In a recent Money and Markets article, I posed the question: “Can the stock market survive an earnings recession?” We may not have the final answer just yet, but third-quarter earnings are pretty much in the books, with the exception of retailers, where the books close in January after all the gift card redemptions. And the results lived down to dismal expectations.
What’s worse, Wall Street analysts are working overtime to slash fourth-quarter profit estimates, too. What has already been a two-quarter profit pullback for S&P 500 companies is about to become a three-quarter earnings slump.
And you can’t simply blame it all on the energy sector this time.
In fact, earnings estimates for financial stocks are now falling at the fastest pace in four years. That’s a troubling sign, because the financial sector has accounted 21% of the S&P 500’s profits so far this year, more than any other sector.
And the financial sector is not alone.
The energy and basic materials sectors have experienced huge profit declines this year, not surprisingly as oil and other commodities plunged in price, but estimates are still coming down dramatically in both sectors.
In addition, since August profit forecasts have fallen by $2.5 billion for the financial sector, $1.75 billion for consumer staples and $1.5 billion for technology sector stocks, according to Bloomberg data, as you can see in the chart above. The conclusion is simple …
The profit decline that started with resource stocks earlier this year is now spreading to multiple sectors of the U.S. economy.
If these estimate cuts prove correct, S&P 500 earnings are on track to decline another 5.6% this quarter, after falling 4% during the third quarter and 2% in the second quarter of this year; a back-to-back-to-back earnings slump.
You can chalk this up to a persistently slow-growing global economy, which seems to be downshifting again over the past few months, but there may be a more sinister reason behind the S&P profit slump; it has everything to do with the cult of stock buybacks.
Maximize shareholder value at any cost
It has become a fashionable strategy in Corporate America to deliver cash back to shareholders — not from organic growth in the business — but via large stock buybacks and dividend increases. I just read an eye-opening and frankly disturbing article about this practice by Reuters, which should be required reading for every investor in America.
In theory, stock buybacks and dividend payments are a great way to directly share-the-wealth with stockholders by delivering immediate returns.
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Since buybacks reduce the number of shares outstanding, they have the effect of boosting stock prices, at least in the short-term.
At the same time, buybacks also boost earnings per share even if the underlying business isn’t growing much, if at all, because the same amount of profit gets spread over fewer shares in the hands of investors.
In practice, Corporate America has spent billions of dollars on buybacks over the past 10 to 15 years, and not always at the best time, when stock prices are cheap, but instead as steady, recurring way to manufacture earnings per share growth out of thin air.
Financial engineering at an extreme
When taken to excess, which Wall Street insists on and Corporate America tends to oblige, this practice amounts to little more than financial engineering. The sinister side-effect to this, as Reuters points out, is to “cannibalize innovation, slow growth, worsen income inequality and harm U.S. competitiveness.”
In fact, many S&P 500 companies have taken this practice to excessive levels, as chronicled by Reuters, by spending far more on stock buybacks and dividends than they earn in net income!
Hewlett-Packard is a classic case in point, as chronicled in the Reuters story. Once an icon of American innovation, this blue-chip has fallen from grace over the past decade and fallen hard, after several ruinous acquisitions (Compaq) and a long succession of CEO changes.
Since 2000, HPQ has spent a whopping $75.5 billion buying back its own shares, and spent another $13.2 billion in dividend payments, for a total of $88.7 billion, meanwhile its cumulative net income over all those years was only $54.4 billion.
In other words, over the past 15 years, HPQ spent 63% more on buybacks and dividends than the company earned in profits! How is that creating long-term shareholder value? And HPQ is by no means alone …
In fact, this seems to be the preferred strategy to boost sagging share prices of old-school technology firms. Over the past 15 years …
International Business Machines (IBM) spent almost as much on share buybacks ($70 billion) as the company earned ($75.8 billion) over the past five years. When you add in $18.9 billion in dividends, IBM’s cash returned to shareholders over that period exceeded profits earned by $13.1 billion!
Cisco Systems (CSCO) spent $94.5 billion on buybacks, but only earned $90.8 billion in profits.
Texas Instruments (TXN), the company (along with HPQ) that invented the personal calculator, spent $31.3 billion on buybacks while earning just $30.3 billion in profits. This math just doesn’t compute!
Corporations are free to spend the money they earn in any way they see fit, of course. And it’s up to attentive shareholders to make certain this money is well spent on productive uses.
But when too much money gets spent on share buybacks, as a cheap and temporary way to boost earnings per share, the long run productivity and competitiveness of the company can be sacrificed.
As Reuters points out, too many companies are “spending on share repurchases at a faster pace than they are investing in long-term growth through research and development and other forms of capital spending.”
I’m not trying to pick on IBM, but Big Blue has spent $125 billion on buybacks since 2005, more than the $111 billion the firm invested in capital spending and R&D during the same period. No wonder IBM keeps reporting negative sales and profit surprises.
And this isn’t just a tech sector problem, plenty of iconic American companies are cutting back on investing in the long run competiveness of their businesses in order to repurchase shares and boost stock prices in the short run.
Drug giant Pfizer Inc. (PFE) for example spent $139 billion on buybacks and dividends in the past decade, compared with just $100 billion invested in R&D and other capital spending.
3M Co. (MMM) spent $48 billion on buybacks and dividends, compared with $30 billion on R&D capital investment.
Lockheed Martin (LMT), once legendary for its “Skunk Works” aircraft innovation that produced the U2 spy plane and more recently the stealth fighter, has been cutting back on R&D due to stock repurchases.
LMTs sales have been flat since 2010, as defense spending gets cut, but that didn’t stop the company from spending $12 billion on buybacks since then.
The cumulative stats on all of Corporate America are alarming, as displayed above. Reuters analysis shows that “spending on buybacks and dividends has surged relative to investment in the business.”
Among 1,900 companies that have repurchased shares since 2010, buybacks and dividends amounted to 113 percent of their total capital spending, compared with just 38 percent in 1990.
In 2015 alone, total share repurchases at the publicly traded companies Reuters examined hit a record $520 billion. When you add in $365 billion in dividends, the total amount of instant gratification doled out to shareholders last year was $885 billion.
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That’s more than the combined net income of these companies, which was only $847 billion.
This is simply not sustainable. The stock buyback cult has gotten so excessive in fact that it’s attracting attention from politicians, which is never a good thing. Several 2016 Presidential hopefuls, including Hillary Clinton, are openly talking about buybacks as a form of stock market “manipulation.”
This raises the specter of heavy-handed government regulation, with all the negative unintended consequences it would surely bring.
That is unless Corporate America is able to police itself. Of course that’s easier said than done for two reasons.
First, corporate executive compensation is almost always tied to per share earnings growth and other financial metrics. And management is ALWAYS under pressure from Wall Street to boost earnings per share by any means possible.
Second, ever since the financial crisis, record low interest rates have provided companies with a dirt-cheap source of financing to boost stock buybacks and increase dividend payments.
It goes without saying that Wall Street is more than happy to oblige, and even cheerlead this process, because they collect hefty fees on both the bonds issued as well as the shares of stock that are bought back with the proceeds, a classic double-dip.
But at some point these financial shenanigans must come to an end. Corporations need to make capital investments in order to organically increase top-line sales growth, and in turn create new jobs.
That’s the only legitimate way to grow the long term value of a business. Without investing in the future, more companies will surely go the way of HWP and IBM as fallen blue chips.
Perhaps Corporate America is already paying the piper for years of artificial earnings stimulus from buybacks. S&P 500 sales have been flat to down for over a year now, and it’s no surprise that profits are now in an extended slump too. Financial engineering can carry you just so far.
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