Don't Buy Into Share Buybacks

Bull Market - A random market movement causing an investor to mistake himself for a financial genius.

– Anonymous

The bull market is over and the days when everyone was an expert are gone. Merely buying a stock and watching it go up day after day is history. “Buy and hope” is dead.

However, that doesn’t mean you can’t make money and get your portfolio back in shape. You can, but you just have to separate fact from fiction. One of the most dangerous myths that could cost you even more money is that share buybacks are good.

You see, the world is not coming to an end. The economy will recover - eventually. A new bubble will form, and greed will replace fear. It always does. The best part is that a few companies will emerge stronger than they were before. The trick is to identify which ones will make the best of a bad situation.

This is a time when great companies increase their market share. The strong get stronger, while the weak disappear.

Companies have to make investments to get stronger. They can refurbish factories, develop new products, or aggressively build a brand while advertising costs have dropped significantly. If a company has a mountain of cash, it should be reinvesting it to take advantage of future growth opportunities, reduce costs, and increase efficiency. Frankly, there’s no better time to do it than now.

That’s why it pains me to see the sharp increase in share buybacks recently. A share buyback, or repurchase, is when a company buys its own shares. It’s a way for companies to reduce the number of shares outstanding. Earnings per share will increase because there are fewer shares to divide profits.

On the surface, it makes sense. Less shares and same profits equal, more profits per share and a higher share price. It seems like they’re doing something good for shareholders. In fact, the markets will usually reward a buyback plan and bid shares up a few percentage points when the plan is announced. But it’s just one of the many stock market myths that are allowed to live on.

Over the past couple of weeks, dozens of companies took “advantage” of the market turmoil to announce share buybacks. In some cases, the buyback programs are reaching well into the billions.

Last month Microsoft (MSFT) set a new record when it announced it would be buying back $40 billion worth of its stock. Following behind it are other cash-heavy companies including Intel (INTC), Nike (NKE), Hewlett-Packard (HPQ), and Oracle (ORCL).

Wall Street viewed all of these buyback announcements positively. It’s considered a sign of strength to be buying back your own shares.

But Wall Street, as it has been so many times before, is dead wrong. Share buybacks are not positive. There are some benefits, but the long-term benefits are limited.

When a company is buying back shares, it is telling the world, “We cannot find anything better to do with our money.”

It’s just that simple. A company that is buying back shares is doing so because it can’t find any better investments to make. Microsoft isn’t launching any more major projects. Intel is not building any new plants. They’re giving up on growth. And when the economy does recover, these companies will not turn out to be any stronger, more efficient, or more profitable.

Two Big Pharma companies provide the perfect example.

Pfizer (PFE) has repurchased more than $19 billion worth of its shares since 2005. Its share price has steadily slid from $28 to under $17 during that time.

Meanwhile, its core business has gone down the tubes. The company’s pipeline of new drugs is very limited, and a few of its key cash cow drugs are set to go “off patent.” This means that generic drug companies will start selling generic versions for much less.

Pfizer’s share buyback has been a big mistake. For $19 billion, it could have bought itself a very strong pipeline of new drugs. A few patent-protected blockbuster drugs would keep the cash flowing in for years to come.

One of Pfizer’s competitors, GlaxoSmithKline (GSK), isn’t taking the same path. Last week, Glaxo announced it would be halting its buyback program.

Andrew Witty, Glaxo’s CEO, explained,

We’re not reserving capital for a rainy day that may or may not come. Opportunities are surfacing with some frequency on the small to medium scale. More of these have surfaced in the last month.

Glaxo is setting up to start making acquisitions while the markets are in turmoil. It’s not buying its own stock for marginal benefit, and it’s not announcing an extended buyback plan just to get a slight uptick in its share price either. Glaxo is taking its cash hoard, and going shopping.

As a result, it will be in a much stronger position when the economy recovers. While the rest of its competitors are buying back their own shares, Glaxo is investing in its future. That’s what I like to see. It’s thinking long-term.

Just imagine if the banks would have thought long-term. Over the past few years, some of the biggest share buyback leaders have been the banks. Bear Stearns, Lehman Brothers (LEHMQ.PK), and Freddie Mac (FRE) all were buying billions of dollars worth of their own shares. If they would have sat on the cash to bolster their balance sheets, they might have had the reserves to save themselves.

Corporations also have a knack for buying their own shares at the worst possible times. S&P 500 companies spent $135 billion on share buybacks in 2003 when the market was bottoming. In 2007, when the Dow was setting new all-time highs, they bought $590 billion worth of their own stock. In fact, between 2000 and 2005 companies which bought back their own shares, only beat the rest of the market by one percent.

Don’t get me wrong, we can learn a lot from buybacks. Just look at ExxonMobil (XOM). The oil giant has been a very aggressive buyer of its stock, and over the past three and a half years, it bought back just over $96 billion worth of its own shares.

If oil really was going to $200 a barrel or more, wouldn’t the world’s largest oil company who employs thousands of true oil industry experts, spend some of that cash on acquiring smaller oil companies which have made new oil discoveries or have large amounts of reserves? Exxon kept its cool throughout the oil boom, and now it’s still in a great position.

That’s exactly what we need to be doing now, keeping our cool and looking at the facts. Share buybacks really don’t tell us much about the long-term prospects of a company or the value of its shares. At Q1 Publishing, we try to avoid many of the myths that can destroy even a conservative portfolio. So if you see one of the companies you’ve held on to announce they’re buying back shares, it’s time to re-evaluate.

Disclosure: None

Comments

[pelican:]

I can't agree with you completely. You could have given examples of companies that have done relatively well and actively buy back shares, such as Philip Morris. Your PFE example is a good one, however, and in the long run the benefits of buybacks are at best mixed. I think it comes down to what the opportunities are. For some companies, buying back shares is better than overpaying for another company. Frankly, I'd like to see cash rich companies raise their dividends more. IMO that's a better way to return shareholder value.

2008 Oct 26 10:12 AM

[Jimmy Lathrop:]

Your article makes a strong case against share buybacks, but the analysis between PFE and GSK is a little apples-and-oranges. We buy actual PFE stock here in the States, as opposed to GSK ADR. Keep in mind that R&D of new drugs has an extremely low recovery rate and it is easier said than done to simply purchase another pipeline of patented drugs. If you balance the risk of investment on testing new drugs, going through regulatory hurdles and the potential lawsuit liability for unintended side effects of drugs, share buybacks may be a more prudent return on cash as opposed to dumping money into the new Vioxx. Finally, when is the right time to buy back your company's stocks - when the price is high or the price is low?

2008 Oct 26 10:16 AM

[WaveNet Pharma:]

The rationale for buybacks is to improve earnings per share (EPS). That goal is only meaningful to the extent that a company can sustain its profitability. In our current environment how many do ?

Even with companies having an unassailable market position with essential products and services, buybacks send 2 signals to shareholders :
a) we have excess cash which we have decided NOT to share directly with you in the form of dividends ( because your BoD knows better than you the shareholder how to use these funds.)
b) we think that of all the uses of cash we can make , buying our own shares is the best approach ( if that is not arrogant and self-centered what is it ?)

The truth is that buybacks are really a protective mechanism to put a floor on a plummeting share price. It seldom does. If that is the case, why do companies do it ? More importantly, because it is paramount to manipulating a stock's price ,why is it legal to do ??

2008 Oct 26 12:12 PM

[icandoitdon:]

this article is spot on. the financial graveyards are full of companies that have squandered capital in this manner. it is the market's job to price securities...not the job of management. well managed companies that perform will have their shares bid up based on that performance. those who base their investment decisions on buybacks do not understand the critical role that capital plays in long terrm performance.

2008 Oct 26 12:19 PM

[Andy Garcia:]

I don't agree with you fully either. You make some good points but what if the company is buying back shares because they know they will come back stronger and with new products, so their share price will increase again? Take intel for example, do you know what they are doing right now? They are investing a large portion in research and development to make electricity flow through the air. Do you know what thats going to do if it gets implemented which i don't see why not in the near future? It could revolutionize the way we use cable, we wouldn't need to plug in anything! A buyback plan right now seems perfectly understandable because they understand that something like this could double, triple or possibly even quadruple their stock. Buying when the market is down seems logical for them and hey did you know? they have a 75% efficiency on it, which means its not far off....

2008 Oct 26 12:25 PM

[stopwhining:]

This article is flawed in many ways. Companies should buy back shares if the ROE on the company shares exceeds the expected ROI of capital spent on growth initiatives. For companies such as MSFT which generate significant ROE, the decision to buy back shares becomes very appealing relative to growth opportunities. The same can be said for certain oil companies - if the expected ROI of developing new finds is lower than the ROE, the smarter choice is to buy back shares.

2008 Oct 26 12:34 PM

[Warm_Paw:]

When there is a mass exodus of investors dumping equities for T-Bills, companies are wise to buy back shares.
It saves the company from financial ruin while it's capital disappears.
Large amounts of capital disappear in one major bear day.
Buybacks prop up that share price.
Using the capital to shop and buy other companies now compounds the amount of capital a business risks losing as long as the flight to treasuries continues.
The sub prime mess is going to get ugly in November and lay dormant until March 2009.
I'm not sure I'd be buying anything right now.
It would be like picking up pennies in front of a steam roller, the gain does not balance the risk.

2008 Oct 26 01:59 PM

[mrresponsible:]

It is one thing if the company's board voteing to buy back stock but what if insiders and employees are purchasing the stock?

Thanks for any comments.

2008 Oct 26 02:58 PM

[Poltrader:]

For sound financials like IBKR buybacks do make a lot of sense. They differentiate them from the rest who have to - but cannot - do the exact opposite - raise new capital.

2008 Oct 26 07:52 PM

[whtkr:]

I disagree in some aspects of this article. First off the point here is that they stocks are at the low points in the 52 week averages or overall in general. Therefore a company is just like any other investor and sees real value in buying the common stock back. At this point the company is then making less stock available to the public which is better for the public and the employees. This also says you know what we believe in our business Model more the John Q public does and good luck picking another stock!!

2008 Oct 26 11:10 PM

[jimmy Turano:]

Maybe there is some validity to your article. But investors still can capitalize on an insider buying $25 million dollars worth of stock too. Case in point, year ago August when an insider bought WYNN at average of $65.00 and 6 months later it hit $118.00. The other side of the coin is, when insiders sell the most shares in a given year like 'MRNA', while it was $18 dollars and today it is $.17 cents. If that wasn't a sign while Research firms were signaling buy recommendations, then you don't belong in the market.
Maybe in late 2009, the stock market may start to show signs of life again.

2008 Oct 27 08:36 AM

[Richard Col...:]

Andrew Mickey:
Most of the comments disagree with you and I also have to disagree with you. If you do your homework and ignore the Cramers and their weak advice then I feel you will make money on the stock market.
My favorites are the gaming stocks. They are quite low and show lots of promise when the market turns around.
Remember Buy low, Sell high.

Dan Kowkabany

2008 Oct 27 11:22 AM

[kurt walter:]

I don't like stock buybacks. I want the dividends. Many companies end up buying at too high a price. They goof it all up. Just pay out more dividends.

2008 Oct 27 06:37 PM

[Humble poster:]

I can't agree with you as i don't think you take all aspects of buybacks into consideration. In a period of declining sales and profit margins, it is not in a company's best interest to deploy its capital in a way that does not exceed its ROIC. This is unprofitable growth. I concede that increasing market share in rough times might help profitability once the macro environment recovers, yet during times of decreasing demand and declining margins, there is no need to spend for the sake of "putting money to work". If NKE earns, historically, 20 to 25% ROE, and in a recession cannot, there is no reason not to repurchase shares or increase its dividend. Repurchasing shares helps to increase that ROE during distressed times.

Take a look at Autozone. This company has a huge share buyback and it is the best way they can generate EPS growth and high ROE, especially with minimal unit growth and same-store sales. Their share buybacks actually increase shareholder value.

2008 Oct 28 11:49 AM

[Diegojames:]

Pfizer is a dismal company with no direction compared to its past-must reveal that I am a pharmacist- Glaxo is on my watch list and I own XOM , but wonder why buy back XOM??? The US Government would never let it be purchased for national security reasons....so it is prudent for XOM to buy energy producing assets or technologies which could be sold at their service stations. I am disappointed in EXXON but it is the only game in town since you cannot buy into the Saudi Royal Family and be given a 747, a Bentley, and a sky scrapper in Dubai and Diamond underwear.
Diegojames
Porter Ranch, California

2008 Oct 29 09:56 AM

[prudentinve...:]

I posted the comment below in response to another article on this website, just a few days ago. It bears repeating, as I believe many shareholders may not have realised how management uses share buy backs to defraud them:

Dividends benefit all shareholders equally, while buybacks disproportionately benefit management who have options.

If you are a CEO of a company with a stock price of $20 and have an option on a million shares at $22. A year later, the stock price has gone up to $23. Your options are now worth $1 each, i.e. $1,000,000. Now the company has $1 per share of surplus cash which can either be paid in dividends or used to buy back, let's say, 10% of the outstanding shares.

If you pay out the $1/share in dividends, all shareholders, you the CEO included, benefit equally, and your take is modest, just the dividend on the shares you already own.

If you buy back 10% of the stock, the price per share for the 90% remaining outstanding share increases by 1/0.9=11%, so your options are now worth 1.11x23 minus the strike price of 22 = $3.53 per option, i.e. $3,530,000 instead of $1,000,000 that they would have been worth if you paid the $1/share as dividend.

Thus, you the CEO, get $3.53 m instead of $1m if you buy back shares, whereas if you paid dividends your extra income per share that you already own will just be as modest as what the other shareholders get.

If company proxies were voted by knowledgeable shareholders, share buy backs would either be disallowed, or any outstanding options should be re-priced upwards to reflect the reduced number of shares outstanding.

The reality, however, is that most shares are voted by mutual fund managers, who are either ignorant of the basic math, or who are members of a "club" that includes the management, so options are not re-priced to adjust for fewer shares outstanding, and share buybacks are used to enrich option holders at the expense of the other shareholders.

2008 Oct 31 12:21 PM