US companies are using a simple trick to look better on paper…
According to Bloomberg Business, companies in the S&P 500 are on track to buy back nearly $1 trillion worth of their own stock this year. This would be an all-time record.
A share buyback is when a company buys its own stock from investors. This reduces the number of shares on the market, which increases the company’s earnings-per-share (EPS). It’s a way for management to goose EPS numbers without actually improving the business.
It’s simple math. Say a company earned $10 billion last year and has 10 billion outstanding shares. It’s EPS is $1.
Then the company buys back 1 billion of its own shares…
The company still has $10 billion in earnings. But now it only has 9 billion shares in the market. This makes its EPS jump to $1.11.
The most important thing to understand about share buybacks is they only increase a company’s earnings-per-share…not its actual earnings.
Bloomberg Business explains how US companies have used buybacks to boost EPS.
The impact of buybacks was harder to see in the first three years of the bull market, when ballooning profit margins helped companies in the Standard & Poor’s 500-stock index almost double their earnings. Now that margin growth has flattened out, buybacks’ contribution is more significant. Companies in the S&P 500 bought more than $550 billion of their own stock last year, boosting EPS growth by 2.3 percentage points, according to data compiled by Bloomberg.
• Share buybacks can be a good thing…
If a company’s shares are cheap or fairly priced, a buyback can be a smart way for management to spend money. When a company buys back undervalued shares, the shares left on the market become more valuable. And that benefits shareholders.
Plus, sometimes CEOs have selfish reasons for doing buybacks. Bonuses are often tied to EPS numbers. So buybacks can be a quick way for management to give itself a raise.
• And sometimes CEOs just don’t have a better way to spend the money…
CEOs are timid about spending money during times of economic uncertainty. They don’t want to spend on big projects if a recession is coming. Giving money back to shareholders with a share buyback is less risky.
Like any spending decision, buybacks are about opportunity cost. Every dollar a company spends on buybacks is a dollar it isn’t investing in the company’s future.
Bloomberg Business explains:
Investing in people, facilities, and research arguably could have a much bigger long-term impact on a company’s bottom line—not to mention the entire economy—than a company taking advantage of low interest rates to borrow money to buy its own stock.
• Zero interest rates are a huge driving force behind buybacks…
Regular Casey readers know that the Fed effectively cut rates to zero to fight the financial crisis. It has left rates at effectively zero ever since.
Interest rate cuts are the government’s go-to weapon to fight economic downturns. However, leaving rates at zero for 7 years, as the Fed has done, is not normal. It’s an extreme act that’s unprecedented in modern history.
Interest rates aren’t just some number for the government to tinker with. Interest rates are the price of money.
And when the government messes with the price of money, it warps the price of everything else.
Zero interest rates have made it extremely cheap for US companies to borrow money. And a lot of them are using this cheap money to buy back their own shares.
Many of the world’s greatest investors have warned about this recently...
Laurence Fink is the CEO of (BLK), the biggest money management firm in the world. Fink recently wrote in a letter:
With interest rates approaching zero, returning excessive amounts of capital to investors—who will enjoy comparatively meager benefits from it in this environment—sends a discouraging message about a company’s ability to use its resources wisely and develop a coherent plan to create value over the long term.
And here’s Jeremy Grantham, founder of the global investment firm GMO:
And what of the current Fed regime – the Greenspan-Bernanke-Yellen Regime – that promotes higher asset prices and lower borrowing costs, which facilitate stock buybacks amongst other speculative forces?
Grantham goes on to explain that the Fed’s zero interest rate experiment will eventually fail…
Painfully, politicians, the public, businessmen, and possibly even some economists will recognize the current regime as a failed experiment.
• Buybacks are a big reason why US stocks are in one of their biggest bull markets of all time…
International Business Times explains that US companies have spent more than $2 trillion on buybacks since 2009:
…it may surprise ordinary savers that stock-market gains stem more from companies gobbling up their own shares
than from fundamental economic activity...
Since 2009, companies have bought up an average 2.5 percent of their market capitalization -- that is, the total value of their outstanding stock. In that time, corporations have spent at least $2.4 trillion repurchasing shares, the largest buyback binge since the market last peaked in 2007.
• With so much “financial alchemy” going on in the US stock market…
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Chart of the Day
The US stock market is on the verge of a “revenue recession.”
The chart below shows the yearly sales-per-share growth rate for companies in the S&P 500. Revenues declined 2.4% during the first three months of 2015.
We’re still waiting on full second quarter results…but so far it doesn’t look pretty.
In early August, Charlie Biello of Pension Partners analyzed
the 80% of companies in the S&P 500 that had already reported earnings. He found that S&P 500 sales were on pace to drop 3.1% from the second quarter of 2015.
As you can see, revenue growth is now negative for the first time since 2008.