A Look At How Small Businesses Are Doing

The chart below shows a new tailwind the stock market has going for it now that the earnings recession is over. As you can see from the chart on the top, the green line showing operating earnings has surpassed the combination of dividends and buybacks. This decline in capital returned to shareholders is only because of the decline in buybacks as dividends can’t be cut that easily. Many income investors rely on dividends which is why they are sacrosanct. Often firms highlight their consistency with paying dividends as reason to buy their stock. As you can see from the chart below, buybacks are almost always larger than dividends which means they are more important than dividends. Then you must add in the tax benefits of buybacks which only supports their case as being more important. My point isn’t that buybacks are better than dividends; it’s that buyback changes have a greater effect on shareholders’ returns, so they must be studied.

The capital returned is a lagging indicator as the buyback and dividend plans are announced before they occur. It takes time for the capital returns to respond to changes in earnings. Capital returns are similar to the 12-month moving average of operating earnings. As you can see, it’s a great time to buy stocks when operating earnings are above buybacks + dividends and it’s a time to avoid stocks when the reverse is true. There’s two reasons why the increase in operating earnings above buybacks + dividends is good. First, it means corporations aren’t buying back stock with borrowed money which is an unsustainable practice. The addendum to that is it means buybacks are about to start increasing in the next few quarters if earning are stable.

The most recent quarters are the best part of the trailing 12 months in earnings, making it even easier to maintain this trajectory. The second chart below makes this trend clearer. The capital return to operating earnings ratio in 2016 didn’t reach the levels in 2008 because the earnings collapse caused the increase in 2008, while overzealous buybacks and dividends caused the increase in 2016. The trough likely won’t be as low because the earnings recession ended quicker in 2016 than 2008 as there was no economic recession.

In a previous article, I discussed the NFIB survey report. I didn’t get into all the data it has because it is so rich with information. The chart below is a survey of what small businesses feel is the biggest problem. Not surprisingly, almost no one claimed inflation was a problem. Insurance was a problem in the early 2000s. Big business has never been listed as the top problem by 20% or more respondents. Looking at the more recent results, what I find interesting is that regulations have started to become more problematic after falling for the past few years. Regulations were named as the top problem by 19% of respondents which is the same as 12 months ago. This might be a false indicator of a future change or it may be something more. What this survey doesn’t show is the relative intensity of problems small businesses face. For example, the economy crashing in 2008 made each problem more of a factor. When the economy is strong, problems aren’t amplified. As a side note, I view these challenges businesses face as cyclical. It’s easy to start getting political and blame certain sides for regulation problems, but the fact is regulations go up after recessions and fall after recoveries have been going for a while.

The chart below shows my point as the percent of small businesses seeing higher earnings than lower earnings is relatively positive. The problems businesses face aren’t as bad as they were in 2008. This chart is interesting because the small firms in the S&P 600 small cap index are seeing weakening margins while small businesses are doing relatively well. One possible explanation for this is it may be easy for a small business to not lose money, but difficult for a bigger business (small cap) to improve margins. It’s critical to see how big business may not be effecting firms with only a few employees, but is likely causing the margin declines for the S&P 600 firms.

While some of the conditions small businesses are seeing are different from larger firms, what’s not different is credit conditions. C&I lending is improving and so is loan availability for small businesses. A lot of small businesses lose money, so they need access to credit more than larger firms which can weather the storm. The moment the spigot turns off for credit, these small businesses go bankrupt. This is why it’s critical for credit to keep the wheels of this economy turning. Small businesses created 2/3rds of new jobs since the 1970s, so they sway the labor market. Small businesses often aren’t accounted for in larger surveys which is why this NFIB survey is so insightful.

Small businesses are in tune with junk debt as you can see in the chart below. The chart is very useful as it also shows how the junk bonds are not selling off with government bonds. Once simple explanation for that is the is unwind of the Fed’s balance sheet. It could be a huge issue for junk bonds when the ECB tapers purchases as it is buying corporate bonds. Buying investment grade bonds causes junk bond yields to fall as investors take more risk to get adequate returns.

It’s important to realize that now it may seem obvious to avoid junk bonds at low yields, but there’s pressure for money managers to make returns. They can’t afford to wait for better prices as the next correction may come in 2 years. Most investors claim to be long-term oriented, but practicing it is more difficult. If you can’t afford to underperform the market for 2-3 years, then you aren’t a true long-term investor. Some investors need to have great performances each month as part of their job and others put undue pressure on themselves. In the long-term junk bond yields will see another crash, but timing it is difficult unless you accept the opportunity cost that comes with waiting.

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