How Public Companies Manipulate Their True Value

Here’s a quick tale from the annals of Americana.  My very first entrepreneurial venture was a lemonade stand I set up on a busy street corner in Philadelphia. I must have been about eight.  I handled everything – the preparation of the product, advertising (a crooked sign written in black crayon and nailed to an orange crate) and retail sales.  I offered shameless and unprofitable discounts to thirsty groups of two or more.

I consider this early effort an abject failure. Yes, it was a failure because I hung in there only about a day and a half.  But, more importantly, it was a failure because I learned nothing about the local market for lemonade. Sure, I scored some sales with ten, maybe twelve, people.  But all of these customers were neighbors eager to support the effort of a kid they thought was cute and whose parents they knew. When they laid down their thin dime for a glass of lemonade, I couldn’t even be sure they were thirsty.

I mention my early entrepreneurial disaster by way of introduction to a current problem in the stock market – corporate stock buybacks.  A buyback occurs when a company uses its own money to pay investors the market price for their shares in order to reclaim equivalent portions of ownership.

While the move is certainly strategic and perfectly legal, it ultimately distorts the true value of a public stock.  Companies that buy back stock send a deceptive signal to the marketplace. Just as my childhood sense of the local lemonade market was distorted by well-meaning neighbors, both existing and prospective investors in a public company are left with a skewed sense of a company’s stock if it’s being propped up by a reduced number of outstanding shares. As Fortune sagely points out:

“…All of those stock purchases are making corporate profits look better than they are. Fewer shares make companies’ closely watched per-share earnings go up, or go up more, than actual profits.”

Clearly management would be much wiser if it used its cash to invest directly in the company’s operations or marketing initiatives.

But there’s usually a method to a company’s madness in stock buybacks. When a company reduces its number of outstanding shares, it automatically increases its stock’s earnings-per-share ratio. At this point, a much rosier picture of the company can be presented to future investors (and their stockbrokers).

And here’s another piece of the puzzle. Alert and savvy investors looking for a quick profit will frequently buy a company’s stock just before a scheduled buyback because they’re assured of an automatic increase in its price.

But investor beware! What you perceive as a profit opportunity could turn out to be a ploy for putting money in a CEO’s pocket. If his compensation is linked to a gain in the price of the company’s stock, a modest profit for you on a stock buyback could prove a windfall for him or her.

Now here’s food for thought: Gold is already the best-performing asset of 2016. When you hold physical gold, you don’t have to play the shell game of selling back shares for a quick hit.  You need not be concerned about whether a CEO’s compensation has artificially inflated the value of your investment.  You’ll be holding a time-tested tangible asset that’s subject to no one else’s secret agenda.