US companies are undergoing a transformation so huge it’s ‘nothing short of stunning’

US companies are undergoing a massive shift, from the top down, and it isn’t going to change anytime soon.

The very way companies are approaching their business has shifted, said Mike Thompson of S&P Global Market Intelligence, and it’s changing the companies and the markets.

Thompson argues that due to slower economic growth and mounting pressure from investors, S&P 500 companies have gone on a binge of cost-cutting and short-term engineering that has produced results, but has also shifted how they are being run.

Changing DNA

It starts at the top, said Thompson, who runs S&P GMI’s Investment Advisory Services.

“It’s almost as if activist investors have passed along their DNA to managements,” Thompson told Business Insider.

“If you look at the S&P, the DNA of these CEOs and C-suite operations is more about remaking the company to meet goals and the expectations for the company. If you want to beat off activist investors, you end up becoming one.”

Instead of continuing to invest in the business and focus on growing over time, according to Thompson, managements are trying to undercut possible disruptions by showing constant earnings growth and streamlined companies.

This activist-style, short-term attitude is exactly what Blackrock CEO Larry Fink decried in a letter to all S&P 500 CEOs at the start of 2016. Thompson said that these larger firms are most susceptible due to the nature of their size.

“Revenue growth is predicated on economic growth and innovation,” he said. “We don’t have that sort of economic growth and let’s be honest big companies simply aren’t that innovative. So instead these big companies shift their focus.”

Cutting to the bone

Facing the need to improve performance, said Thompson, companies turned first to what was easiest: cutting costs.

“Companies have cut costs in ways that I have not seen before,” Thompson said. “The extremes companies are going to in order to cut costs are incredible. It’s nothing short of stunning.”

These cuts have come in two simple ways said Thompson.

“Literally, there’s a worksheet for this, ” said Thompson. “Executives go through a worksheet of their companies and identify geographies and layers, and see what could be cut.”

On the one hand, there is layers. This would be cutting out parts of a supply chain that could be streamlined. Or for example, in the case of Wall Street, the automation and juniorization of the banks has allowed costs to stay lower while keeping efficiency around the same.

Net Change In The Number Of Bank Branches

The second type of cuts have come from geographies. Again using a financial example, banks have and continue to shut down physical branches in favour of more digitised banking. You can also shift the companies geographic footprint.

“They continue to skim down the labour costs,” said Thompson. “In the US, for example, you can get material differences between San Francisco and New York versus other, cheaper places around the country.”

This isn’t necessarily a bad thing, said Thompson, efficiency can be helpful. “Companies are figuring out how to provide the same product or service, just differently, for less,” said Thompson.

On the other hand, the cuts have become radically deep.

“Ther’es only so much meat on the bone, you can’t keep cutting like that. At some point you’re going to have to do something different,” he said.

Unprecedented engineering

Now costs cutting can only go so far to provide the sort of performance Thompson told us about. With that avenue nearly played out, they have also resorted to financial engineering.

“With this kind of economy, you’re bound on selling more and you focus then on engineering,” Thomspon said. “And the amount of engineering we’re seeing right now in these companies is simply remarkable.”

Thompson said this engineering higher earnings per share has shown up in the explosion of buybacks, “If you can’t meet the top line number for your earnings, you just buy back shares and shrink the denominator.”

This isn’t just limited to buybacks according to Thompson, large companies are also finding ways to bring down costs to boost the bottom line.

“There’s a trend going on where you see the S&P’s effective tax rate rates decline and decline,” said Thompson. “This tells you that companies are finding ways, whether it’s through shell companies or inversion or something, to pay less.”

This is true, as the effective tax rate for S&P 500 companies is somewhere around 29%, much lower than the statutory rate of 39%, and this number has been on the decline for over 40 years.

Screen Shot 2016 04 08 at 5.02.04 PM

All of these moves — buybacks, shell tax havens, and more — are on a “broad continuum of financial engineering.”

“These companies are saying ‘we’re going to get those numbers no matter how’ and they have done it through cuts and engineering,” Thompson told Business Insider.

Not ending anytime soon

When asked if this is just a passing fad or something more, Thompson was direct.

“I don’t see any change coming to it,” he said. “If you get the economy to suddenly kick up its growth that could take some pressure off, but I don’t imagine that’s going to happen.”

Additionally, he said, because “the current generation in the C-Suite” at many of these companies have been ingrained with the practice for so long, it’s doubtful to end.

NOW WATCH: This 7-minute fitness routine is all you need to get in shape