Tag Archives: earnings growth

Buying High and Selling Low

Stock buybacks have occurred at a faster pace this year than last year. According to the Wall Street Journal, “Companies in the S&P 500 increased share repurchases by 29% during the three months through January 2014 compared with a year earlier”. During a stock buyback, a company purchases outstanding shares at current market prices and pays stockholders cash for their shares. The repurchased shares are placed in the company’s treasury stock, which means they are no longer considered outstanding shares. According to the Wall Street Journal, “In theory, buybacks are nearly equivalent to dividends as a way to return cash to shareholders”. Both cash dividends and stock buybacks provide investors with a cash payment based upon the number of shares they own. Cash dividends, which are decided upon by the company, are usually a small fraction of share price. On the contrary, stock buybacks occur at market prices that are determined my market forces. Although investors prefer stock buybacks when stock prices are high, corporations should prefer repurchasing their own stock when it is cheap. However, companies are performing stock buybacks while stock prices are very high – this rewards investors while the company takes unnecessary risk.

Besides returning cash to shareholders, companies have other incentives to conduct stock buybacks. With less shares outstanding, stock buybacks artificially increase earnings per share (EPS). According to the Wall Street Journal, “By reducing shares outstanding, repurchases flatter earnings per share, making stocks look more attractive. During the reporting season that just ended, earnings growth slowed to a crawl and likely would have been negative without buybacks”. A company’s business model should prioritize producing goods and services. A successful business model will exhibit continuous growth in earnings. When organic growth slows, however, companies can propel stock valuations through stock buybacks. Although buybacks can inflate EPS and push up a company’s stock price, it can be a risky strategy that can cause problems in the future.

Despite the bull market and lofty stock prices, companies have been conducting a record amount of stock buybacks. According to the Wall Street Journal, “Buybacks and bull markets are self-reinforcing”. During a bull market, companies feel pressure to keep increasing EPS (and subsequently increasing stock price) and to put all of their cash to use. Unfortunately, spending too much on stock buybacks benefit the short run while causing damage in the long run. According to the Wall Street Journal, “If share repurchases consume too much of companies’ excess profits, the underlying businesses might end up starved, which could lower future returns”. Although companies might wish to perform buybacks and boost EPS in the short run, it can be a waste of cash that would otherwise be spent to increase EPS in the long run. Companies should be careful in how much money they spend on share repurchases, which are not essential to day-to-day business operations. Corporate spending should prioritize other expenditures before stock buybacks.

Ironically, companies would get more bang for their buck if they conducted buybacks when they feel least comfortable (i.e. during bear markets when stock prices are low). According to the Wall Street Journal,

During the previous bull market, buybacks peaked in the same quarter the stock market did. Less than two years later, during the quarter in which tock prices bottomed, companies spent 83% less on buybacks. That is despite the fact they would have gotten far more earnings-boosting effect at those low prices for each dollar spent.

When done at the right time (i.e. when stock prices are low), stock buybacks can be more effective and less risky. In order to time buybacks right, management must be patient and not give into short term temptations. Although it can be tough (or even impossible) to determine the exact value of a stock, companies should be able to tell if their stock price is roughly overvalued or undervalued. Even when stock prices are low and stock buybacks would make  sense, the economic climate and outlook might be more negative causing companies to make conservative decisions. Stock buybacks might be hard to time, but I think it is pretty clear that companies should avoid buying high and selling low.

U.S. Stocks Are Not in a Bubble and Here’s Why (Part 2)

This is a continuation of my previous post about why I do not think the U.S. stock market is nearing another asset bubble. I concluded the previous post with a discussion of the output gap and it’s relation to stock prices. In this post I will talk about two other signs: the Correlation Between the Rise in Stock Prices and the Rise in Corporate Profits, and The EV/EBITDA ratio.

2. Correlation Between the Rise in Stock Prices and the Rise in Corporate Profits

One thing that characterizes practically all asset bubbles is an unjustified surge in stock prices. What I mean by ‘unjustified’ is that people begin to ignore fundamental analysis and start buying up stocks simply because their price is rising, much like what happened during the Tulip-Bulb Craze we read about in Malkiel’s Random Walk Down Wall Street. In contrast, the recent rise in stock price has not been unjustified because stock prices have been rising along with corporate profits:

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This positive trend gives credence to the argument that investors are not simply building ‘Castles In the Air,’ and rather are basing their investments in sound fundamental analysis. Something to watch out for though is the growth rate of corporate profits versus that of stock prices. I would argue that it is somewhat worrisome that the growth rate in profits for the past three years has been smaller than that of stock prices, and could potentially be a sign that the U.S. stock market will be overvalued in the future. For now though, the difference in growth rates is both tolerable and reasonable.

Taking a look at the left side of the graphic above, we also see that the length of the current bull run is just below the average of past bull runs, yet its return has been slightly higher than average. Roughly average returns + a typical duration time further justify the point that the current bull run on U.S. stocks is not forming an asset bubble

3. The EV/EBITDA to VIX ratio

The final part of my argument has to do with a common market indicator- the EV/EBITDA ratio- a tool that gives a measure of US corporate valuations, leverage, and investor complacency by dividing enterprise value (EV) by earnings before interest, taxes, depreciation, and amortization (EBITDA). This ratio is then divided by the stock market volatility index in order to measure investor complacency.

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BlackRock’s 2014 Investment Outlook provides a solid interpretation of the above graph:

The ratio of the [the EV/EBITDA and the volatility index] is the key. High valuations combined with low volatility can make for a lethal mix. This market gauge sounded the alarm well before the financial crisis. Where are we today? Valuations are roughly in line with their two-decade average (and leverage is lower). Yet volatility is hovering just above two-decade lows. The result: The market gauge stands well above its long-term average, 
but is far short of its pre-crisis highs.

The main point the above graph and discussion make is that although we may be seeing early signs of the formation of an asset bubble, it is not expected to form in the imminent future. It also gives further weight to the argument that corporate earnings need to start rising faster if the economy is to avoid a bubble in the future (assuming volatility stays low, a rise in earnings would drive the EV/EBITDA to VIX ratio down).

In summary, I have laid out a three-pronged argument for why I think the U.S. stock market is not experiencing an asset bubble. A wide output gap, a close correlation between earnings growth and stock price growth, and a reasonably small EV/EBITDA ratio tells me that the U.S. economy is not on the cusp of another bubble. Furthermore, I am generally in agreement with Dalio’s claims (mentioned in the first part of this post) when he asserts that we are currently in the reflationary period of the long-term debt cycle. Consequently, I expect the economy to make a full recovery in the next couple of years: QE tapering will continue, interest rates will rise slowly but steadily, and both corporate earnings and incomes growth rates will rise, further dispelling doubts of a possible bubble. With all this in mind though, I think it’s important to keep a close watch on the indicators I discussed throughout these two posts because they provide a good summary of the state of the U.S. stock market.