On today’s show we’re talking about the dangers of stock market manipulation and why every investor who has exposure to the stock market needs to pay attention .

The performance of the stock market is a phrase that makes no sense. What we’re describing is the aggregate performance of the underlying companies that make up the stock index. 

There are a few things that determine company value. First there are the fundamentals. Is the company generating a profit? Is it growing both revenue and profit? Is it gaining market share?

Then there are technical factors that are influenced by market sentiment? These are the headwinds and tailwinds that have more to do with the buyers and sellers of shares than the underlying companies. We’ll come back to that in a minute.

Finally, there is the financial engineering that manipulates the price per share of a company without changing the fundamental value of the business. In fact, sometimes the management can goose the price of a stock artificially for short term gain while harming the long term health of the business. This is the part that is the most troublesome and we’ve seen happen on a large scale in recent years.

A buyback occurs when a company uses some of its cash to repurchase its own shares. Other choices include investing for growth, acquisitions, paying down debt or paying dividends.

Legalized in 1982 by the Reagan administration, buybacks took off after a 1992 tax bill created incentive for more stock compensation. Now stocks and options making up about two-thirds of executive pay.

In the current low-interest-rate environment, many companies have taken on more debt, whose interest cost can be tax-deductible, to buy back shares whose dividends may be more costly.

Imagine if you have a preferred share that has an interest coupon at 7%, and you can borrow funds at say 5%. You can buy back equity which reduces the number of outstanding shares, and reduce your interest expense. That would be an obvious move for any company to undertake.

Where it gets dangerous is when a company retires common shares that do not pay a dividend and increase the company’s interest expense in order to reduce the number of shares outstanding.

Reducing a company’s float of outstanding shares through a buy-back program increases the earnings per share, creating the illusion that the company is performing better than it really is. The increase in earnings per share can drive bonuses for company executives. Imagine for a moment that executive compensation is tied to earnings per share. In some cases the compensation might be a cash payment, or as increasingly the case, stock options. On the surface that seems like a fair and reasonable method.

Let’s create a fictional example. We’re going to use the company from the Road Runner and Wiley Coyote cartoon. Our company is Acme. The company has an enterprise value of $1B with virtually no debt and the stock is trading at $10. The company is earning $1 per share in earnings. The company executives are given a stock option grant at $10. The company had a hiccup in the past year and isn’t growing. It’s revenue is flat, and earnings are flat.

So the executives decide to go borrow $100 million dollars to buy back 10% of the shares of the company. The interest cost has gone up a bit, so they decide to lay off a few employees to reduce expenses. The impact of the layoffs is on projects that would deliver revenue in 3-4 years, so the immediate impact to revenue is zero. It’s merely a cost saving.

With fewer shares in circulation, the earnings per share has increased by 10%. All other things being equal, the shares are now worth $11. The company executives are now sitting on $1 worth of profit on their stock options.