Tag Archives: corporate profits

Corporate Profits Are Worse Than You Think – Addendum

We recently published Corporate Profits Are Worse Than You Think to expose stock prices that have surged well beyond levels that are justified by corporate profits. 

A topic not raised in the article, but a frequent theme of ours, is the role that share buybacks have played in this bull market. Corporations have not only been the largest buyer of stocks over the last few years, but share buybacks result in misleading earnings per share data, which warp valuations and makes stocks look cheaper. Over the last five years, corporations have been heavily leaning on the issuance of corporate debt to facilitate share buybacks. In doing so, earnings per share appear to sustain a healthy upward trajectory, but only because the denominator of the ratio (number of shares) is being reduced as debt on the balance sheet rises. This corporate shell game is one of the most obvious and egregious manifestations of imprudent Federal Reserve policies of the past decade.

Given the importance of debt to share buybacks, we provide two graphs below which question the sustainability of this practice.

The first graph below compares the growth of corporate debt and corporate profits since the early 1950s. The growing divergence, especially as of late, is a clear warning that debt is not being used for productive purposes. If it were, profits would be rising in a manner commensurate or even greater than the debt curve. The unproductive nature of corporate debt is also seen in the rising ratio of corporate debt to GDP, which now stands at all-time highs. Too much debt is being used for buybacks that curtail capital investment, innovation, productivity, and ultimately profits.  

Data Courtesy St. Louis Federal Reserve

The next graph uses the same data but presents the growth rates of profits and debt since 2015. Keep in mind the bump up in corporate profits in 2018 was largely due to tax legislation.

Data Courtesy St. Louis Federal Reserve

Lastly, we present a favorite chart of ours showing how the universe of corporate debt has migrated towards the lower end of the investment-grade bucket. Many investment-grade companies (AAA – BBB-) are issuing debt until they reach the risk of a credit downgrade to junk status (BB+ or lower). We believe many companies are now limited in their use of debt for fear of downgrades, which will naturally restrict their further ability to conduct buybacks. For more on this graph, please read The Corporate Maginot Line.

Hint For Stock Investors: Margins Matter

Sooner or later, stock prices are related to corporate profits. Anything can push stock prices around in a day, month, or year. But a stock or an ownership unit of a business ultimately has to do with how profitable that business is. When you buy a stock, you’re buying an interest in a company’s future profits, pure and simple.

Since around 2000, corporate profits as a percentage of GDP have been stellar. Accordingly, stocks have traded at prices relative to underlying earnings that can only be justified if profits will be permanently higher than they were prior to 2000. Will they be? Justin Lahart of the Wall Street Journal said no over the weekend. And that could mean bad news for stock investors.

For the first time in over two years corporate profit margins are falling, according to Lahart. Nobody knows if that’s a permanent trend, but Lahart argues that margins rose so much in the first place because of a lower share of revenues going to labor, increased global trade, lower taxes, and gains in market share.

All of these factors seem to be at risk now. Concerns about inequality might make squeezing workers further difficult politically. A trade war may change how we conduct commerce with China. And big companies with high market share that set prices and have little competition for labor are on the defensive.

Lahart’s article had three excellent charts — one showing increased net profit margin since 2010  for S&P 500 constituents (from around 8% to nearly 12.5% last year), another showing decreased employee compensation as a share of GDP since 1970 (from 58% to 53%), and the last showing decreased corporate taxes since 1975 (from more than 35% to less than 15%).

Here’s another one we constructed with data from the St.Louis Fed’s website, showing corporate profits as a percentage of GDP since 1947. The average from 1947 to 2000 was a little more than 6%, but the average since 2000 is nearly 9%.

If profit margins decline, Lahart is correct about that being bad news over the longer term for stock investors. That doesn’t mean nobody should invest in stocks. But it means investors should moderate their return expectations.

For more on the intersection of profit margins, valuations and return expectations we suggest reading our article : DIY Market Forecast.