Companies keep using this trick to make their earnings look better

Second-quarter earnings season is almost over.

A look back to the first and second quarters shows that companies continued to use the financial engineering required to sustain earnings-per-share beats, through buybacks.

"US earnings continue to be helped by buybacks," Jefferies' Sean Darby wrote in a client note on Tuesday.

"On reflection 1Q earnings were not only poor but were exaggerated by huge share buybacks. The second highest ever quarterly buyback (around US$167bn) meaningfully contributed to EPS even though the overall number was poor."

The scoreboard for the second quarter looks above-average. Of the more than 3,000 companies that have reported earnings, 63% has beaten analysts' expectations by about 5% on average, according to Darby.

That's up from the first quarter.

In recent years, buybacks - or share repurchases - have grown in popularity as a way for companies to try and mask any underlying weakness in performance. When a company buys its stock, it reduces the number of shares outstanding. This lowers the denominator in the equation that divides net income with the tally of shares to derive EPS.

And so, the cycle is something like: a company buys back shares, then crushes earnings expectations, then investors buy the stock and its price surges on. Rinse and repeat the following quarter.

This is not the only reason why companies buy their shares. Another main reason is that they believe the stock is undervalued, based on their expectations for future performance.

An analysis by HSBC showed that buybacks have been the biggest source of demand for stocks since 2009.

So how can earnings grow for real, again?

Darby wrote that as the inventory overhang is slowly been worn down at the expense of current production, and energy prices settle somewhere between $40 and $50 per barrel, there's some room for optimism.

Also, Pavilion Corp. noted that the US is pricing in greater long-term growth than its peers.

"The spread between implied US earnings growth and the rest of the world is especially high currently," the firm wrote in a strategy note on Tuesday. "It seems normal to us that this spread should be positive, as the US equity market contains a more important new tech" component and has more of an intrinsic Growth bias relative to Europe or Japan."