We've sounded like a broken record lately: the global economy is thriving, 2007 will be another good year for stocks, and so on. Well, it's earnings season and once again and the record is spinning the same tune. Now is the time of year where we sift through stacks of financial statements, conference call transcripts, and analysts' analyses to see what corporations did, how well they did it, and how well they intend to do it in the future.
Through all of it one pervasive trend remains intact: earnings are consistently coming in ahead of expectations. (See our past commentaries "Consistently Too Low" and "Ho Hum – Another Stellar Earnings Season"). Have a look for yourself:
Earnings for the S&P 500:
Year Initial Estimate Actual
2004 13% → 20%
2005 11% → 14%
2006 12% → 15%*
2007 9% → ???
(* Note: includes current estimates of 4th quarter results.)
So, why are the actuals coming in consistently higher than what the experts believe? Two reasons. First, analysts have failed to predict the strength of the global economy…predominantly undershooting its growth. This alone would lead operating earnings to be better than expected.
But the second reason is the real kicker: analysts are failing to appreciate the size and scope of the one-time items that are pushing earnings per share much higher. Specifically, analysts are failing to anticipate share buybacks and other uses of cash that add to earnings. We've written at length on this in past commentaries:
- The Age of Conglomerates
- Privatizing Profits
- Not All Destruction is Created Equal
- Even More Destruction
The bottom line is that public corporations today can boost earnings by simply buying their own shares back because the yield on most shares today is greater than the cost of capital. They can also add to earnings by purchasing other companies with high earnings yields with cash or debt, too. These aren't simple one-offs specific to a few companies. It's reflective of optimal behavior by companies within the context of a fundamentally attractive economic situation. Just because so-called "GAAP" accounting rules calls this a "non-recurring item" doesn't mean it's not significant.
It's easy. It's simple. And few forecasters are catching on to it. Until they do, estimates will continue to be consistently too low.