News emerged this week that David Einhorn, founder and President of hedge fund Greenlight Capital Inc., has been lobbying General Motors’ (GM) CEO Mary Barra and its board of directors to create a second class of stock in order to unlock shareholder value. His essential complaint is that he has not made much profit on his 13.2 million shares of GM stock. He’s pouting because the stock’s dividend is not “respected by the market.” (I can’t help but conjure up an image of Rodney Dangerfield.)
Mr. Einhorn spells out his plan to create two classes of GM stock in this presentation on his website.
It’s a very attractive and readable presentation; clear, concise. It can easily suck you in and get your head nodding up and down. But there’s something important that Mr. Einhorn fails to mention, so let’s talk about that.
What makes stocks rise? What gives investors capital appreciation?
Clearly, dividends do not deliver capital appreciation. Mr. Einhorn makes that clear in his proposal to create GM Dividend Shares. He plans to specifically isolate the stock’s dividend in a new class of shares, with no expectation of capital gains for those shares. The GM Dividend Shares would trade based on yield, just like a corporate bond or a utility stock.
He refers to the second class of shares as Capital Appreciation Shares. These are supposedly the shares that will magically rise, once investors realize, “Hey, this stock is supposed to go up! I’d better get on board and buy some, and drive the price up!”
It’s hard for me to withhold laughter as I read about his catalyst for price appreciation, which focuses entirely on share repurchases. Yes, when companies buy back stock, there are fewer shares outstanding, thus giving the remaining shares a higher earnings per share (EPS) number. However, it’s well known in investment circles that big, growth-stagnant companies use share repurchases (a.k.a. stock buybacks) as a sleight of hand to push EPS a little bit higher.
“What’s that you say? Sleight of hand??”
Yes, it’s nice that share buybacks help increase EPS a little bit. But let’s circle back to a basic premise of stock investing: over the long-term, stocks go up when company profits rise. Investors gauge the increasing profits via earnings per share, commonly referred to as EPS.
And here’s GM’s essential problem—the elephant in the room, which Mr. Einhorn conveniently fails to point out to shareholders: GM has no prospects for near-term earnings growth. And without earnings growth, there is no logical reason for a growth stock investor to buy a stock with an expectation of capital appreciation.
Let’s stare at this little table that shows earnings expectations and dividend yields on a sampling of famous companies’ stocks.
Earnings per share (EPS)
2016 2017* 2018* Dividend Yield
General Motors (GM) $6.12 $6.02 $6.13 4.3%
Chevron (CVX) $0.94 $4.54 $5.98 4.0%
Mattel (MAT) $1.06 $1.45 $1.71 6.0%
* Wall Street analysts’ consensus earnings estimates
The first thing you’re going to notice is that General Motors has EPS numbers that are not expected to rise in 2017 and 2018; the numbers are stagnant. In comparison, Chevron (CVX) and Mattel (MAT) are each expected to have significant increases in EPS in 2017 and 2018.
Now you might say, “Wait a minute. That comparison’s not fair. Both Chevron and Mattel had down years in 2016, so of course the 2017 and 2018 numbers look favorable in comparison.” Exactly, and that is a main point of my discussion on how EPS correlates to stock price appreciation. The rebound in those companies’ EPS numbers will attract and excite investors, who will buy those stocks, thus driving their share prices upward. There is no such catalyst for General Motors’ stock, and from the look of things, earnings growth is nowhere in sight. So why would an investor purchase David Einhorn’s proposed Capital Appreciation Shares when General Motors is not projected to have any earnings growth at all?
You also might say, “Well Crista, anybody can be a Monday morning quarterback. What did YOU do with General Motors stock?”
I’m glad you asked. I bought GM stock for the Cabot Undervalued Stocks Advisor’s Growth & Income Portfolio in October 2015. At that time, just like with CVX and MAT today, GM was coming off of a big down year in 2014, and expected to have a huge earnings rebound in 2015, with additional EPS growth in 2016. Timing is everything. I bought GM stock, not to blindly own it for 10 or 20 years, but to capitalize on the earnings rebound, which I knew would push the share price up. Then in December 2016, when it became clear that EPS growth was grinding to a halt, I sold the stock, in order to reinvest into another stock that would more likely offer capital appreciation to my subscribers.
My subscribers made 16% total return (capital appreciation plus dividends) on GM in 13.8 months. Not bad for a blue chip stock.
You’ll also notice that both Chevron and Mattel offer big dividend yields, comparable to General Motors, in addition to fantastic EPS growth. So why would anybody choose to buy GM stock when they could buy CVX or MAT? In fact, I could easily name additional famous companies’ stocks that offer both EPS growth and attractive dividend yields.
Mr. Einhorn, the problem at GM is not that investors don’t understand what the company has to offer. The problem is that they clearly do understand what the company is offering, and it’s not compelling them to buy the stock. Investors are not stupid. Sure, there are always rookie investors who buy stock based on the glamour or politics associated with a company’s products or its industry prospects. But the vast majority of investors know that EPS growth is the key to unlocking the shareholder value that you so desperately seek.
Face it, Mr. Einhorn: you bought a huge amount of GM stock without understanding that the prospects for capital appreciation would ebb and flow with EPS growth. Rookie mistake. Perhaps you should join a recovery group with Bill Ackman, the famed hedge fund manager who lost $4,000,000,000 (yes, that’s $4 billion) on a bad investment in Valeant Pharmaceuticals (VRX) – a stock my readers also made money on earlier, but that I then began warning investors about prior to Mr. Ackman’s first purchase of the stock.
David Einhorn: “Hi, my name is David, and I’m a stockaholic.”
Recovery group members: “Hi David!”
There is no place for magical thinking in the stock market. Magical thinking and addictive behavior belong in Las Vegas, where participants understand that they might lose all their money ... and maybe their minds, too. But at least they’re not gambling with other people’s money, as Mr. Einhorn and Mr. Ackman have done so woefully.
On Wall Street, there’s a lot that investors can do to minimize the risk associated with stock investing. Learn more about value investing by subscribing today to my Cabot Undervalued Stocks Advisor newsletter.