Buybacks are hurting growth

Preliminary Q1 results from S&P Dow Jones Indices show S&P 500 dividends and buybacks continue to exceed reported earnings in the first quarter of the current year.

S&P 500 Buybacks, Dividends & Earnings

While this could be a spill-over of offshore funds repatriated as a result of the 2017 Tax Cuts and Jobs Act, companies have distributed more than they earned since 2014 (Q4). That leaves nothing in reserve for new investment or increases in working capital, both of which are necessary to support growth.

In my last post I highlighted that before-tax corporate profits, adjusted for inflation, are below 2006 levels and declining. Reported earnings for Q1 2019 on the above chart (preliminary results) are only 3.5% higher than the same quarter in 2018. If we strip out inflation, estimated at 2.0%, that leaves only 1.5% real growth.

S&P 500 earnings per share growth for Q1 2019 is marginally better,  at 6.1%, because of stock buybacks.

S&P 500 Earnings per share Growth

But the S&P 500 buyback yield is 3.49% (Source: S&P Dow Jones Indices). On its own, that should boost eps growth by 3.6% (1/[1 – 0.0349] – 1 for the quants). There seems to be 1.0% missing.

S&P 500 Earnings per share Growth

Warren Buffett has pointed this issue out repeatedly for the past 20 years:

“…We will repurchase stock when it falls below a conservative estimate of its intrinsic value. We want to be sure that when we repurchase shares that the remaining shareholders are worth more the moment after we repurchased the shares than they were before.”

If stock is repurchased at above intrinsic value then shareholders will be worse-off. The company receives a poor return on its investment in much the same way as if it had over-paid for an acquisition.

Here is a simple example:

If a company is trading at 100 times earnings and achieving 20% organic earnings growth per year, it is most likely over-priced. Now that company buys back 10% of its own stock (numbers are exaggerated for illustration purposes). Earnings will stay the same but earnings per share (eps) increases by 11.1% (the inverse of 90%).

If the same funds used for the buyback had been invested in a new project with a modest 5% initial return on investment, earnings would have increased 50% (and eps likewise).

The larger the buyback yield, the more that growth is likely to deteriorate — especially when earnings multiples are dangerously high.