Share buyback binge is going strong, investors beware!

Is there anything wrong with this? Yes, it means that companies are spending more money on “financial engineering” than on capital spending. It certainly does indicate that companies are at a loss on how to improve their top line, which is what will ultimately improve the bottom line. It leads to frequent complaints by analysts about the “quality” of earnings.

It’s a very important point. Apple is part of an elite group I call “buyback monsters,” companies that have been aggressively buying back stock for years. Apple’s shares outstanding topped out in 2013 at roughly 6.6 billion shares. Since then it has been down every year and now stands at 5.2 billion.

That is a reduction of 21 percent in shares outstanding since 2013. What’s that mean? It means all other things being equal, the company’s earnings per share are 21 percent higher than they would have been had it not done the buybacks.

But that’s only since 2013 … there are companies that have been doing this much longer. IBM shares outstanding topped out at 2.3 billion way back in 1995, it’s been going down almost every year since then, and now stands at 939 million shares. Think about that. That’s a 60 percent reduction in shares outstanding in a little more than 20 years.

Same with Exxon Mobil, after the Mobil acquisition in 1999, shares outstanding topped out at just shy of 7 billion in 2000 and have been going almost steadily downhill since. There’s now 4.2 billion shares outstanding, a reduction of 40 percent since 2000.

Here are just a few more buyback monsters:

  • Northrup Grumman: 50 percent since 2003
  • Gap: 55 percent since 2005
  • Bed Bath & Beyond: 50 percent since 2005
  • McDonald’s: 36 percent since 2000
  • Microsoft: 30 percent since 2004
  • Intel: 30 percent since 2001
  • Cisco: 32 percent since 2001

Why are there buybacks at all? They were originally used to support the issuance of stock options. The options increased the share count outstanding, so to keep the countdown the company bought back shares. But as the opportunity for significant top-line growth waned, buybacks to reduce share counts became a separate strategy to prop up earnings growth.

What is my beef with buybacks? Part of management’s compensation packages include stock options. Buying back company shares ensures that their stock options don’t expire worthless.  It not only fools investors that the earnings are growing but it rewards poor management.

Take IBM for example, despite being one of the most aggressive buyback monsters on the Street, you can’t say IBM’s stock price has soared in the last decade. In 2014, the company eased off a bit on its buybacks, and the stock headed south. It headed south because IBM was beset by fundamental growth issues: Its revenues from its old line businesses were shrinking and there was not revenue from emerging  businesses (like Watson and artificial intelligence) replacing it.

The lesson: No amount of financial engineering like buying back shares can replace management’s inability to grow the business.

 

 

Opportunities for option traders on the takeover of Time Warner

Back in late October, I wrote that AT & T had reached an agreement in principle to buy Time Warner for about $85.4 billion, Time Warner shareholders would get a combination of cash and AT & T stock. The total purchase price would be around $107.50 and the whole process could take around a year to complete.

Click here to read “Looking for option trades on the Time Warner takeover by AT&T”

The stock price of Time Warner was trading at around $86.75 at that time which was way below the takeover price. I suggested two option trades with April expiry dates and one that didn’t expiry until Jan 2018. All three trades turned out profitable.

  1. Buy 300 shares of Time Warner at $86.75 and sell 3 April $90 call options for $3.00 each. This reduces the adjusted cost base to $83.75 and I am hoping that these call options will expire worthless.

Results: Time Warner stock was called away at $90.00 in April for a $6.25 profit or 7.46% in 6 months.

  1. Buy 100 shares of Time Warner at $86.75, sell 1 April $90.00 call option for $3.00 and 1 April $85.00 put option for $3.80 reducing the purchase price to $79.95 a share. ($86.73-$3.00-$3.80 = $79.95)

Results: Time Warner stock was called away at $90.00 in April and the put option expired worthless. Profit of $90.00 – $79.95 = $10.05 or 12.5%

  1. Buy 10 Jan $97.50 call options for $3.50 that expire in 2018. If the deal goes through, these options could be sold for $10 each.

Results: Time Warner stock closed at $99.18 on Friday, I still have 8 more months to take profits. I could sell the Jan $97.50 call options for $6.05 on Monday for a profit of $6.05 – $3.50 =$2.55 or 73%

Being a senior, I totally forgot about this post, I have to apologize for not providing an update sooner. However, I repeated option strategy number 2 by buying 500 shares of Time Warner at $97.50, selling 5 May 97.50 call options for $1.95 and 5 May 97.50 puts for $1.45 (which reduced my purchased price to $94.10) and made $3.40 or 3.6% in one month.

Unfortunately, the VIX which is the ticker symbol for the Chicago Board Option Exchange volatility index has been falling. It measures the market’s expectations of 30 day implied volatility. (Referred to as the fear index) A falling VIX means a reduced amount of fear and cheap option premiums.

Despise the lower possibility of profit, I repeated option strategy number 2 and bought 500 shares of Time Warner at $98.96, sold 5 June 30 100 call options for $1.00 and 5 June 98 put options for $1.00 reducing my overall cost to $96.96 per share. I could potentially make $3.04 if TWX is above $100 by June 30th or 3.14.%

A falling VIX tends to widen the bid / ask price spread on most options. It makes it harder to get your order filled. I had to change my limit order a couple of times during the day to get this Time Warner trade completed.

There is always a risk that this deal will not be approved by regulators. However the takeover price gap has narrow from $86.75 / $107.50 in October to $99.18 / 107.50 in June. A good sign that investors believe that this deal will go through.

Disclaimer: This post is for educational purposes only.

A few suggestions on how to invest a $300,000 inheritance

Last week’s post contained a real life Canadian couple’s financial dilemma on how to invest a surprised inheritance. I asked writers and readers of financial blogs to email me their suggestions. This couple is in their mid-fifties and are hoping to retire in 8 to 10 years. They are debt free, have poor paying jobs and only managed to save $55,000 for retirement. Unfortunately, my bullet point list of Canadian tax info wasn’t very clear.

Additional clarification of  the Canadian Tax system

Canadians have three choices for saving for retirement if they don’t have a company pension.

Registered Retirement Saving Plan (RRSP)

  • Contributions are limited to 18% of working income (max. $25,370 investment income not included)
  • Tax deductible, refund based on your tax rate (lowest 20%, highest is 53%)
  • Tax free compounding, withdrawals are 100% taxable at your personal tax rate (lowest 20%, highest is 53%)
  • Government requires you to make withdrawals at age 72
  • Not usually recommended for low income families

Tax free Savings Account (TFSA began in 2009), geared to low income families

  • Personal contributions are limited to $5,500 per year, not tax deductible
  • Unused contributions are carried forward indefinitely
  • Tax free compounding, withdrawals are not taxable
  • No restrictions on withdrawals, money can be taken out and put back in the following year.

Taxable investment account

  • Interest income, foreign interest and foreign dividends are 100% taxable at your current tax rate (lowest 20%, highest is 53%) Plus there is 15% foreign tax withheld. If personal your tax rate 30%, foreign dividends of $100 minus  $30 personal tax – $15 of foreign tax = $65
  • Canadian Dividends have an eligible tax credit that increases the after tax yield. In theory, a Canadian could earn $40,000 in dividends tax free if they had no other income.
  • Capital gains has the lowest tax rate because only 50% of the gain is included in income, so only $50 of a $100 gain would be included. High income earners (53% tax bracket) would only pay 26.5%  in income tax.

I only received two suggestions and didn’t receive any input from any Canadian bloggers or readers.  So, I asked a financial planner who works at one of my local bank branches to weight in.

From the United States, Bear with the Bull offered the following:

I am not sure I am most qualified to be a financial adviser and I really do not know Canadian tax laws. I would think they might want a mix of income, bond, possibly cash, and growth stocks.  For my 401, I have about a 60/40 split of stocks and income/bond allocation. So if they are looking for more cash / income, maybe they would be more comfortable with something more 40/60 instead. 

They probably would look to a portion to be cash or bond fund that could be used to maximize yearly retirement contributions and or have readily available should they need it.  Since the Canadian real-estate market is seemingly doing well, how about investing in some Canadian REITs?  It would have a short term growth opportunity and dividends as well.  ETF’s also seem to be the latest investing vehicle and generally have lower fees than mutual funds.

  • The 40% equities ($120,000) 50% Canada 40% U.S 10% Emerging markets
  • The 60% fix income ($180,000) Perhaps a 1/3 split.  $60,000 Bonds, $60,000 Reits, $60,000 Cash

Realize that this response and $5.00 will get you a good cup of Starbucks so take it for what it is worth.

From Belgian, Amber Tree Leaves offered the following:

Here is a potential solution, as I am not sure to fully understand the Canadian system, I will skip that part.

General comment: As they have not yet accumulated a lot of assets, it might be tough to retire in the next 8-10 years. It is reasonable to expect a severe correction in that period. As it seems that they have little investing experience, it might be better to go for an approach that generates cash from dividend stocks. The assumption here is that it generates higher yields than ETFs. 

  • allocation: 70 % stock and 20 % bonds and 10 % gold.
  • The 70% equities 20% in Canadian dividend stocks, 50% world wide in dividend paying stocks

The gold is there as a hedge against the really bad times. It should be managed in a way that it needs to be sold and converted into stock/bonds when the price rises a lot. Timing this is hard, it is not the goal to get the absolute top.

Bank Financial Planner

First of all, I believe that money has different weights or “gravity” depending on how you acquire it.  Inheritance money seems to have the most weight as often people feel they “owe” a higher degree of care of duty to it and are less likely to deal with it the way they would a lottery win or an insurance settlement.

Obviously, the first thing I would need to do is get a better understanding of their situation and their time horizon and risk tolerances.  Let’s assume they are comfortable with a balanced approach. I would recommend 60% equity/40% fixed income.  ($180,000 in equity and $120,000 in fixed income.)

I would recommend they start by contributing fully to TFSAs, which would account for $102,000 between the two of them.  In the TFSA, I would use a ladder of market linked GICs to give them diversification, security of capital and the potential for higher returns than offered by traditional GICs.  This allows them their only chance to earn interest without paying tax on every penny of it.  It also means there are no fees to pay on almost one third of their investments. 

For the non-registered account, I would recommend a core holding of a growth ETF portfolio ($100,000 with additional positions in our Canadian ($30,000), US ($15,000 and International ETF funds $25,000), with a portion in our US Dollar ETF $15,000) for additional diversification on currency. 

After the initial investment occurred, I would want to have an annual strategy to move the maximum TFSA contribution for each of the clients.  This would involve selling a position of the non-registered investments (unless there are additional savings available) and reinvesting in the same fund inside the TFSA to maintain the balance in the overall account.   This would allow the gradual transition into the TFSA accounts, helping with taxes and probate fees down the road.  A portion of capital gains (or losses) would be triggered each year, smoothing the tax impact on the clients.

I am not sure if this inheritance is big enough to bail out this couple’s retirement plan. A key element is understanding after tax returns when investing.

 

 

 

Three key tips for option traders

Most new option traders start by selling covered calls. It is an income producing strategy where you sell a call option on a stock that you own to collect the option premium. However, the premium comes with an obligation, if the call option you sold is exercised by the buyer, you may be obligated to sell your shares of the underlying stock.

1.  Consider the ex-dividend date

A common mistake to avoid is selling a covered call near the ex-dividend date of a stock that you own. Sometimes investors will come in to buy a stock a few days before the dividend date causing the stock value to briefly go up. This could make it very profitable for the buyer of the call option to force you to sell and collect the dividend payment. Not only do you lose the dividend but your broker’s fee to sell your shares will be much higher than normal.

For example; Royal Dutch Shell (RDS.b) has an ex–dividend of May 17th and pays $0.94 per share every quarter. So if you sold a May 19th call option, your shares could be called away early if the call option is in the money.

2.  Open interest or liquidity

Sometimes there is a wide spread between the bid and ask price of an option based on trading volume or the amount of open interest. The open interest will tell you the total number of option contracts that haven’t been exercised or assigned. Many options on Canadian stocks are illiquid and the bid-ask spread can be really extensive.

For example; Shopify (shop) trades on the Canadian exchange at $128. 14 and $93.58 on the U.S. stock exchange. If you wanted to sell a cash secured put option June 125 strike price the bid is $4.50 and ask is $5.75 but the open interest is zero contracts. However, the June 90 put option on the U.S. exchange has an open interest of 873 contracts and the bid is $3.10 and ask is 3.30 making it much easier to trade.

3. Implied volatility can increase when earnings are released

Implied volatility represents the expected price action of the stock over the life of the option. As expectations change, or as the demand for the option increases, implied volatility will also rise. Earnings expectations can influence the option premiums that expire when companies release their earnings.

For example; Ulta Beauty (ulta) is currently trading around $297.55 and is reporting their earnings on May 25th. See the weekly at the money call and put options below:

Calls Bid Ask Open Interest
May 19 $297.50 $2.45 $2.85 141
May 26 $297.50 $8.90 $10.60 87
June 2  $297.50 $10.30 $11.80 0
June 9  $297.50 $10.80 $12.30 2

 

Puts Bid Ask Open Interest
May 19 $297.50 $2.45 $2.80 99
May 26 $297.50 $8.90 $10.50 13
June 2  $297.50 $10.40 $11.90 1
June 9  $297.50 $10.70 $12.00 0

Without the change in implied volatility  the May 26 calls and puts options bid-ask price would have been in the $4.90 to $5.60 range but earnings expectations have increased the value of these options. Take note of the wider bid-ask spread on the June 9 and 16 call and put options which have little or no open interest contracts.

Before you buy or sell options you should always check for the ex-dividend date and earnings release date. Keep a close eye on the number of open interest contracts, a large bid-ask spread could turn a profitable trade into a loser.

 

Disclaimer: The stocks mentioned in this post are for educational proposes only and not recommendations.

Is Basic Income the answer to a new AI world?

I am so glad that I am a retired senior. I don’t have to worry about a robot taking my job. Since I have lots of time on my hands to think, I wonder what a new AI world would look like. For example; will my 2 year old granddaughter even need to get a driver’s licence? Will the Uber or cab that she orders even come with a driver?

Now I have always been a big fan of science fiction movies. There is a scene in the movie “Logan” where Wolverine has to dodge driver-less trucks to cross the highway to help some people. Installing AI in 16 wheeler trucks could replace the need for a lot of truckers.

Fast food restaurants have been the training ground for teenagers and young adults.  I used to tell my kids that they better get a good education or you will end up using the phrase “would you like fries with that” while working at MacDonald’s. However, even MacDonald’s are installing new self-serve kiosks. Now you can even order your Starbucks coffee using your phone. Where will young people get work experience?

Everywhere I look, jobs are slowing disappearing, the new AI technology seems to have very few limits.

“For example, Australian company Fastbrick Robotics has developed a robot, the Hadrian X, that can lay 1,000 standard bricks in one hour – a task that would take two human bricklayers the better part of a day or longer to complete.”

Japan has the highest percentage of people over the age of 60 and their population is shrinking. As a nation, there is a shortage of workers and they have embraced the use of robots in the work place. This trend could be coming to North America sooner than you think.

As a baby boomer, I worry about the future cost of health care. The world population is aging and health care costs are raising. I hope that science fiction turns into reality and my caregiver looks something like this.

   or this 

Why universal basic income may be necessary

A 2013 study by Oxford University’s Carl Frey and Michael Osborne estimates that 47 percent of U.S. jobs will potentially be replaced by robots and automated technology in the next 10 to 20 years. Those individuals working in transportation, logistics, office management and production are likely to be the first to lose their jobs to robots, according to the report.

For many, basic income sounds like a free ride or welfare. Economist believe that masses of people will not just sit at home but will make a contribution by continuing to work. The basic income would allow recipients to explore other options not available to them if they are struggling just to survive,  such as retraining or to find new job opportunities.

In theory, new opportunities would spring up to replace jobs done by machines. However, there are some practical problems, like where will government get the money if less people are working to pay for a basic income program? The North American education system would require a major overhaul to put more job training skills into the curriculum.

Some additional information to consider

The government of Ontario just announced a three year basic income pilot project to help low income earners in three cities. A single person can apply to receive $16,889 a year and couples will receive $24,027. Recipients who are employed will keep what they made from their jobs but their basic income would be reduced by half their earnings. For example, a single person earning $10,000 per year from a part-time job would receive $11,989 in basic income ($16,989 less 50 per cent of their earned income), for a total income of $21,989.

Is basic income just a pipe dream or a future reality?