A Look at Stock Buybacks

David Galland, Partner, Casey Research

(Chris Wood filling in for David Galland)

Dear Reader,

Stock buybacks have been in the news a lot lately. Sitting on piles of cash and too nervous to invest in new workers or plant and equipment, many companies have started to deploy their cash reserves to buy back their own stock. So far this year, according to stock market research firm Birinyi Associates, firms have announced they will purchase $273 billion of their own shares, more than five times as much compared to this time last year.

Which begs the question, are these buybacks an optimal allocation of capital benefiting investors, or should companies be doing something else with their cash?

If you’re unfamiliar with stock buybacks, or share repurchases, as they are also called, they’re just another way for management to boost returns for shareholders in addition to stock price appreciation and dividends, or so the story goes. Theoretically, by increasing earnings per share via a share repurchase, Wall Street will reward the stock with a higher price.

The thinking goes like this: Let’s say Company X has earnings per share (EPS) of $2 and is currently trading for $35. That’s a price-to-earnings ratio (P/E ratio, also called a multiple) of 17.5. Now management at Company X buys back enough of the stock to boost EPS to $3. If nothing has changed at the company, except fewer shares outstanding and a higher EPS, Wall Street should apply the same multiple of 17.5 to Company X’s earnings, which would result in a stock price of $52.50.

But does it really work like this? What’s the real-world effect of stock buybacks on price?

To get a sense of the thing and in the interest of time, I randomly picked three of the top spenders on buybacks in 2007 and compared their P/E ratio at the beginning of the year to the end of the year, to see if the billions they spent on buybacks had the desired effect. (Note: I picked 2007 because it was generally a flat year overall with little volatility that wasn’t distorted by the current crisis; so if stock buybacks generally benefit investors, the effect should be visible in 2007). Here’s what I found:

  • IBM spent $18.8 billion on stock buybacks in 2007, but the earnings multiple dropped from 15.7 at the beginning of the year to 14.7 at the end of the year.

  • GE spent $12.4 billion on stock buybacks in 2007, but the earnings multiple dropped from 19.0 at the beginning of the year to 17.0 at the end of the year.

  • Home Depot spent $10.8 billion on stock buybacks in 2007, but the earnings multiple dropped from 14.7 at the beginning of the year to 11.3 at the end of the year.

So for these three companies at least, the higher relative EPS from the stock buybacks did not result in a proportional jump in price as would be expected.

Obviously, there are more variables at play here, and I’ve simplified things, but I think we can still glean valuable insight from this small set of data – namely that the Street does not always respond favorably to stock buybacks, and the action does not always benefit investors. Often times, what we see is a percentage or two jump in price in conjunction with the announcement of a large stock buyback, but then prices settle back to previous levels in the days that follow as investors absorb what the buyback really means for the company.

As it turns out, in many cases, the real implications of the buyback are not positive. For starters, CEOs generally engage in a stock buyback at the worst possible time. Share repurchases peaked in 2007 at around $600 billion, with stocks at record highs. As stocks fell in 2008 and early 2009, so did stock buybacks. According to Standard & Poor’s, stock buybacks fell nearly 70% in the fourth quarter of 2008, despite record levels of cash in corporate coffers and much lower share prices.

Second, and more importantly, when a company repurchases its own shares, it’s saying that it has nothing better to do with its cash than employ a strategy that may or may not benefit shareholders and will do absolutely nothing to improve the firm’s long-term prospects. Personally, I’d rather see a company invest in future growth via new plant and equipment, new workers, or acquiring a new company or new technology as opposed to a stock buyback. If that’s not feasible, then I’d prefer a one-time special dividend.

In any event, let’s go back to the initial question of: are these buybacks an optimal allocation of capital benefiting investors, or should companies be doing something else with their cash? I’d say that, while each buyback has to be considered independently, based on the historical evidence and reasoning outlined above, many of these buybacks are not an optimal allocation of capital, and these companies should be exploring different ways to use their cash.

But that’s just my opinion. As an investor, it’s up to you to decide on a case-by-case basis. If the company has surplus capital and is trading below intrinsic value, a stock buyback may not be a terribly bad thing. But if the CEO and/or other insiders are actively selling their shares in conjunction with the announcement of a stock buyback (yes, this actually happens), you shouldn’t be too psyched about it.


Real Estate Investors or Speculators?

By Vedran Vuk

A friend of mine met an interesting real estate investor recently. The guy claimed that he escaped the entire market crash relatively unscathed. At first, I didn’t really believe it, but his strategy made a lot of sense. I thought that it was worth passing along.

Essentially, he flipped houses throughout the entire boom as many did. The difference between this investor and others is his discipline. Every time a property increased by 10%, he sold it. On the way down, he was equally disciplined. As soon as the market turned downward, he priced his remaining inventory below the market to liquidate them all. Sometimes, it’s better to take a known loss than face an unlimited downside.

Most real estate investors didn’t have this kind of self-control. In a way, it’s strange, because often, individual investors are far more disciplined in the stock market. Many of us have personal rules, such as “If I’m down 20%, I’m out of a stock… If I’m up 30%, I’m selling as well.” The most successful market traders strictly adhere to similar limits.

Recently, I read the excellent book, Market Wizards: Interviews with Top Traders. The book interviews dozens of multi-millionaire traders from the 1980s and asks them about their early years and their basic approaches to trading. The book is a great read as you can pick it up whenever. Every chapter is about a different trader. (The book includes an interview with Jim Rogers that may be of particular interest to our readers.)

Across the different interviews, one thing becomes clear: every major trader has defined rules on taking profits and limiting losses. In fact, almost every trader has a painful story recounting how they learned that exact lesson. There were no specific limits shared by all traders, but the point to take away is that you must have limits.

Limits and risk control are exactly what many real estate investors lacked. Risks were taken that no one would pursue in the stock market. Even focusing on real estate alone breaks a key investment rule: Never put all your eggs in one basket. Few would similarly invest in just oil companies or just fast food chains.

On the upside, there was a strange lack of limits as well. I knew a guy who made an incredible profit during the boom. He picked just the right property at the right time. His vision should be applauded, but his self-control should be a cautionary tale. As the housing market had already started to crash, he received an offer on his property for $2 million, a 500% return. But for some reason, he thought the market would go up even more. So he rejected it. Ultimately, the property was sold six months later for half a million dollars less. That’s still an amazing return, but he left half a million on the table only due to his lack of discipline.

No one would treat a stock the same way. Imagine being up 500% on a stock as the market began to drop. Instead of selling, you hope for 700% returns instead. That’s insanity! But there’s something about real estate that makes people go crazy. 

Other risks, such as extreme leverage, would never have been utilized by individual investors in the stock market either. Few of us would borrow $500,000 and put it into the S&P 500. But for some reason, it was different with real estate. One could make the argument that real estate always went up. But then again, the same argument could be made for the S&P 500 in the past few decades.

The real estate market’s problem wasn’t necessarily too many investors; it was too many speculators and individuals who didn’t understand the risks. Even today, I know so many people who refused to take offers 15% below the peak of the market at the beginning of the housing crash. Now they would be lucky to get a price 30% below the peak. However, they would have been easily convinced to sell a nonperforming stock in a tough market.

Before jumping back into real estate, investors need to realize that this sector is not a magical fairyland where the regular rules don’t apply. Risk exists in every investment whether it’s the stock market, antiques, art, or real estate. Each sector does not have different rules.

Chris again. Thanks, Vedran. And that, dear reader, is that for today. One last thing before I run: as we mentioned a couple of days ago, we’re having a special offer on BIG GOLD this week. Until October 29 (just two days away), we’re offering 70% off our list price with a 90-day money-back guarantee. Also, if you buy now, your $39 annual price (less than 11 cents a day) will be locked in for the lifetime of your subscription. BIG GOLD makes it simple to take advantage of the security, inflation protection, and huge potential profits that gold investments offer with an easy-to-maintain portfolio of mid- to large-cap precious metals producers, ETFs, mutual funds, and more. And this special offer is simply too good to pass up. Details here.

Now I must run. As always, thank you for reading and for subscribing to a Casey Research service. David returns from Argentina tomorrow but probably won’t be able to take back the reins of this missive until Monday – so I, along with Vedran Vuk and other members of the team, will be with you for the rest of the week. Until tomorrow…

Chris Wood
Casey Research, LLC

Oct 27, 2010