Saturday, May 05, 2007

Keep Earnings Surprise In Perspective

As noted in a prior post, S&P 500 companies have spent large amounts of corporate cash on share repurchases. Some of this cash has been obtained through an increase in corporate borrowings. As noted in a recent article from, General Cable, Developers Diversified, Cypress Semiconductor and Celanese, have raised money in the debt markets at the same time as announcing share repurchases.

John Hussman, Ph.D. of the Hussman Funds, recently noted that earnings surprises are partly being supported by corporate share repurchases. The surprises may be a result of securities analyst not adjusting earnings estimates for these share repurchase programs.
It is wrong to hail an increase in per-share earnings as if it is an “earnings surprise” – as if it reflects an improvement in corporate operating conditions, when it is in fact an expenditure of existing earnings on shares instead of on business investments. When such repurchases are done at rich valuations, they are a signal that the company lacks other productive business opportunities and is instead propping up per-share earnings by disposing of what it does earn.

Why haven't investors figured this out? The story constantly repeated on CNBC is that companies low-balled their earnings guidance in order to surprise investors with better than expected earnings (with the implication that the market will rise forever because companies can continue to do this indefinitely). A good part of the true story is that analysts made their forecasts of per-share earnings based on old, higher share counts, so the juiced per-share figures resulting from repurchases are now showing up as “earnings surprises.”
Hussman points to a Bloomberg report that notes the average surprise on operating earnings per-share has been 9.66%. On a dollar basis the surprise has been 5.85%. If one looks at the median operating earnings per share surprise, it has been 2.94% and on a dollar basis only 1.93%.

Given the recent uninterrupted advance in the market, an investor may wish to look at potentially less volatile high quality equities as a foundation for their equity portfolio. As the investor reviews equity purchases, they should take into account the impact of share repurchases when reviewing per share figures.

Double Counting
Hussman Funds
By: John P. Hussman, Ph.D.
April 30, 2007

Borrow from Peter, Buy Back from Paul
By: Stephen Taub
March 2, 2007

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