Mirror, mirror, on the wall: The markets look so beautiful, is there anything to worry about at all?
Everything is great! Just look at how none of your earnings per share fall!
This week I’ve been trying to figure out why corporate buybacks always make me think of the old adage about looks being deceiving. Perhaps it’s because buybacks only make a company look profitable while diluting your stake beneath the surface. Although you may see an increase in reported earnings per share, profits aren’t moving an inch.
When actual dividends are paid, that means the company is doing something other than opening up its wallet and rebuying shares. (Like, you know, manufacturing products or developing disruptive technologies. The stuff that really keeps our economy afloat.)
But on Wall Street today, it seems corporate buybacks are the new dividends. Don’t believe me? Just ask any of the 500 largest public companies in America. In 2018, they plan to distribute $600 billion via stock buybacks, potentially setting a new record. It’s so extreme that the largest share of U.S. equity demand in 2018 will be—you guessed it—the buyback of common stocks.
Since December, companies including Apple, Visa, Mastercard, Boeing, PepsiCo and eBay have all announced buybacks, and that trend is expected to continue into the first quarter, which is already looking strong. Thomson Reuters analysts predict that S&P 500 companies’ profits will be 18.6% higher in the first quarter of 2018 than they were in 2017, which would be the most substantial increase since 2011.
This means that a lot of uninformed investors are going to be really happy with what’s reflected in their portfolios this year—at least on paper. Those of us who know that beauty isn’t only skin deep should probe a little deeper to see what’s really going on.
What’s actually happening in a buyback?
Let’s try a simple example: If a company has 100 shares and makes $100 in profit for 2018, then the company’s earnings per share will be $1. Then in 2019, let’s say the company makes another $100 in profit, but it also buys back 20 shares, leaving only 80 shares on the market. This means that the company’s earnings per share will be reflected as $1.25, despite the company’s profits remaining totally stagnant.
Additionally, the shareholders who remain will see their stake in the company diluted. If you can’t quite wrap your head around what’s happening here, it’s nothing to be ashamed of. The entire mechanism is a bit like something out of the upside-down: Most investors know they should never buy high, but with corporate buybacks (which usually occur during a bull market), that’s exactly what’s happening— all in an effort to increase a company’s earnings pattern.
kay, so what do I do from here?
The next time you see a company posting high earnings per share, take a closer look at where those gains are coming from. Are you getting a real dividend that shows the company is hard at work, or are you getting a short-term reward that feels good? The words “corporate repurchases” in a quarterly or annual report doesn’t necessarily mean the company is slacking—a buyback could be part of a broader company strategy during a time in which substantial profits are earned. But if corporate repurchases are all you see, with no gains indicated elsewhere, that could be a red flag.
There’s no doubt that today’s market is great—many companies nationwide have benefited from the recent corporate tax cut and historically low borrowing costs, and confidence is high. But when the markets are at their peak, it may be a good time to get conservative, or, in some cases, get out. Buybacks are often a sign that the markets (and investors) are overconfident.
The worst thing that can happen to an investor is to wake up a couple of years after a peak and realize that while they’ve been getting more from their investments all along, they haven’t been spending real earnings—they’ve blown their whole principal.
Hopefully, this year’s buybacks can put investors of all stripes on a path to becoming a more informed market player. It’s a good idea to go over your portfolio several times a year, whether you’re keeping an eye out for EPS deceptions or just trying to get a feel for a new CEO’s strategy. When it’s your financial future hanging in the balance, those balance sheets are always worth a closer look.