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Stock Buy Backs Are A Bad Idea

This article was first published on the website "Dividends, Derivatives and a Camera" under the title Don't Buy into Those Buy Backs.

"I don't like stock buybacks. I think if a company has the money to buy their stock back, then they should take that and increase the dividends. Send it back to the stockholder. Let them invest their money again from the dividends."

--T. Boone Pickens, Investor, Oil Man, Hedge Fund Chairman

Great companies generate more money that they currently need to execute their business. When that occurs companies need to make the decision as to what they will do with those excess profits. When the decision is made to buy back its own stock on the open market it signals that the company has no better productive use for that money. More importantly the company's management has also made the decision not to share those profits with its shareholders. I can't think of any good reasons why a company would do this, but I can think of a few bad reasons why it would.

Management has no new good ideas for the profits the company generates. Most companies have a Research and Development (R&D) Department where they develop new ideas, concepts or uses for new as well as existing products that the company produces. Companies that have products under development also have a tremendous need for whatever money the company can generate from its current product lines. A great company uses those profits to efficiently and effectively improve the company's revenues and earnings. A company totally bankrupt of new ideas, however, will use the money to buy back shares or worse, spend it on themselves. This is not the kind of company I want to own shares in. I want to own shares of companies that either put the profits back into the business or distribute the profits to the shareholders in the form of dividends.

Management wants to artificially manipulate the earnings per share (NYSEARCA:EPS). Some companies find themselves in the unenviable position of being at a total loss on how to improve their future earnings. Their earnings may not be going down but they're not going up or not improving as fast as they had been in previous quarters or years. These companies often make the decision to use the company's profits to buy their own stock on the open market in order to reduce the number of shares outstanding. The company's stagnant or declining earnings are then divided by a fewer number of shares. This artificially increases the company's quarterly and annually calculated earnings per share. Any investor not paying attention to the company's income statement wouldn't notice this until it's too late. I always feel that in these instances management isn't being honest when they report an increase in EPS when it's a result of fewer shares rather than increased income. This is not the kind of company that I want to own shares in.

Management wants to award themselves stock options. Most companies sell most, but not all, of the shares of their company to the public and retain a small portion of their shares for bonuses to be handed out to management based upon management's performance (both good and bad performance!). When the company wishes to give away more shares than is in their treasury, the company takes some of their retained earnings and goes out into the open market and buys shares. The usual justification for buying shares on the open market is to reduce the overall number of shares outstanding. This decrement will consequently increase the company's EPS even without an increase in income. In reality is often doesn't occur because the shares are just redistributed to the managers of the company at a reduced cost. Sometimes they're redistributed at no cost to management at all. This is simply management giving itself a raise at the expense of the shareholders. This is money that the company didn't need to improve its future earnings and that should have been rightfully distributed to the individual shareholders. Instead it was used to buy stock and then "gift" it back to management. This is not the kind of company that I want to own shares in.

Each of these reasons why companies buy back their shares are bad reasons. None of these actions enhance the value of the shares for the individual investor in the slightest way. Companies that I am interested in are companies that increase their revenues, earnings, and dividends in a consistent and honest manner. I'm not interested in accounting "tricks" that make these data look better than they actually are. And I'm not interested in managements that don't have the interests of the shareholder ahead of themselves.

Companies are suppose to be established for the sole purpose of creating profits. And those profits should only be used for two reasons. Profits can either be put back into the company so that the company can create new or improved products that will enhance future profits and grow the company, or profits can be returned to shareholders in the form of dividends. Any other use of those profits is a misuse of funds and management is not acting responsibly. As I analyze quarterly and annual earnings and I find this to be the case, I sell the stock and move on to another company with a more responsible management team.