Pretend you are an average CEO of an average S&P 500 company. (Don't worry—even average CEOs can make yacht-loads. Capitalism is awesome!) One day, you call your friend Jim—another CEO of a fairly average company. Jim's a nice guy, but no one's mistaking him for Jack Welch. Shockingly, Jim's no longer there! His company's been bought out, and he's at home, updating his Monster.com profile.
What happened? You knew Jim had been struggling with a stagnant stock price for the last few years, but his earnings were decent and he helmed a big company. Who'd takeover a company with a $20 billion market cap? Your company is even bigger—$25 billion—does that mean you're safe?
What happened to Jim was Bob. Bob's another CEO of just an average BBB-rated company, but slightly smarter than your friend. Bob saw Jim's stagnant stock price and decent earnings. He knew he could borrow money at about 6%, which is 4% after tax. Jim's P/E of 14.5 translates to an earnings yield (the inverse of the P/E) of 6.9%—a healthily profitable spread between the Bob's borrowing cost and Jim's earnings yield. Bob knew he could easily borrow, take over Jim's company with the cash, and apply all of Jim's earnings to his own shares. Ergo, Jim's company and its share's are gone.
Even after the borrowing costs, Bob's earnings-per-share got a nice boost and his stock price went up. His shareholders are happy, his board is happy, and Bob's happy. Meanwhile, Bob's share price has risen enough so his earnings yield has dropped, making Bob's company look less attractive as a takeover target to another just-slightly-smarter-than-Bob CEO.
You like your job. You have a big paycheck and you finally got your desk chair adjusted just the way you like it. How do you avoid Jim's fate? You like to think you're just a bit smarter than Bob—how do you keep from being made redundant?
You realize if you don't get your stock price up, Bob or someone else will come along and do it for you. You have an earnings yield of about 6.9% and a low after-tax borrowing cost of 4% too. You can do what Bob did for your own company. You can borrow money to buy back enough of your own shares to boost your earnings-per-share and juice your stock price. Now your shareholders think you're the smartest CEO, and you get to keep your job.
This anecdote represents a very real phenomenon. The market's earnings yield has been above the bond yield long enough for CEOs to begin figuring out how to, cheaply and easily, raise their stock prices—as is evidenced by the record numbers of buybacks and cash-based takeovers recently. CEOs who can't figure it out end up like Jim.
CEOs of publicly traded companies are not the only ones playing the game. Witness the record number and size of private equity deals being transacted. The good news is all this leads to the destruction of stock supply. All else being equal, less supply should mean higher stock prices. Game on.
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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.