The Earnings Mirage

Earnings season is underway, and the path to quick profits (or losses) is right in front of us.

Expectations are high because of tax reform and solid trends in earnings growth. Sales are trending up, and operating profits are on the rebound. Meanwhile, profit margins are high, with Wall Street analysts projecting more of the same.

All this should propel the market higher.

However, there’s a disconnect between the market and the typical company.

Government statistics compiled from all corporations show that not only did profit margins peak years ago, but that the trend has deteriorated further over the last 12 months.

The differences likely come down to one thing that public companies can do that private companies can’t that can make a big impact on its profits.

That one thing? Buying back stock.

When companies buy back stock or pay a dividend, it’s called “shareholder yield.” Returning capital to shareholders is great, right? Possibly, but…

Not all shareholder yield is created equal.

At Hidden Profits, I focus on a version of my forensic accounting stock tracker called “Show Me the Money.”

I overweight the shareholder-yield component while also keeping the earnings-quality factors in the model so that, when I make a stock recommendation to my readers, we can have more confidence that management isn’t pulling the wool over our eyes by returning capital to shareholders.

IBM (NYSE: IBM) is a great example of a company that loaded up with tens of billions in debt to buy back stock and dish out dividends. Meanwhile, revenues were slowing (down quarter after quarter for about five years), and cash flow performance was dismal.

Propping up earnings by buying back stock is not good shareholder yield. While we can simply avoid investing in specific companies that do this, what’s scary is the market as a whole is flashing a huge red flag… marked “shareholder yield.”

Companies are using their tax windfalls to goose the numbers. Financial engineering is reaching new heights. In the past five years, companies have spent $4.9 trillion in mergers and share repurchases. In the first quarter of 2018, that trend actually accelerated, with $305 billion spent on takeovers and buybacks.

This has been going on for a while. When it ends, it will expose the market for what it is: financially engineered without sustainable profits to support stock prices.