What You See Is Not Always What You Get

Adam O'Dell

My parents took the family to a magic show dinner party once when we were kids.

I remember not having a single bite to eat because I was too busy trying to figure out the tricks. I knew the show was based on the magician doing “more than meets the eye.” But I just had to figure out how he was doing it!

That’s the intrigue of magic.

What you see is not always what you get.

And, in a less-entertaining, more-painful way, that’s also true for investing.

Last week I talked about what I’ll call the “Index Mirage.” That’s when a stock market index, like the S&P 500, trends higher… even though a majority of the index’s individual stocks are trending lower.

It’s a mirage – a “magic trick” – because to the investor who simply glances at the index… things look good.

But of course, there’s more than meets the eye once you scratch below the surface.

This mirage has me concernrned because it suggests the stock market isn’t as stable as it looks.

And I worry about individual investors who passively own stocks – because a majority of those shares will already be in a bear market by the time the index signals a warnrning.

But I’m also worried about another mirage – one which has its origins in the boardrooms and C-suite offices of Corporate America.

I’m talking about the “Buyback-EPS” mirage, where CFO-magicians are creating positive earnrnings-per-share growth for a captivated audience… while, below the surface, revenue and net income growth is negative.

We’ve touched on this topic before.

While stock buyback programs aren’t evil in and of themselves – they’re dangerous when they fall into the wrong hands. That’s because a flailing company can mask the degree of deterioration in earnrnings-per-share growth, simply by buying back its stock.

In doing so, they reduce the number of shares outstanding (the denominator in the “earnrnings per share” equation)… and voilà, the darling metric of Wall Street analysts gets an upbeat (but undeserved) lift.

According to recent FactSet and Deutsche Bank reports, the extent of this manipulative magic-trick mirage is intensifying.

For the past four years, stock buybacks have accounted for nearly 25% of earnrnings-per-share (EPS) growth – which has averaged 6.2% annually.

That’s a hefty portion. And it has certainly made Corporate America’s income statement appear stronger than it is.

Now though, it’s gotten much worse than that.

Earnrnings growth has declined each of the last four quarters. This past quarter, earnrnings actually contracted by 1.8%, showing a negative growth rate, with revenue also down a sharp 4%.

Get this though…

Earnrnings-per-share growth was positive last quarter! But only because of buybacks!

That’s right – more than 100% of earnrnings-per-share growth is now being manufactured by CFOs buying back their own stock.

Magically, this maneuver turnrns a negative profitability metric positive… and everyone is happy.

But it doesn’t change the facts. Companies are selling less, and taking in less income. And that can’t be good for the stock market.

Adam O’Dell, CMT

Chief Investment Strategist, Dent Research