The US corporate earnings season is almost half over. Fears that the US S&P 500 would report the first decline in income since 2009 have eased.
One of the key reasons is that operating margins appear to have improved more than anticipated. Many had seemed to exaggerate the impact of the dollar’s appreciation. It is true that many corporations have cited the dollar’s rise as a factor dampening the value of their foreign sales. However, many analysts have confused this with a comprehensive evaluation.
As we have argued, the US does not have an export-oriented model like Germany or China. Instead for numerous reasons outside the scope of this note, the US companies have pursued a direct investment strategy of build and selling abroad. Analysts appear to have under appreciated the savings achieved by affiliates of US companies that manufacturer outside the US, but sell their products to dollar-based customers.
Moreover, as one insightful analyst noted, there is a difference between international exposure and non-dollar exposures. Of the S&P 500 with the greatest foreign exposure, 63% of those that reported beat consensus earnings expectations. About half of the purely domestic companies have beat expectations thus far.
Separately, we note an inversion of the past relationship between corporations and the capital markets. Traditionally corporations were net borrowers from the capital markets. This is no longer an accurate portrayal of the relationship. Between share buybacks and dividends, corporate America has become a net provide of funds. This year the combination of share buyback and dividends may exceed $1 trillion for the first time.
This is not simply a cyclical phenomenon. Share buybacks have been rising for three decades as a share of profits. In 2014, the S&P 500 companies paid out in buybacks and dividends 95% of their profits. This year is on track to surpass 100%.
According to Bloomberg data, last year, US companies bought back about $550 bln worth of stock. This easily surpassed the net money that flowed into US mutual funds and ETFs (~$85 bln). This year, Bloomberg estimates that through February, US companies plunked down more than $100 bln to purchase shares while investors have liquidated some of their US equity holdings.
Buybacks reduce the shares outstanding (though partially offset by the exercise of stock options), and this impacts the earnings per share. The shares of companies that have been more aggressively buying back their own stock have outperformed the less aggressive companies’ stock by around 5% in 2014, according to some estimates. Smaller cap companies have been more rewarded, with those buying back their own shares outperforming by 11%.
According to a Brookings Institute study, IBM spent $116 bln on share buybacks in the 2004-2013 period. This is equivalent to about 92% of Big Blues profits. Apple is another notable example. Between August 2012 and March 2015, Apple has returned $112 bln to shareholders. Yesterday it announced that it would boost its share buyback program by $50 bln (to $140 bln) and increase the dividend by 11% (~$20 bln). Its revenues rose by 27% to $58 bln.
We have argued that the return on the factors of production (land, labor and capital) is a function of supply and demand. The low commodity prices, for example, reflect weaker demand and greater supply. The weak wage growth is a function of slower growth creating few opportunities. Similar the low return to capital (interest rates and profits) are a reflection of the ample supply.
The push back against the argument is that the low interest rates are a function of central bank activity. In particular, QE is understood as depressing the return of capital. While we recognize QE as a factor, we recognize that weak growth and low inflation also play important roles. Traditionally, economists would expect that low interest rates would lower the threshold for investment projects, and in turn boost demand for investment. This does not appear to be happening.
The high payout of profits to shareholders has been embraced by many share activists and other investors. However, it is controversial. Larry Fink of Blackrock is critical. He has argued that returning so much capital to investors is tantamount to “eating one’s own seed corn.”
However one comes down on the issue, it seems indisputable that corporations have more money than profitable investment opportunities, and that in reducing the number of shares outstanding, corporations are boosting per share measures more than organic growth.
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