Corporate profits might not be as good as they appear. The reason: stock buybacks.
For the uninitiated, stock buybacks are when companies use their cash to buy shares of their own company. Investors like buybacks because it returns cash to shareholders and potentially boosts the value of their stock by reducing the number outstanding shares in a company. But buybacks have been criticized recently. Corporations are spending more money than they have before on buybacks and that has many thinking the economy would be better off if firms used their cash for seemingly more productive things, like reinvesting in their businesses.
Another concern is that all of those stock purchases are making corporate profits look better than they are. Fewer shares make companies' closely watched per-share earnings go up, or go up more, than actual profits. So, earlier this week, a group of analysts at Deutsche Bank, led by the firm's strategist David Bianco, put out a report detailing just how much recent corporate profit growth is a result of the financial engineering of buybacks, versus actual growth.
The Deutsche Bank analysts say that look at pure earnings growth—that is, when you ignore buybacks and one-time charges and other adjustments—and the profits from companies in the S&P 500 are basically flat this year. Factor in buybacks and per-share earnings are magically up 1.4% this year, meaning that all of the per-share earnings growth in the first three quarters of the year came from buybacks.
At the same time, it's not like this is all that different from recent earnings history. Since 2012, corporate per-share profits have increased by an average of 6.2% a year, of which about 1.4 percentage points have come from share buybacks. Same as this year. Deutsche's analysts expect the companies in the S&P 500 to collectively have per-share earnings of just over $119 in 2015. Only about $1.66 of that is coming from buybacks.
And buybacks might not even be the biggest earnings distorter. Add one-time charges and the other items companies cite when they adjust their earnings and corporate profits among the S&P 500 would be down more than 10% this year, according to S&P Dow Jones Indices analyst Howard Silverblatt.
Silverblatt thinks the Deutsche analysts didn't go back far enough in their analysis. According to S&P data, on average, 20% of the companies in the S&P 500 have lowered their share count by 4% in each of the past seven quarters. (Quarter by quarter, it's not always the same group of companies.) Silverblatt says that share reduction right now is much more prevalent than in other times when buybacks have peaked. As a result, he think buybacks are meaningfully boosting per-share earnings growth and, potentially, the price of a company's stock.
Buybacks increase the value of a company's shares. But the problem is that, unlike real earnings, buybacks, at least at the current level, may not be sustainable. An investigation published by Reuters this week found that companies in the S&P 500 are expected to spend more on buybacks and dividends than their total earnings. It will be the second year in a row that buybacks and dividends will outpace profits. Low interest rates have made borrowing to do buybacks possible. But that's beginning to change.
Already, buybacks seem to be slipping. In the third quarter, buybacks contributed just 1.2 percentage points to per-share earnings within the S&P 500. Next year, Deutsche analysts expect the earnings bump from buybacks to be even smaller. Detractors have long argued that buybacks are bad for the economy because they divert cash from more productive uses. Investors might soon regret the buyback binge as well.