Choose Profit Growth Over Buybacks: 4 Picks - Analyst Blog
For everyone who is pondering why the U.S. economy seems to be stuck in second gear, consider this theory:
Rather than investing in new plants, equipment and products, or paying their taxes and giving raises and bonuses to their employees, big corporations have made a habit of squandering their profits — plus bundles of newly borrowed money — to buy back their own shares.
Fed Chair Janet Yellen churns out a rounded plethora of numbers regularly, which analysts attempt to fit into the square of economic growth. Yet, there is one astounding statistic that is curiously nowhere in the data of the mad money printers. Last year, S&P 500 companies have distributed about 95% of their cumulative net income in stock buybacks and dividends — and that includes the massive gains from cost cuts, restructuring and downsizings.
In fact, the frenzied corporate stampede to buy back their own shares has resulted in stock repurchases actually exceeding profits in two quarters of 2014.
The Arithmetic Magic of Buybacks
In this era of short-term-focused activist investors, corporates are under a lot of pressure to boost their bottom line. By reducing the number of outstanding shares, corporates have been able to sustain their earnings per share ("EPS") and prop up their stock prices despite falling sales and operating profits.
The rock-bottom costs of credit have further helped dump trillions of dollars into stocks as CEOs leverage their balance sheet by issuing cheap debt and using that money to buy back their own shares.
However, even when buybacks shrink a company’s float and drive up the stock price, it is tough to argue that buyback is a particularly prudent use of a company’s capital, when compared to capital expenditure, investments and innovation.
In fact, GMO asset allocation manager James Montier discovered that since the 1980s, public corporations have had a net negative equity flow, which means they have actually bought back more equity than they have issued. That said, instead of providing capital to the corporate sector, shareholders are actually extracting it.
Buyback vs. Organic Growth
A persistently easy monetary policy has possibly masked organic economic conditions, leaving corporates unable to gauge the true state of economic growth. Taking advantage of exceptionally easy corporate financing conditions at the expense of reinvesting in organic business growth has become a status quo these days, with companies focusing on maximising short-term shareholder value over investing in the future.
Corporate management teams are giving themselves a pat on the back as this debt/equity arbitrage boosts the bottom line and equity prices. However, it may well be stunting future growth as it redirects funds away from growth-oriented capital projects and crowds out long-term investment.
Dig Deeper into the Books
Admittedly, buybacks and dividends don’t really negate the possibility of companies also investing in capital equipment and innovation. For instance, Apple Inc. AAPL recently announced plans to return $200 billion to shareholders over the next two years, mostly through share repurchases. And yet, Apple is also among the top spenders on research and development as well as equipment and structures.
What investors need to do in these unusual times is to delve into company books and find out whether a company’s growth in EPS has travelled just two short steps from Profit after Tax ("PAT") to the bottom line, or whether it has more stable, supporting metrics higher up in the profit statement.
Our Picks
Here, we have handpicked 4 exceptional stocks that have displayed impressive profitability in these wayward times, and also have promising growth prospects.
We took the assistance of our new style score system, and zeroed in on stocks that have a Growth Style Score of “A” or “B”. Our Growth Style Score condenses all the essential metrics from the company’s financial statements to achieve a true sense of the quality and sustainability of its growth.
Our research shows that stocks with Growth Style Scores of ‘A’ or ‘B’ when combined with Zacks Rank #1 (Strong Buy) or #2 (Buy) offer the best investment opportunities in the growth investing space.
Avago Technologies Limited AVGO makes RF chips for smartphones, optical components for servomotors, and enterprise-level networking equipment. Avago is poised to grow organically as the proliferation of the Internet of Things (IoT) devices takes shape.
The company also leverages accretive acquisitions to boost its growth. After buying LSI Corp and PLX Technology Inc last year, the chipmaker recently inked a deal to acquire Broadcom Corp. BRCM for $37 billion. This latest deal will create a semiconductor titan that will be able to stand shoulder-to-shoulder with industry giants QUALCOMM Inc. QCOM and Intel Corp. INTC.
Avago has achieved a remarkable operating margin of 31.8% over the past 12 months. Further, it boasts a projected EPS growth rate of over 74% this year, dwarfing the industry average of 27.2%. The growth potential of this Zacks Rank #2 company is further underlined by its impressive Growth Style Score of ‘A.’
Additionally, the company has beaten estimates in each of the last four trailing quarters, registering an impressive average surprise of over 19%.
EQT Midstream Partners, LP EQM owns, operates, acquires and develops midstream assets in the Appalachian Basin. The strength of the company’s business is its Equitrans natural gas pipeline and storage system that serves Marcellus Play producers in Pennsylvania and West Virginia.
This midstream stock recorded a massive operating margin of 55.6% in the past 12 months. Further, it has expected earnings growth of 37.7% for the current year, overshadowing the industry average of 18.4%. The growth potential of this Zacks Rank #1 company is further emphasized by its Growth Style Score of ‘B.’
Additionally, the company has beaten estimates in three of the last four trailing quarters and met in one, registering a striking average surprise of over 9%.
Ares Commercial Real Estate Corp. ACRE is a specialty finance company that operates in two segments: Principal Lending and Mortgage Banking. The young REIT is striving to build up its loan portfolio base, and will leverage its new Freddie Mac license to secure new business. Also, the interest rate tightening cycle that is expected to take off soon will be a key catalyst for the company.
Ares Commercial recorded a notable operating margin of 36.4% in the past 12 months. Further, it has expected earnings growth of almost 30% for the current year, dominating the industry average of a negative 0.7%. The growth potential of this Zacks Rank #2 company is further underlined by its impressive Growth Style Score of ‘B.’
Moreover, the company has beaten estimates in three of the last four trailing quarters.
Essent Group Ltd. ESNT provides private mortgage insurance and reinsurance for mortgages secured by residential properties located in the U.S. The company has displayed great operating performance in recent times, and flaunts predictable future earnings stream and stellar credit quality.
The company reported a remarkable operating margin of almost 40% in the past 12 months. Further, it boasts a projected EPS growth rate of over 64% this year, dwarfing the industry average of just 26.3%. The growth potential of this Zacks Rank #2 company is further underlined by its impressive Growth Style Score of ‘B.’
Moreover, the company has beaten estimates in each of the last four trailing quarters, registering a striking average surprise of almost 12%.
Let’s Go Old School
Financial engineering can only take you so far before you need real, tangible growth in a business. So let’s pass over the buyback titans, and get real. The call of the future is to invest in companies that are investing in themselves.
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