In 2019, we wrote about how corporate share repurchases, or “stock buybacks,” had accounted for nearly all buying in the market. A year later, that significant support for asset prices has reversed.
While markets have certainly been on a tear this year, due to massive amounts of Federal Stimulus, it has been an advance solely on valuation expansion. While the decline in 2020 earnings was no surprise given the pandemic, earnings were already declining in 2019. The chart shows this in the return attribution of the S&P 500.
Notably, while investors are willing to “pay more for less” in earnings, revenue growth deteriorated more.
Overpaying for Earnings
Such is not a new phenomenon. Since 2009, sales per share, what happens at the top of the income statement, has cumulatively grown by just 43% through Q3-2020. It is hard to justify bidding up stocks by 400% based on meager revenue growth. So, Wall Street created metrics like “Operating Earnings” to provide justification. The problem with “Operating Earnings” is they are heavily “fudged” to create a more optimistic picture.
“The tricks are well-known: A difficult quarter can be made easier by releasing reserves set aside for a rainy day. Or, recognizing revenues before sales are made. A good quarter is often the time to hide a big “restructuring charge” that would otherwise stand out like a sore thumb.
What is more surprising though is CFOs’ belief these practices leave a significant mark on companies’ reported profits and losses. When asked about the magnitude of the earnings misrepresentation, the study’s respondents said it was around 10% of earnings per share."
The reason companies do this is simple: stock-based compensation. Today, more than ever, corporate executives have a large percentage of their compensation tied to stock performance. A “miss” of Wall Street expectations can lead to a large penalty in the company's stock price.
In a survey conducted with corporate executives, 93% of the respondents pointed to “influence on stock price” and “outside pressure” as the reason for manipulating earnings figures.
A Buyback Boost
The use of stock buybacks has continued to rise in recent years and went off the charts following tax cuts in 2017. As I wrote in early 2018. most thought tax cuts would lead to rising capital investment, higher wages, and economic growth. However, it went where we expected it would. To wit:
“Not surprisingly, our guess that corporations would utilize the benefits of ‘tax cuts’ to boost bottom line earnings rather than increase wages has turned out to be true.
‘In just the first two months of this year companies have already announced over $173 BILLION in stock buybacks. This is ‘financial engineering gone mad’” – Axios:
The heavy use of buybacks turned cumulative revenue growth of 43% into a 276% gain in operating earnings.
To gain a better perspective on the real growth of corporations’ profitability over the last decade, just look at corporate profits after tax. These are the profits reported to the IRS for tax purposes and includes all the write-offs, expenses, and other items. Considering profits didn’t grow from 2014-2019 and then collapsed to 2010 levels in 2020, it is hard to justify current valuations.
However, while retail investors are piling into stocks, the corporate executives are cashing out.
Insiders Cashing Out
One cannot argue the changing dynamics of the market from “passive indexing.” Currently, the new “gold rush” on Wall Street is to issue “exchange-traded funds,” also known as a “product,” to meet retail investor demands. (Also known as “dumb money.”)
As retail investors’ exuberance to take on more risk increases, they push more money into equity-based funds. Currently, we are back to levels seen before the 20% decline in 2018. Importantly, as money flows into these funds, the underlying company stock prices rise.
This all aligns with SentimenTrader’s “Dumb Money” index hitting the highest levels in history.
Therefore, it should be of no surprise that corporate executives, who, as noted, have large exposures to stock-based compensation, are “cashing out.”