Overpaying For Earnings

Such is not a new phenomenon. Since 2009, sales per share, what happens at the top of the income statement, has cumulatively grown by just 43% through Q3-2020. It is hard to justify bidding up stocks by 400% based on meager revenue growth. So, Wall Street created metrics like “Operating Earnings” to provide justification. The problem with “Operating Earnings” is they are heavily “fudged” to create a more optimistic picture.

What do I mean by “fudged?” 

“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day. Or, recognizing revenues before sales are made. A good quarter is often the time to hide a big “restructuring charge” that would otherwise stand out like a sore thumb.

What is more surprising though is CFOs’ belief these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share.“

In a survey conducted with corporate executives, 93% of the respondents pointed to “influence on stock price” and “outside pressure” as the reason for manipulating earnings figures.

A Buyback Boost

The use of stock buybacks has continued to rise in recent years and went off the charts following tax cuts in 2017.

As I wrote in early 2018. most thought tax cuts would lead to rising capital investment, higher wages, and economic growth. However, it went where we expected it would. To wit:

“Not surprisingly, our guess that corporations would utilize the benefits of ‘tax cuts’ to boost bottom line earnings rather than increase wages has turned out to be true.

‘In just the first two months of this year companies have already announced over $173 BILLION in stock buybacks.  This is ‘financial engineering gone mad’” – Axios:

The heavy use of buybacks turned cumulative revenue growth of 43% into a 276% gain in operating earnings. 

However, while retail investors are piling into stocks, the corporate executives are cashing out.

Insiders Cashing Out

One can not argue the changing dynamics of the market from “passive indexing.” Currently, the new “gold rush” on Wall Street is to issue “exchange-traded funds,” also known as a “product,” to meet retail investor demands. (Also known as “dumb money.”)

If the “executives” are cashing out while you are rushing in, maybe ask what they know that you don’t.

Such brings us to the main point of our analysis.

“The misuse, and abuse, of share buybacks to manipulate earnings and reward insiders has become problematic. As John Authers pointed out:

‘For much of the last decade, companies buying their own shares have accounted for all net purchases. The total amount of stock bought back by companies since the 2008 crisis even exceeds the Federal Reserve’s spending on buying bonds over the same period as part of quantitative easing.

Both pushed up asset prices.’

Between the Fed injecting massive amounts of liquidity, and corporations buying back shares, there have been no other real buyers in the market.” 

Hoarding Cash

But here is the crucial point we made last September in that article:

“CEO’s make decisions on how they use their cash. If concerns ouing debt, they are taking advantage of investors’ “irrational exuberance” to sell shares into the market. The outcome is the same. There is less corporate demand underlying the financial markets.

Review the chart above that showed nearly all of the previous equity buying came from corporations. Corporations have now switched by markedly decreasing share buybacks from the 2015-2019 levels. Now they are beginning to increase outstanding shares.

Notably, over the last  20-years, the only two previous periods where corporations were increasing the number of shares outstanding was during the 2000 and 2008 recessions. (Important note: Increasing shares counts reverses the bottom-line EPS boost.)

The Problem Of Debt

Corporations also have another problem.

Over the last several years, debt was the funding source for a large chunk of the share buybacks completed. As Goldman Sachs noted in 2019, an analysis of corporate balance sheets found that dividend and stock buybacks accounted for 103.8% of their free cash flow. Meaning they were paying more out in cash

Review the chart above that showed nearly all of the previous equity buying came from corporations. Corporations have now switched by markedly decreasing share buybacks from the 2015-2019 levels. Now they are beginning to increase outstanding shares.

Notably, over the last  20-years, the only two previous periods

The chart below compares the total amount of corporate debt issued versus the reduction in the number of shares.

The chart below compares the total amount of corporate debt issued versus the reduction in the number of shares.

It shouldn’t be surprising to see that when corporations have previously been “net issuers” of stocks versus “buyers,” asset markets have not performed well.

Such is something Dallas Fed President Robert Kaplan

Such is something Dallas Fed President Robert Kaplan warned about: