Rush of stock buybacks may not be a good thing

/ Source: The Associated Press

Companies are gobbling up their own shares this year. Should you join in the buying spree?

For stock investors, there is seemingly no better bullish sign. After all, the corporate executives behind the decision to buy presumably have a good idea whether their company will prosper. If they're buying, the thinking goes, the shares must be going up. Except they often do not — and may not now.

"Companies have been pretty poor at timing purchases," says Robert Leiphart of Birinyi Associates, a research firm that has studied buybacks. Gregory Milano, the CEO of consultancy Fortuna Advisors, is more blunt: "We're in the middle of a buyback bubble."

Since the start of the year, U.S. companies have announced plans to buy back $150 billion of their own stock, a 38 percent jump from last year, according to Birinyi. The buying fever has swept across industries. Tech giant Intel Corp. plans to buy $10 billion more of its stock. Drug-maker Pfizer Inc. says it will buy $5 billion this year. Home Depot Inc. says it will buy $1 billion worth now, more than a quarter of what it generated in profits last year.

The last time companies were so hot on their own stock was 2007, which points to the problem: That was right before the market began a long, painful drop to a 12-year low. Contrary to popular belief, companies often buy high, not low — and ordinary investors are the worse off for it. In a study last year, Fortuna's Milano compared stock returns of 1,000 large non-financial companies broken down by buyback activity. Shares of the 250 companies that spent the most on buybacks lost 3 percent over five years through 2008. By contrast, shares of the 250 companies that spent the least on buybacks gained 28 percent.

Milano says many companies that don't buy stock use their money instead to build factories or buy equipment or invest in R&D, and that often leads to more profits and a higher stock price.

Unfortunately, companies not only tend to buy too much stock at the wrong time, they tend to buy too little when the time is right.

Two months after stocks hit their peak in 2007, the economy fell into its deepest recession since the 1930s. Stocks eventually hit a low in March 2009. It was a perfect opportunity for companies to make up for their earlier ill-timed purchases with some well-timed ones. They got tightfisted instead. Birinyi's Leiphart notes that many companies were understandably scared that a depression loomed, and so some pullback in repurchases was prudent. In the event, buybacks fell in 2009 to a fifth of what they were at the bull market high.

Home Depot followed the general pattern. After pouring $10.8 billion into its stock in 2007, it bought just $213 million in 2009 — or 2 percent as much, according to Birinyi. Its stock hit a low of $18 that year, half its price two years earlier.

Now its stock is rising and it's buying again along with plenty of others. But is repurchasing stock wise now that prices nearly doubled in two years? For its part, Home Depot says it is "disciplined and balanced" in allocating capital. It also notes its buybacks over the past eight years have averaged $36 a share, below the closing price Friday of $37.56.

The appeal of buybacks is that they make earnings per share rise. Consider a company that generates $100 in profit a year and has issued 100 shares. The owner of a single share theoretically has claim to $1 of those profits ($100 divided by 100 shares). If the company buys half those 100 shares back, that investor's cut of profits doubles to $2 even if overall profits don't change ($100 divided by 50 shares). Another reason to repurchase shares is to compensate for stock options used to pay employees. Because they increase the share count, companies issuing options must repurchase just to keep per share profits from falling.

But even if companies get the timing right, buybacks can hurt investors. That's because it takes money away from better uses.

"At business school, you learn about the pecking order for cash: First it should go into R&D and advertising and buying plants and equipment," Milano says. "Then maybe an acquisition or paying down debt. And only if you have any left over do you buy your own stock."

The problem is, Corporate America often gets the order reversed. In another Milano study last year, he compared money that companies spent on repurchases to what they spent building factories and buying equipment to make their businesses better. At the height of buyback lunacy in 2007, companies spent 12 percent more on repurchases than on such investments. Last year, repurchases fell to a more healthy 35 percent less than investments.

There are a number of reasons buybacks backfire so often. Some corporate executives fall victim to the all-too-human tendency to take comfort in the wisdom of the crowd — feeling confident buying when others are buying and scared when others are selling.

There is also a more prosaic reason: When times are bad and the market is dropping, companies often don't have a lot of cash with which to repurchase shares. Of course, this wouldn't be a problem if they didn't spend it all in good times, which is why the current buybacks are so worrisome. U.S. companies hold nearly a trillion dollars in cash now.

"There are articles everywhere about all the cash at public companies, and why aren't they spending more," Milano says. "It may be better to hoard the cash and wait, but it's a hard thing to do now."