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Introduction

Companies that buy back stock do so for different reasons with varying success. However there should be only one reason for companies to buy back their own shares: to create shareholder value. Like investors, companies buying back their own stock must heed the most essential axiom of investing: buy low and sell high. Unfortunately, like most investors who pathologically buy high and sell low, companies engaged in repurchasing their own stock often buy high. While they don't often sell low unless they need to raise capital, the fact that they bought high leaves them in a position where they do not have the capital to buy low.

A company that is in a position to buy back its own stock because it has excess cash should desire its company's share price to decline, as it can buy back more shares at lower prices, which benefits long-term stock holders. The lower a company's stock price, the more beneficial a share repurchase program becomes relative to the company's other means of employing its excess capital. In effect, a company looking to repurchase its own stock should consider itself to be short its own shares.

Yet this line of thinking contradicts the psychology of managements, who view excess capital as a reason in itself to repurchase shares. Worse, managers are often long stock options, and share repurchase programs become a means by which to unload these options at a higher price in order to make short-term profits.

In this article I identify three reasons, or categories of reasons, that company's buy back their own stock: the "good," the "bad" and the "ugly."

1--The Good

The only reason a company should buy back its own stock, assuming it is able to, is that its management perceives value in its shares at the price they trade at in the marketplace. Such buybacks are aimed at creating shareholder value, and as a result one often finds that the share repurchases are extremely well timed when evaluated several years later.

Sturm, Ruger and Company (NYSE:RGR) is an example of this. When I was listening to its quarterly conference call a year or so ago, Michael Fifer, the CEO, said that the company will buy back stock only at valuations that are below the level at which an investor would consider buying shares on the market. While this sounds vague, the company's track record speaks for itself. Sturm, Ruger and Company bought back stock in 2008, when the company's shares traded at under $10, and again in 2010, when the company's shares traded between $10 and $20. Now that the stock is trading well over $40 (over $50 at the present time) the company is not buying back any stock. This pattern gives me enormous confidence in RGR management's ability to recognize the value of the company, and in its commitment to long-term shareholders.

Of course we do not have hindsight, and we often must evaluate a company's stock repurchase plans without any history of the company repurchasing its own stock. In such cases share repurchase announcements must be evaluated. Specificity as to the stock price at which repurchases will occur gives me confidence in a share repurchase program before it happens. Berkshire Hathaway (NYSE:BRK.B) told the market in 2011 that it will repurchase shares so long as they trade at less than 110% of their stated book value. Investors may choose to agree or disagree with the company's method of valuing itself, yet there is complete transparency, and it is simple to predict the efficacy of these stock buyback programs.

2--The Bad

Many companies, in particular large "blue-chip" companies with a lot of free cash flow, buy back their stock with a consistency that pays little heed to market conditions. McDonald's (NYSE:MCD), IBM, and Colgate Palmolive (NYSE:CL) fit into this category. While these companies consistently reduce the number of shares outstanding, their buybacks are often in proportion to their profits. As stock prices tend to rise along with profits, these companies often direct the most capital to share repurchases when their stock prices are highest. As a result, these company's will not have the cash necessary to buy back their stock at lower prices should the market correct substantially, as it always does from time to time.

Stock repurchases falling into this category may not necessarily be a reason to avoid a given company. Consistent stock repurchases by Colgate trading at 20X earnings are not the same as Exxon Mobil (NYSE:XOM) repurchasing shares at 10X earnings. Although keep in mind that Exxon Mobil, in repurchasing a lot of stock in 2008 when its stock price was high, did not have capital to repurchase its stock in 2009 when its stock price was low. I would view Exxon Mobil's stock repurchase plan as less bad than Colgate's, but I would not categorize it as good.

3--The Ugly

The worst sort of share repurchase program is engaged in by managements seeking to raise the price of its company's stock. They may also be attempting to "defend" their company's stock price, when, as I stated above, they should be hoping for lower stock prices in order to maximize their use of capital. Hewlett-Packard Company (NYSE:HPQ) is an excellent example of this. The company repurchased an enormous amount of stock in 2010 and 2011 when the stock price was twice what it is now, despite the fact that the company's fundamentals were in decline. The stock repurchases served to defend the stock price at around $40/share for a little while, yet when reality set in the share plummeted by more than 50% in value, consequently revealing inefficacy of managements' use of shareholder capital. In the end the only beneficiaries of the stock repurchase program were short-term traders. HPQ's stock repurchase program failed to create shareholder value, and it seems that the only reason for the program was to improve market psychology. Thus the "ugly" stock buyback is the complete opposite of the "good" stock buyback exemplified by RGR insofar as it attempts to manipulate market psychology rather than benefit from its irrationality.

4--Conclusion

I want to conclude by providing a few tips to investors that are useful in evaluating potential investments in companies with stock repurchase programs.

A: Never invest in a company solely because it is repurchasing its own stock

B: Look at management's stock repurchase track record to gain clues as to whether the stock repurchase program falls under the good, the bad or the ugly.

C: Differentiate between companies that view stock repurchase programs as mandatory and those that view them as optional. The companies I discuss in the "bad" category seem to fall into the former camp, as they seemingly repurchase shares quarter after quarter, regardless of the price of their shares, so long as the share repurchase program is in place. Companies that view their stock repurchase programs as optional may not repurchase any stock for some time, or the amount of stock they repurchase might vary from quarter to quarter depending on the stock price. CF Industries Holdings (NYSE:CF) is a good example of this. The company has a stock repurchase program, although it did not repurchase any stock in Q4 of 2012. During this quarter the stock traded at record high prices. It seems to be saving dry powder for a rainy day.

D: Avoid companies with management motivated by short-term appreciations in the companies' share prices. Usually investors can identify these situations by looking at executive pay packages and finding that they contain a lot of stock options that expire in the next couple of years.

Sticking to these simple rules should steer investors toward companies with management that is a steward of shareholder capital. Ignoring them will lead investors to invest in companies with management that is effectively robbing them of their hard earned wealth.

Source: Stock Buybacks: The Good, The Bad And The Ugly