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One thing that can make stock buyback programs so dangerous for shareholders is the fact that there is a meaningful disconnect between theory and reality when it comes to the actual execution of stock buybacks. In theory, stock buybacks sound great (and even seem superior to dividends because of present taxation laws). It seems so simple: your stock is undervalued, you buy back shares, you retire them, earnings per share go up, and shareholders get richer. But as Jack Hough of Barron's recently reported, this has not been the case for S&P 500 companies.

Hough writes:

Last quarter, 317 companies in the Standard & Poor's 500 index repurchased shares, but only 98 of these reduced their share counts, according to the S&P. Many companies use repurchases merely to offset shares that are issued to employees as compensation. Net buybacks-repurchases that whittle down a company's sharecount - are what matters.

Ignore net buybacks that look like short-term financial fixes. Studies show that companies often turn to buybacks when manager pay is linked to earnings per share, and when companies would otherwise miss Wall Street's earnings-per-share targets by a penny or two. Just 36 companies in the S&P 500 shrank their share counts by 1% or more last quarter.

Let's not sugarcoat this. These statistics are terrible. Only a third of companies currently doing stock buybacks in the S&P 500 are actually reducing shares. And only three dozen out of over three hundred are actually doing it by an amount over 1%. There can be a lot of temptation to mess up the good effects of a stock buyback because it is so easy to pay executives in the form of shares, thus wiping out the benefits of a stock buyback in the first place.

There are a couple of things that investors should keep in mind going forward in light of this information:

First of all, the fact that executives are paid in relation to earnings per share growth is not necessarily a terrible thing. IBM executives explicitly get paid for earnings per share performance, and IBM (IBM) shareholders have done quite well as the result of the buyback program. The share count has gone down from 1.5 billion shares in 2005 to a little over 1 billion shares today. This has helped the price of the stock improve from $71 per share in 2005 to $211 today, and more importantly, earnings have almost tripled over that time frame.

Personally, I use some of the same techniques to approach stock buyback companies that I use to evaluate dividend companies. Something that I like in dividend growth stocks is this: long histories of raising dividends. Johnson & Johnson (JNJ) and Coca-Cola (KO) receive prime consideration for purchase because they have been raising dividends since the early 1960s. I do the same thing when considering stock buybacks. Loews (L) had 1.3 billion shares outstanding in 1971 (on a split adjusted basis). The company has reduced the share count to under 400 today. It has a long history of doing buybacks right. There is no guarantee it will do well in the future, but I would rather own a company that has a record of an excellent buyback than one that does not.

Obviously, not all companies have such long track records. Short of that, I'd like to see a recent history of reducing share count by a meaningful amount. Lorillard (LO) has reduced its share count from 521 million shares outstanding in 2007 to 380 million shares today on an unweighted basis. Sonic (SONC) has reduced its share count from 84 million shares in 2006 to under 60 million shares today. Exxon Mobil (XOM) has reduced its share count from 6.9 billion shares in 2000 to under 4.5 billion today. When you see that only 36 out of 317 companies doing stock buybacks are actually reducing share count by an amount greater than 1% per year, it may be worthwhile to discover those 36 companies and gravitate toward them.

And lastly, you can find a lot of value in finding companies that are not doing stock buybacks right now. The whole point of creating value through stock buybacks is that you buy the stock for less than it is worth, and create value by retiring it from the market. A lot of S&P 500 companies are fairly valued or overvalued right now. It may be a sign of strength that a company is not conducting a stock buyback program right now, because that demonstrates management discipline. I'm glad to see that Kellogg (K) management has stopped buying back shares. If I were a Berkshire Hathaway (BRK.B) shareholder, I would be delighted that shares do not get repurchased at any price point above 120% of book value.

These new numbers on stock buybacks are terrible. When well over half of the S&P 500 companies are conducting stock buybacks and only 20% are actually reducing the share count, we've got a problem. But this is one of the reasons why I am not an index investor. I don't have to own shares of these companies that do pitiful jobs of executing the buyback (of course, some companies have such bright prospects that they might still be worth owning in spite of a mediocre buyback program). The good news is that we have tools at our disposal to succeed in spite of the disconcerting records for most companies with buybacks. If you look for companies that have a track record of actually reducing share counts, and read the regular financial statements to make sure that shares are actually getting retired, then you can avoid a lot of this buyback waste that is prevalent in corporate America today.

Source: More Bad News For Stock Buybacks