Saturday, May 19, 2007

Reflexivity and the "Buyout Bubble"

Let me first start out by saying that I read George Soros' book, "The Alchemy of Finance", and found it rather boring and a little difficult to follow. His idea of "reflexivity" is very subtle and very hard to explain. It basically has to do with bubbles, and how bubbles reinforce themselves up to the breaking point. I'll use an example from his book and then try to explain how it applies to the current market.

The following is an excerpt from Soros' book. It details the conglomerate boom of the late 60's and the subsequent bust.

"The key to the conglomerate boom was a prevailing misconception among investors. Investors had come to value growth in per-share earnings and failed to discriminate about the way the earnings growth was accomplished. A few companies learned to produce earnings growth through acquisitions. Once the market started to reward them for their performance, their task became easier because they could offer their own highly priced stock in acquiring other companies.

...conglomerates started out with high intrinsic growth rates that were rewarded by high multiples. They started to acquire more mundane companies, but, as their per-share earnings growth accelerated, the multiples expanded instead of contracting. Their success attracted imitators and later on even the most humdrum companies could attain a high multiple by going on an acquisition spree. Eventually, a company could achieve a high multiple just by promising to put it to good use by making acquisitions.

...The climactic event was the attempt by Saul Steinberg to acquire Chemical Bank: it was fought and defeated by the establishment.

When stock prices began to fall, the decline fed on itself."

This was an example of "reflexivity", a kind of feedback loop. Something gets out of whack but still seems to work. The more out of whack something gets, the more it is rewarded. Everyone else that is not out of whack begins to purposely push themselves out of whack. Finally, something happens that makes it clear that everything is out of whack. It ends with a bust, bear market, recession, or whatever. It's not pretty, but that is my definition of reflexivity. It is not hard to apply it to the dot-com bubble.

So what does this have to do with the market today? Well, for one, the market is being driven by leveraged buy-outs and stock buyback programs. The floats of all of these companies are being shrunk, resulting in an increase their earnings per share. It seems that every week we see another company being acquired, while other companies announce new stock repurchasing plans. So why is this happening? Will it go on forever?

The answer has been out there for a while, and Ken Fisher has been telling people for quite some time. Here is a quote from a recent interview:

"A medium-sized corporation today in America can borrow money at 6% or less. After tax, it's more like 4%. The average company has a price-to-earnings ratio of 15, and that's an earnings yield [earnings divided by share price] of 6.7%. So if a company can borrow money at 4% after tax and buy back stock with 6.7% earnings yield, it picks up 2.7% as free money, and that makes its earnings per share go up immediately."

Ok, that is why companies are being bought. But why are we seeing the stock buybacks? Fisher addressed this in another interview.

For Fisher, the question is determining which company is likely to get taken out by either a private equity buyer or a rival company and invest in those companies. Moreover, companies that feel threatened - either by hostile suitors or hedge fund activists - often respond by conducting share buybacks to raise their value. Either way, the investor wins. "If you can borrow money and buy back your own stock and make your stock go up in this day and age, if you don't do it, someone else is going to do it to you," says Fisher.

Fisher says more CEOs should also be thinking of making game-changing acquisitions, rather than leave them to private equity firms, which buy companies based on their market prospects and often sell them to strategic acquirers in ensuing years anyway. But at the very least, many companies should buy back their shares and jack up their share prices, says Fisher.

Steel Dynamics, he says, "is a great company with a great CEO, Keith Busse," But says Fisher, "Busse doesn't get the notion that he should be borrowing half his market cap and buying back half his stock and bidding it up."

"It's not an irreversible process," said Fisher. If the buyback fails to have the intended effect, companies "can sell their stock back to the market."For Fisher, investors should get while the getting's good, because it isn't going to last forever. "This is going to blow up and be a disaster eventually. Every bull market leads to a bear market."

So finally, what do we look for to spot the top? Simple. If interest rates go up, or stock prices get too high, the free money Fisher talks about will disappear. This will stop the repurchase programs and its "look out below"! Also, keep a look out for that Chemical Bank high-water mark type event that marked the end of the conglomerate boom of the late 60's.

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