November 25, 2013

Stocks are richer than most investors think

There is clearly a lot of momentum in the equity markets as proven last week by the Dow Jones soaring to an all-time high of 16,000 in one of its swiftest 1,000-point moves in nearly two decades.

Doug Kass, president of Seabreeze Partners Management Inc., in a recent Real Money article argues the current P/E multiple would be a lot higher if you applied a normalized profit margin on the revenues of S&P 500 companies.

Mr. Kass points out earnings are also inflated due to unsustainable low corporate tax rates. As politicians in Washington begin taking a hard look at the U.S. deficit, it is very likely that tax rates will trend higher, thereby taking a bite out of corporate profits.

Another factor that has contributed to record corporate profit margin growth is ultra-low interest rates. They have boosted corporate profits in the U.K. and the U.S. by 5% in 2012 alone, according to a new report from the McKinsey Global Institute.

More importantly, companies such as Tim Hortons Inc., Johnson Controls Inc. and Yahoo Inc. have been issuing billions of dollars of low-cost debt and using the proceeds to buy back their stocks. Companies can inflate earnings per share by reducing their share counts and either taking on more debt or using their excess cash rather than reinvesting it in their company.

More than 80% of S&P 500 companies are currently buying back shares, and they are doing it at twice the pace seen in the 1990s, according to a recent Goldman Sachs report. In total, buybacks are now up 40% on a trailing four-quarter basis and are expected to expand by an incremental 10% in 2014 given that cash balances are currently over US$1-trillion.