December 16, 2013

Earnings inflated

 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 likely 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, firms such as Tim Hortons Inc. and Yahoo! Inc. have been issuing billions of dollars of low-cost debt and using the proceeds to buy back 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 companies.

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.

Overall, the magnitude of financial engineering by corporations has been quite remarkable and something that most, if not all, rational market strategists are only now recognizing. Looking ahead, it wouldn't be surprising to see more of the same as long as the U.S. Federal Reserve under Janet Yellen continues to keep interest rates at or below current levels via quantitative easing.

via- the Star Phoenix