I penned an article recently discussing the many measures that corporations have used in recent years to “beat” Wall Street estimates. Of course, the beating of Wall Street estimates, so adamantly adored by mainstream media, always ignores the fact that estimates are continually reduced so that companies to “beat” them. This is the equivalent of moving the “target to the arrow.”
This “target moving” can be clearly witnessed by the quarterly movement in estimates over time. Dr. Ed Yardeni regularly publishes the trend in earnings estimate revisions over time. From the initial to the final estimates, the overstatement has been roughly 33% on average.
Most importantly, notice that during the two “great bear markets,” starting estimates continued the previous trend of “bullish hopes” that were quickly quenched by “bearish realities.” In other words, Wall Street never saw the coming “bear markets” and led investors to their demise.
With estimates once again being ratcheted down to meet current economic realities, it is not surprising that forward expectations remain extremely optimistic. “Hope” springs eternal.
But, therein lies the problem. If we assume that an investment into the S&P 500 index was made at the beginning of this year, the valuation was 16.26x earnings based on the then estimated earnings of $126.57 for the year. As of June 2015, that valuation rose to 17.20x earnings, a 5.8% increase. The problem is that the valuation rose not because of a substantial increase in the “P,” but due to a decrease in the “E.”
Given the deterioration in the profit picture, by the time the end of 2015 arrives, the valuation of that investment is likely to be even more unattractive.
This brings me to the current problem. It is not just the deterioration in earnings that is concerning, but also the “quality” of those earnings. While there has been a consistent droning of articles and analysis suggesting profit growth is still strong, it is how those “profits” are being achieved that is concerning.
As I suggested above, corporations have been using a variety of measures from cost cutting to accounting manipulations to offset weak revenue growth. This allows them to play the “beat the lowered Wall Street estimate” game where the prize is elevated stock prices to support stock option based compensation plans.
One of the primary measures used to boost bottom line profitability has been “share buybacks.” The reduction of the number of outstanding shares boosts the profits per share calculation.
This aggressive use of this tactic was brought to light recently in a Bloomberg article by Oliver Renick which stated:
“It’s official, using proceeds from debt sales to send cash to stockholders has never been more popular.
Standard & Poor’s 500 Index companies listed buybacks or dividends among the use of proceeds in $58 billion of bond deals in the past three months, the most on record, according to data compiled by Bloomberg and Sundial Capital Research Inc. More than $460 billion in repurchases were announced during the first five months of 2015, on pace to top last year’s record.”
While there is much talk about the end of the “bond bull market,” recent data suggests that this is far from the case. Investors, yield-hungry in a near zero interest rate environment, remain eager buyers of any and all debt issued, even if that debt is “junk rated.”
That debt issuance has led S&P 500 companies to repurchase $2.7 trillion in shares during the last six years. That frenzy to repurchase shares has been a primary support for the second longest “bull market” since the 50’s.
“An S&P 500 index measuring the performance of the top 100 stocks with the most buybacks has added 13 percent in the past year, compared with an 8.3 percent gain in the benchmark index.”
The chart below, courtesy of Goldman Sachs, shows that stock buybacks as a percent of total cash use has reached the highest level since 2007.
Of course, it is not just the overall increase in stock buybacks that is concerning, but the surge in buyback announcements. The rush to market suggests a near “panic” by companies to take advantage of both low rates and investor appetites. The chart below, courtesy of Deutsche Bank, should elicit some concern.
The problem for investors is that inorganic measures to boost profitability, like cost-cutting, wage suppression, layoffs, and stock buybacks, are finite in nature. Eventually, these options are exhausted. There are only so many employees that can be terminated, wages can only be suppressed for so long, and there is a finite number of shares that can ultimately be repurchased from shareholders.
The question that investors need to be asking is what happens when companies inevitabilty reach “the end of road.” Importantly, with the Fed determined to begin hiking interest rates, despite weak economic data, the end may be nearer than most are currently expecting.