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Last year, S&P 500 (NYSEARCA:SPY) companies bought back around $450 billion worth of stock. During the past few months, many more companies launched significant repurchase programs but are increasingly being funded by debt, raising some questions about their merit. This leads to much higher balance sheet leverage, both through stock reduction and debt issuance. Although in the short-term this can give a boost to stock prices, over the long-term, a more conservative approach may be warranted.

Regarding the negative factors behind share buybacks, I highlight the following: the timing of buybacks is usually bad; there is little cost in announcing a buyback; and, they are not binding. Also, targets based on improving earnings-per-share [EPS] mean that buybacks should help management reach them and cash dividends are increasingly accounting for a smaller proportion of distributions, killing off the effects of compounding over the long-term, boosting volatility and embedding too much value in the fortunes of the prevailing stock price.

Companies execute buybacks when they are loaded with cash, or are increasingly taking debt. Ideally, share buybacks should be funded with excess cash flow after the company paying a progressive dividend and after all investment considerations have been exhausted. However, this may often not be the case, leading management to possibly overlook other investment alternatives. Some companies may also justify issuing debt because interest on debt is tax deductible, leading to a lower tax burden and optimization of shareholder returns. However, the tax benefit may be illusory as the company loses some of its financial flexibility and leveraging the balance sheet usually comes back to haunt the company when the economy enters a downturn.

Furthermore, management can also favor repurchases against dividends as they are viewed as being more flexible. Indeed, the announcement of a sizable repurchase program doesn't necessarily mean it will be fulfilled in its entirety or can't be suspended in the future. Usually investors react much more negative to dividend cuts than to share buyback suspensions, therefore also justifying management's preference for share buybacks. However, isolating buyback-related performance is clearly difficult as many other factors come into play.

All those factors discussed can create distorted incentives for buybacks, which can be reduced through the introduction of price limits.

Price Limit

One reason to perform share buybacks is when management thinks the company's stock price is cheap. Theoretically, this makes perfect sense but many CEO's never stop believing their stock is cheap. This bias may lead to stock buybacks being performed at very high stock prices and suspended during a crisis, when prices are lower and stock should be purchased. As a result, buybacks are plentiful in the good times and largely absent during bad times, when investors may need them most. The fact that share buybacks by S&P 500 companies peaked at almost $600 billion in 2007, proves the point regarding the timing of buybacks.

To avoid this behavior, setting a price limit would certainly add to the undervaluation argument to perform share buybacks. Thereby, management would set a valuation at which they consider buying back stock would be a good deal for the company's own money.

One company that has performed something similar is Berkshire Hathaway (NYSE:BRK.B). The company launched its own share buyback program in September 2011 and said it would repurchase at a price of up to 110% of its book value, but this proved unrealistic. Berkshire was in the market for just a couple of days, before the price advanced beyond their own limit. This limit was subsequently increased to 120% of Berkshire's book value in December 2012. At the time, it only spent $1.3 billion, and since then, the book value has been above the limit. Even though Berkshire doesn't pay a dividend, Warren Buffet stuck to its buyback principles showing that to deliver value to shareholders, it would need to buy at the right price.

Conclusion

Share buybacks have both benefits and pitfalls. Although I'm not a huge fan of buybacks, preferring instead dividends, I recognize their merits, but think they are much more biased to short-term gains than to shareholder's long-term value creation. In my opinion, setting a price limit would be something that considerably adds value to share buybacks, as long as management sticks with it them even if the company's stock price continues to climb. Thus, when a crisis hits and the stock price goes down, which will eventually happen over the long-term, the company will have the resources to buy back significant amounts of stock and stabilize its price. In this way, it would certainly lead to better timing decisions and stronger balance sheets, also supporting progressive shareholder returns through dividends over the long-term.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Why Share Buybacks Should Have Price Limits