didn’t lose their jobs – had money to spend and lots of free time.

This led to a massive migration to online selling of housewares. Amazon.com, Inc. (NASDAQ: AMZN) attacked the market very aggressively.

Again, BBBY had a good online presence, but it was impossible to compete with Amazon's scale, and the cost of

its stores hurt them.

Looking at the chart of their debt, you can see a significant uptick as they took on debt to get through this period.

It was AFTER COVID-19 that management made their fundamental mistakes.

Management did not understand the magnitude of the migration of houseware buying online, nor that it would persist. This meant that their revenue outlook was going to be impacted.

However, they didn't recognize this and returned to buying back stock as aggressively as before, even despite the higher level of debt.

This fatal combination eventually drove the company to file bankruptcy in April of 2023.

Have you seen an example of a company destroying value through share buybacks? Share it with us in the comments section online or at [email protected].

Do we think the buybacks at BBBY were a mistake?

Up until 2015, we don't think so at all. The aggressive buybacks made sense, considering their end market and no debt. They weren't necessarily a mistake from 2015 until COVID-19 in 2020, as revenues were stable, and the business was still generating much cash.

It was not recognizing the change in the environment that would persist after COVID (and the higher debt load) that would doom the company.

Could something similar happen to AZO someday?

Maybe. Perhaps some change in automobile maintenance around electric vehicles will impair their business, and they will suffer the same fate.

There is a risk to the future of any business.

Like any aspect of a company's financial operations, we think share buybacks – when used correctly – can drive a lot of value. The world changes, though, and ultimately, it comes down to management's ability to recognize those changes and react appropriately.

The Dynamics of Shareholder Capital – Part IV

Our Thoughts on Dividends

(Note - This post originally ran on June 6, 2024)

In the wake of the recently announced 10-for-1 stock split at NVIDIA Corporation (NASDAQ: NVDA), we discussed the benefits of stock splits.

We concluded that no real economic benefit exists, but they can be a mild positive for other minor reasons.

We also discussed share buybacks. We gave an example that has been one of the best outcomes as well as one that has been one of the worst incomes.

We concluded that they can be a powerful tool, but they depend on management's acumen.

Today, we discuss a final large category of shareholder capital – dividends.

We are sure you know what a "dividend" is, but we always like to revisit the definitions.

"Dividends" are cash payments companies have decided to pay to shareholders.

For instance, a company might pay a $0.50 per share dividend. If the stock trades at $10, then the stock is said to have a 5% dividend yield. This is the $0.50 dividend divided by the $10 stock price.

Many companies have “regular” dividends, meaning they have committed to pay the dividend on a recurring basis. Most do it quarterly.

Many also look to increase that payout every year. The increases may not be significant, but they want to return more capital to shareholders each year.

A select group of companies is out there called the "Dividend Aristocrats."  These companies have increased their dividends for the past 25 consecutive years.

They make up some of the most well-established companies in the stock market and have posted impressive returns over time.

Some companies may also choose to pay “special” dividends.

A company might want to return cash to shareholders but not commit to returning that amount regularly.

We have seen a lot of this recently with the energy stocks. They have seen strong cash flow and want to be disciplined about not investing so much that they create too much supply.

Many have repurchased their stocks but have also decided to pay significant "special dividends.”

These companies understand that their results are subject to commodity prices, which can be unpredictable. A special dividend is a way for them to return capital to shareholders and show capital investment discipline while not letting down shareholders if the environment changes.

While they may not be as consistent as a regular dividend, they are still richly rewarded in their share price by paying out the cash. Sometimes, in particular situations, the payouts can be considerable.

Dividends are an exciting area of shareholder return.

They have some similarities to stock buybacks. If a company has opportunities to invest its capital back into its business and generate high returns, shareholders would prefer them to do so.

Dividends also are potentially not as tax efficient. They are treated as income, and many wealthy shareholders are in the highest tax bracket, so this can result in them paying a high tax rate.

In theory, buybacks are better, but this equation has many parts.

Remember that we often make the point that stocks are not companies. Our view is that owning the stock technically means owning the company's cash flows. However, shareholders very seldom see these cash flows.

Buybacks are a way of flowing them back through in a way, but it is not actual cash back to the shareholders.

Dividends are the exception. They are the one-way shareholders are actually paid for their ownership of the company via the stock.

We could write several issues of HX Daily about dividends and how different strategies (regular, special, high, low but consistent) have performed over time. Still, for today, we will stick with some high-level thoughts.

If a company is generating strong cash flow and has a relatively mature business, dividends make a lot of sense.

We don’t like that tax inefficiency, but we appreciate the capital discipline they may impose on the company.

We also ultimately look at stocks as "products."  The reality is that many buyers of this product like to see consistent and growing payouts.

Taking those payouts and re-investing them in the stock is also a great way to compound growth.

Overall – we think dividends and growing them make a lot of sense for the right businesses.

We will add one note of caution. If a dividend is too high or seems too good to be true, it may not be a good investment.

Some of the best shorts we have had in our career were in the highest dividend-yielding stocks. A very high dividend is often a sign of distress at a company, not strength.

Like share buybacks, it comes down to finding good management who can skillfully use this shareholder capital tool.

Market Wizard’s Wisdom

A Market Wizard to Remember

In our opinion, the most interesting job at the major Wall Street brokerages is what they call the “Market Strategist.”

They are tasked with looking at the overall market and figuring out where it is going…

There are many ways to accomplish this goal, and the diversity of approach is what makes it so interesting. We don’t agree with every approach but there is almost always something to learn.

We have had the luck to interact with many of the well-known strategists over the years including David Kostin (Goldman), Tom Lee (Fundstrat), David Rosenberg (Rosenberg Research) and my dear friend Tobias Levkovich (Citigroup). May he rest in peace.

In the long history of Wall Street, one of the most famous strategists was Merrill Lynch’s Bob Farrell.

After graduating from Columbia University (where he studied under Benjamin Graham), Farrell joined Merrill Lynch after two years in the US Army. He would remain at Merrill for an incredible 45 years!

In 1998, during the height of the Internet Bubble, Farrell published a list of ten “Market Rules to Remember.”

In this week’s HX Weekly, we share that list along with our thoughts.

Enjoy!

1) Markets Return to the Mean

This is true in both the short-term and long-term.

Investors may look at this and think of stock market bubbles and valuations. Traders, though, know this can be true both for overbought AND oversold.

In fact, this concept is the key to our highly successful trading strategy at Signal Trader Pro.

This is true because trends are powerful and persist but can be derailed by human emotions. Once those emotions settle, assets prices return to those strong trends.

2) Excesses are Cyclical

This is true both in economics and stocks.

One of the most powerful insights in the commodity markets is, “High prices solve high prices.”

Markets respond to price signals and – since humans are involved – they almost always overshoot.

3) No "New Era" Exists

The details of every market cycle and speculative period are always different. It was railroads, then electricity, then the Internet and now AI.

The physics of economics and the psychology of humans, though, does NOT change.

This time is NOT different in terms of the shape and eventual outcome.

4) Parabolic Trends End Sharply

Rapidly rising or falling markets last longer than expected but reverse sharply rather than moving sideways.

This is because these steep moves are driven by human emotion and it will eventually exhaust itself.

5) Public Sentiment is Contrary

Investors buy the most at peaks (greed) and the least at troughs (fear). Again, Bob was very keyed into the role of human emotion and psychology in investing.

When your Uber driver tells you he is lining up for the SpaceX IPO, it is time to be cautious.

When your elderly aunt tells you she is selling her Apple in a market sell-off, it is time to be interested in stocks.

6) Emotion Overpowers Strategy

Fear and greed are stronger than long-term investment discipline.

Big moves in stock and asset prices literally trigger a physiological response in our bodies. Most investors don’t understand this fully and when this intellectual pursuit (investing) meets biology, they are unprepared.

Preparing your psychology for investing is as (if not more) important than your analysis.

7) Breadth Dictates Strength

Markets are strongest when rallies are broad-based and weakest when they are reliant on a few, narrow, top-heavy stocks.

It takes a LOT of money to move a large number of stocks. This means the underlying trends driving the market are strong.

It takes much less money to move a few stocks.

While there are often periods of narrow breadth in BULL markets, an extended (and steep) period of narrow breadth can indicate danger.

8) Bear Markets Move in Three Stages

Downturns follow a pattern of a sharp drop, a relief rally, and a long, slow decline.

Did you know that EVERY one of the biggest one-day rallies in the stock market have come during BEAR markets?

Negative stimulus impacts our bodies (and our minds) eight times more than positive stimulus. This means that BEAR markets see heightened emotions and volatility.

9) Beware of Consensus

Our experience has taught us that through time, the broad consensus is right 90% or more of the time.

The problem becomes when consensus becomes universal AND combines with very overbought asset prices. THIS is a true danger sign.

10) Bull Markets are More Fun

Rising markets generate optimism and wealth, making them far more enjoyable than bear markets.

Investing can be fun. Letting yourself enjoy it, while managing your psychology, will make you an even better investor.

We hope that you’ve enjoyed this week’s issue of HX Weekly…

Do you have any thoughts, questions, or feedback? Tell us more in the comment section or at [email protected].