INSIGHTS
JAN
14
COSTA’S CORNER
Dig a little deeper, things may not be what they seem.
This being the second full week of January, it’s earnings season!
The two-week period where companies release detailed financial reports about how well they did (or didn’t do) in the previous three months. That report also contains what the company thinks about its present business prospects and hopefully, something a little further out.
As my friend, Larry Kudlow has said numerous times, “Profits are the Mother’s milk of stocks” and what we have seen for an unprecedented 10 quarters in a row are rising profits from US companies.
Above everything thing else, this surging profitability has been the catalyst for the record setting bull market.
No one can debate that companies are doing better. Salaries are rising, some companies are spending on expansion and dividends are rising (albeit much slower than you would expect). The latest report from the Federal Government is that even with a lower tax rate, tax revenues are starting to rise.
Look at the stock market; even with the pullback at the end of last year, P/E ratios are rising year to year.
All signs of a strong, vibrant economy except that some of the data is a tad flawed and that’s when you dig a little deeper and see that some of these earnings growth numbers are tied to something that corporate America has been doing for years, corporate repurchases.
Stock buybacks have been around for decades. In the 80’s and 90’s they were used to reward shareholders and fend off unwanted suitors.
Companies figured out that instead of paying higher dividends to their shareholders, they could use free cash flow to buy back shares and the prices of those shares would rise. With less shares to trade they became more valuable and coincidentally, many executive salaries and bonuses were tied to the stock price. Hmmm.
To fend off an unwanted suitor, a company would begin a corporate buyback program thus putting more of their shares in the hands of the company and raising the price overall of the company’s shares making any unwanted bid a bit more expensive. Sometimes it worked sometimes it didn’t but in the end the price of the stock would go up.
My problem with buybacks is pretty simple. If a company uses free cash flow to repurchase shares and ultimately pad their earnings per share, on paper they look good, but they have not built a model that will help them in the long term.
With the Trump tax cuts of 2018 some analysts were saying that this would be a boon for research and development and expansion of US companies. More money in the bank, more to spend.
However, and I will pat myself on the back here, I was on CNBC right after the tax cuts passed and said that I was worried that companies were going to use this new found cash to increase their buybacks.
David Faber agreed with me and he made the very concise point that the ultimate beneficiary would be the executives of these companies because of P/E targets being met. Untimely it would do little to help the economy.
Surprisingly, a few companies came out and said that they were going to use that money to fund education programs to retrain people for the new economy. If I recall correctly, one of those companies announced a 10 million dollar program to retrain former employees and never heard a word about it since. This company quietly increased its corporate repurchases by almost a half billion dollars year to year.
I was right about companies increasing their buybacks and using little of that money to fund expansion, R and D, or even higher wages for their employees.
That’s why I feel that the earnings reports, while important, need to be dissected a little differently. P/E multiples should be ignored altogether.
Year over year numbers should be compared on their own and no additional math should be included.
As with any of my columns, if it’s confusing or you think I didn’t explain my thoughts well enough, contact me. I am writing white papers all the time and would love sharing these in depth commentaries to anyone who wants them.
I continue to stay the course.
50% Stocks
25% Fixed Income
25% Cash
This being the second full week of January, it’s earnings season!
The two-week period where companies release detailed financial reports about how well they did (or didn’t do) in the previous three months. That report also contains what the company thinks about its present business prospects and hopefully, something a little further out.
As my friend, Larry Kudlow has said numerous times, “Profits are the Mother’s milk of stocks” and what we have seen for an unprecedented 10 quarters in a row are rising profits from US companies.
Above everything thing else, this surging profitability has been the catalyst for the record setting bull market.
No one can debate that companies are doing better. Salaries are rising, some companies are spending on expansion and dividends are rising (albeit much slower than you would expect). The latest report from the Federal Government is that even with a lower tax rate, tax revenues are starting to rise.
Look at the stock market; even with the pullback at the end of last year, P/E ratios are rising year to year.
All signs of a strong, vibrant economy except that some of the data is a tad flawed and that’s when you dig a little deeper and see that some of these earnings growth numbers are tied to something that corporate America has been doing for years, corporate repurchases.
Stock buybacks have been around for decades. In the 80’s and 90’s they were used to reward shareholders and fend off unwanted suitors.
Companies figured out that instead of paying higher dividends to their shareholders, they could use free cash flow to buy back shares and the prices of those shares would rise. With less shares to trade they became more valuable and coincidentally, many executive salaries and bonuses were tied to the stock price. Hmmm.
To fend off an unwanted suitor, a company would begin a corporate buyback program thus putting more of their shares in the hands of the company and raising the price overall of the company’s shares making any unwanted bid a bit more expensive. Sometimes it worked sometimes it didn’t but in the end the price of the stock would go up.
My problem with buybacks is pretty simple. If a company uses free cash flow to repurchase shares and ultimately pad their earnings per share, on paper they look good, but they have not built a model that will help them in the long term.
With the Trump tax cuts of 2018 some analysts were saying that this would be a boon for research and development and expansion of US companies. More money in the bank, more to spend.
However, and I will pat myself on the back here, I was on CNBC right after the tax cuts passed and said that I was worried that companies were going to use this new found cash to increase their buybacks.
David Faber agreed with me and he made the very concise point that the ultimate beneficiary would be the executives of these companies because of P/E targets being met. Untimely it would do little to help the economy.
Surprisingly, a few companies came out and said that they were going to use that money to fund education programs to retrain people for the new economy. If I recall correctly, one of those companies announced a 10 million dollar program to retrain former employees and never heard a word about it since. This company quietly increased its corporate repurchases by almost a half billion dollars year to year.
I was right about companies increasing their buybacks and using little of that money to fund expansion, R and D, or even higher wages for their employees.
That’s why I feel that the earnings reports, while important, need to be dissected a little differently. P/E multiples should be ignored altogether.
Year over year numbers should be compared on their own and no additional math should be included.
As with any of my columns, if it’s confusing or you think I didn’t explain my thoughts well enough, contact me. I am writing white papers all the time and would love sharing these in depth commentaries to anyone who wants them.
I continue to stay the course.
50% Stocks
25% Fixed Income
25% Cash