Margins Or Buybacks: What’s Really Driving S&P EPS Beats?

While perusing FactSet’s “Thought Leadership” section on Friday I ran across something interesting.

There’s a narrative out there about buybacks that’s been propagated by a variety of outlets over the past 12 or so months that ties ZIRP and share repurchases to equity strength. To be sure, it’s a compelling argument.

Here’s how it goes.

Investors are hurting for yield thanks to seven years of unconventional monetary policy and that’s driven demand for corporate credit, both IG and HY. Companies have taken advantage of a kind of goldilocks situation for corporate debt issuance that pairs strong demand with rock bottom borrowing costs. Here’s a look at the trend in total gross high grade supply:

(Chart: Citi)

Companies, the narrative goes, use the proceeds from debt sales to buy back shares, inflating equity-linked compensation for corporate management teams and, more importantly, artificially boosting the bottom line. It’s financial engineering at its finest; leveraging the balance sheet to manage the optics around earnings and keep the stock price afloat. Further evidence of this dynamic can be observed in beats/misses trends for the bottom versus the top line. This is from FactSet:

“In 2016, US companies have been hurdling EPS targets with relative ease. On average, 68.5% of companies in the SPDR S&P 500 ETF (SPY) have beaten quarterly EPS estimates since 2014. In the prior eight years, however, the percentage of companies in this group averaged 65%. Even when excluding the recessionary quarters from Q1 2008 to Q2 2009, companies averaged only a slightly improved beat rate for EPS (65.8%).

“Revenue expectations, however, have proven to be a harder target. Less than 46% of companies in the SPY ETF beat sales estimates in Q4 2015, with an average of 52.5% beating the Street since 2014. This compares to an average of nearly 57% over the past eight years (again excluding the recessionary periods from Q1 2008 to Q2 2009). In addition, less than half of companies in the fund beat sales estimates for three of the four quarters of 2015 (2015/2C was the exception).”

The implication is clear: companies can engineer beats on the bottom line, but not on the top.

Here’s a look at the trend in S&P buybacks going back two decades:

(Chart: Deutsche Bank)

Clearly, there’s some correlation between debt issuance and corporate buybacks.

But FactSet reminds us that correlation doesn’t always equal causation. Here’s what they have to say about the extent to which share repurchases are driving EPS beats:

“This gulf between companies reporting positive surprises for EPS and sales has widened over time. Within the past 10 years, only the unpredictable recovery year of 2009 featured such a large difference in the two metrics.”

“It might be tempting to explain the divergence in EPS and sales surprises on increased share buyback activity, but the hypothesis doesn’t receive much support from the data. Aggregate share repurchases and buyback participation have stabilized since 2014. In addition, companies missing sales estimates while beating EPS expectations are not more likely to have repurchased shares. One-hundred-sixty-five companies were in this group of the S&P 500 index in Q4 2015. Of those, 124 (75%) also repurchased shares in the quarter. This compares to a representation of 74% in Q4 2007, a period in which the difference in the number of companies beating EPS and sales was effectively nil.”

“Margins, on the other hand, have shown a slow and steady march upward since the recession,” FactSet concludes.

As for Deutsche Bank, they’ve done the math: buybacks have accounted for about a quarter of EPS growth over the past three or so years.

(Chart: Deutsche Bank)

In the final analysis then, it would appear that FactSet may be understating the case. Or at least sugarcoating things.

The question going forward is of course this: what happens to stocks when rising rates make borrowing money less attractive to corporate management teams and the buybacks dry up?

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