MONEY stocks

Stock Buybacks Are Back. Uh Oh.

Conventional wisdom says share repurchases are good for investors and stock prices. Here's why conventional wisdom is wrong.

A new report shows that stock buybacks soared nearly 60% in the first quarter and are nearing a record over the past 12 months. In a buyback, a company repurchases its own shares in the open market.

Apple APPLE INC. AAPL -0.0295% alone spent $18 billion at the start of this year buying up its own shares and is committed to repurchasing as much as $90 billion overall.

Sounds good, right? Don’t celebrate just yet.

Stock repurchases are a classic move in the CEO playbook. By buying up their own company’s stock, CEOs are trying to accomplish a couple of things that sound great on paper.

First, they are looking to reduce the total number of their company’s shares outstanding in the marketplace. That way, even if corporate earnings are flat, on a per-share basis the business will at least look more profitable to investors. Second, stock buybacks are thought to send an explicit message to Wall Street. That statement: “We think investors are undervaluing the true worth of our company, and we are willing to put our money where our mouth is.”

That all sounds quite appealing, but here’s the reality:

Stock buybacks don’t necessarily deliver the message companies want:

As Time’s Rana Foroohar points out, Wall Street may be getting jaded to this buyback ploy. For one thing, investors understand that some mature companies may simply be turning to buybacks as a way to artificially prop up their earnings. That’s not a sign of strength, but actually a signal of the onset of weakness.

Not surprisingly, companies that have announced buybacks haven’t been performing as well as you might expect lately. Here’s what’s happened to the price of an exchange traded fund, PowerShares Buyback Achievers POWERSHARES EXCHAN BUYBACK ACHIEVERS PKW -0.7363% , tracking an index of buyback stocks, vs. the S&P 500.

^SPX Chart

^SPX data by YCharts

Just because the CEO declares a company’s stock cheap doesn’t make it so.

If buybacks were really a value proposition, share buybacks would really spike in the depths of bear markets, when a stock’s valuation would be near a low. Yet’s that not the case. Buybacks surged in 2007 and 2008, just before the financial crisis hit. The S&P 500 S&P 500 INDEX SPX -0.0979% was trading at a price/earnings ratio of over 25, based on 10 years of so-called normalized, or averaged, earnings. That’s expensive.

Yet when the market’s P/E sank to a below-average 13 in the first quarter of 2009, buybacks were near their low points.

Today, buybacks are surging again only after the S&P’s P/E has climbed back above 25. This means companies are falling victim to the same force that individual investors do: rearview investing. The problem is, that almost never works.

Buybacks aren’t a sign of value, but rather management’s attempt to make their shares look cheaper.

There are some market watchers who think a buyback is merely an accounting trick. This piece that ran in SeekingAlpha a while back explains how this trick can boost profitability.

For starters, by reducing the total number of shares outstanding, a company’s earnings per share grows. Not only that, other measures of profitability plump up too. For instance, a buyback will also reduce the overall amount of equity on a company’s balance sheet. Thus, its Return on Equity will rise even if overall profitability doesn’t. Similarly, if a company uses cash to fund the repurchase, that money is an asset on the balance sheet. So as cash levels fall in a repurchase, the company’s Return on Assets (ROA) will look more attractive even though nothing fundamentally changed in the business.

Share buybacks don’t always lower the share count.

Sometimes, companies are forced to repurchase their own shares to make up for the fact that they’ve been dilluting their stock in other ways — for instance, as part of executive compensation packages.

It’s no surprise that seven out of the 12 biggest buybacks so far this year, in dollar terms, have taken place in the technology sector. The tech sector is notorious for compensating talent with stocks grants and options. In addition to Apple, IBM INTERNATIONAL BUSINESS MACHINES CORP. IBM -0.1239% , Cisco Systems CISCO SYSTEMS INC. CSCO -0.7435% , Oracle ORACLE CORP. ORCL -4.5367% , Microsoft MICROSOFT CORP. MSFT 0.557% , and eBay EBAY INC. EBAY -0.2562% were among the big tech names buying back their own shares this year.

CEOs time buybacks for their own compensation, not yours.

While a repurchase may seem like a benevolent act — companies often portray buybacks as returning cash to shareholders — it’s far from it. A buyback artificially boosts profits — most noticeably earnings per share (EPS). And what are executives most likely to be compensated on?

In a paper called “Bonus Driven Repurchases,” scholars from the University of Washington and Florida State argue that “By mechanically increasing current-year EPS, repurchases provide a means for CEOs to increase their EPS-driven bonuses.”

This is yet another reason why investors ought to press their companies to return cash to them in the form of dividends, not buybacks.

And lately, the market seems to agree:

^DJDVY Chart

^DJDVY data by YCharts

An index of dividend-paying stocks has pulled well ahead of the buyback group. It’s often good for shareholders when companies stop sitting on their cash. But some options are better than others.

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