Your Company Did a Terrible Thing

Editor's note: A previous version of this article mistakenly included Cypress Semiconductor in the initial table. The Fool regrets the error.

Share buybacks may seem like a shareholder-friendly use of capital, but unless it's done properly, the practice can be about as advisable as spitting in Tony Soprano's spaghetti.

Prior to the recession, it seemed like pretty much every company out there was buying back shares hand over fist. For a while, every day seemed to bring a new billion-dollar share buyback plan -- and the market cheered it all on.

But was it smart?
For a great many companies, I'd say, it wasn't smart. Take a gander at the massive buybacks the following companies made in 2007 only to see their stocks plummet as we headed into the downturn.

Company

2007 Share Buyback

Buyback as % of
Mid-2007 Market Cap

Return Since
Mid-2007

Valero (NYSE: VLO  )

$5.8 billion

14%

(71%)

Macy's (NYSE: M  )

$3.3 billion

18%

(52%)

United Microelectronics

$1.7 billion

15%

(47%)

Tempur Pedic

$320 million

15%

(47%)

Source: Capital IQ (a division of Standard & Poor's).

Now before you start hootin' and hollerin' that I'm being unfair to your company, I will point out that the stocks may have been beaten down too far by the market and the big buybacks may still prove to have been a good idea.

However, I don't think it's simply coincidence that these stocks have fallen much more than the rest of the market. Instead, I think management did a poor job deciding how to use the company's capital and paid too much to buy back shares. In some cases, like Macy's, management ignored the big valuation that the company's stock was carrying and bought shares anyway. In others, such as Valero, management seemed to ignore the fact that the company operates in a highly cyclical industry and that it was buying stock during peak times.

For investors, the performance of a company's stock following share buybacks isn't just footnote material. That's your money that management is using to buy that stock, and if they're overpaying for that stock, then they're wasting your money.

Why do it then?
I find it hard to believe that any management team set out to waste money for the sheer joy of it. There are a handful of reasons that share buybacks might look good to a CEO even if it isn't the best option for shareholders. Here are a few.

  1. Increasing earnings per share: Buying back shares reduces the number of shares outstanding and therefore increases earnings per share. Managers can use buybacks to help meet Wall Street expectations and give the illusion that the company is growing faster than it is.
  2. Boosting the share price: Higher earnings per share, as well as the excitement that can be generated from the announcement of a major buyback, can push up share prices. Unless the buyback was done wisely, this is only a short-term benefit for shareholders since value has been destroyed. For managers who own piles of stock options, on the other hand, even a short-term boost in the stock price can be very lucrative.
  3. Ignorance: Just because someone is a good business manager doesn't necessarily mean they're a good capital allocator. A manager who's a poor allocator of capital may decide to do a share buyback without doing an adequate analysis of whether it actually makes sense.

The bottom line is that there are a great number of managers out there squandering shareholder capital by making lousy investments in company stock. Making it all worse is that investors have more often than not cheered these managers on.

They can't all be Buffett
For Warren Buffett, the process of building Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) has been a process of taking all of the cash generated by the operating businesses that the company owns and finding the most rewarding places to invest that capital. Sometimes that's acquiring new operating businesses, sometimes it's encouraging more insurance contracts to be written, and sometimes it's investing in huge public companies like Goldman Sachs (NYSE: GS  ) and General Electric (NYSE: GE  ) .

Berkshire doesn't pay a dividend and doesn't buy back stock because Buffett believes he can always find more rewarding ways to use shareholder capital.

Most CEOs are not Warren Buffett, though. And that's not necessarily a bad thing. In most cases the chief executives are at the top because they know their businesses inside and out and are in the best position to lead the companies to growth and operational success. But they still need to choose highest-return investments for your capital.

When in doubt
There are really only a handful of options for using the cash produced by a business: organically expanding the business, making acquisitions, paying down debt and improving the balance sheet, paying a dividend, and repurchasing stock. Assuming there aren't extenuating circumstances like dangerously high debt levels, the math should be easy -- choose the option that provides the best return.

Good business operators generally have a very good grasp on what kind of returns can be expected if money is invested back into the business to drive growth. Most of the time -- though maybe not often enough -- they're also good at evaluating the returns that can be had by acquiring another compatible business.

But what if those both promise unattractive returns? This is where problems generally arise. Too many managers these days think that their fancy MBAs give them license to get cute with shareholder capital. This is why we end up with nonfinancial companies investing in risky debt or stocks, buying businesses outside of their core competency, and making ill-advised share buybacks.

Once we get out a nice big dictionary and whack these overreaching CEOs over the head with it, we can tell them exactly what to do with that extra money. The answer is simple: Give the money to the owners of the company. Shareholders are investors, and investors are capital allocators. When reinvesting in the operating business doesn't make sense, and shares are not undervalued, it's time to give the money back to shareholders in the form of dividends so they can find a better place for it.

If you're fed up with management teams squandering the capital of the companies you own and are ready to own companies that put that money back in your pockets, you may want to check out the Motley Fool Income Investor newsletter. The advisors at Income Investor are dedicated to finding the very best dividend-paying companies that understand that you should end up with profits that aren't reinvested because you are a co-owner of the business. Better still, you can check out the newsletter's stock recommendations free for 30 days by simply clicking here.

Fool contributor Matt Koppenheffer owns shares of Berkshire Hathaway, but does not own shares of any of the other companies mentioned. Berkshire Hathaway is both a Motley Fool Stock Advisor and Motley Fool Inside Value selection. The Fool owns shares of Berkshire Hathaway. The Fool's disclosure policy thinks shareholders deserve their own money just like Michael Vick deserves ... well, let's just leave it at shareholders deserve their money.


Read/Post Comments (5) | Recommend This Article (22)

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  • Report this Comment On September 21, 2009, at 6:52 PM, plange01 wrote:

    citigroup needs to start the biggest share buy back in history in order to reduce the unbelievable amount of shares it issued to the government and save itself from failing.........

  • Report this Comment On September 21, 2009, at 10:35 PM, memoandstitch wrote:

    Given that Citibank is failing, isn't it better for C to buy shares of other companies e.g. WFC?

    Going back to the topic, shouldn't we stop giving executives bonuses based on share price because that encourages reckless share buybacks?

  • Report this Comment On September 22, 2009, at 10:28 PM, mountain8 wrote:

    Dear MF and Mr. Koppenheffer,

    I would be more inclined to enjoy and find value in your articles if they were comparing apples to apples.

    I believe if you are going to use this small amount of time(a couple years), unless you compare pre October 2007 to pre October 2007, your results are going to be skewed due to the massive dump of 2007/8/9.

    For instance, Compare June ("mid 2007(?)") to September 2007, before the first dump in October. What would be the return figures you place in the final column of your graph? Do you still show a loss? . I feel reasonably certain you wouldn't. Ergo buyback would look to be a positive move.

    Now compare June 2007 to November 2007. Do you show loss or gain. I feel pretty sure you would show loss. Ergo buyback would look to be a negative move, the conclusion being 180 degrees opposite separated by only two months of data.

    Anyone who writes comparisons about the market in any way should realize that this massive collapse in market value from October 2007 through the recent rally will skew figures for the next decade.

    Another small point is that out of the multiple thousands of stocks in the multiple markets of the world, anyone could find five to support their contention. If you wish validity, compare all the buybacks since the great depression with the results from pre October 2007. This result would eliminate the skew and provide a larger sample data base for you to make your comparisons, i.e. voila! validity!.

    I would guess (!) that if you compare the buybacks of the post-dump era 2009, from the bottom, to results in, say 2012 you will probably find rebuying is positive. The results would, of course, be skewed by the recovery, and still invalid.

    Please, unless I'm blowing smoke, (and that's always possible), Mf and sir, please don't publish anything like this that compares pre October 2007 to now. This is a very new old ball park.

  • Report this Comment On September 23, 2009, at 4:05 PM, TMFKopp wrote:

    @mountain8

    Your suggestion to track all buybacks since the GD would prove or disprove the thesis that share buybacks are generally a bad idea -- but that's not the contention in this article. Share buybacks can be a good idea, but they have to be done with a focus on valuation and potential returns.

    The reason the pre-October 2007 period was used is because that was a period when stock valuations were generally high and the economy was at a cyclical peak. We could similarly go back and look at any number of other high-valuation periods (say, pre-2000) and come to the same conclusion. That is, that buybacks are a poor idea when valuations are high.

    I expect that any company that was flush/brave enough to buy back stock during the depths of the downturn will show great returns on those buybacks. However, there were far fewer companies buying back stock during, say, February or March of this year versus early 2007.

    In fact, there were quite a number of companies issuing new stock during the depths of the downturn and many of these companies were buying back stock just a couple of years prior. How's that for buying high and selling low?

    So again, the point here isn't to deride stock buybacks completely, but rather to say that they can destroy shareholder value when not done properly. For management teams that don't have the interest/aptitude to make sure to do buybacks properly, the best approach is probably just to give the capital back to shareholders so that they can make their own decisions (one of which could be to buy more stock).

    Matt

  • Report this Comment On September 23, 2009, at 9:27 PM, mountain8 wrote:

    Thanks for your response. I am always glad to learn. I agree, anything done by management to enhance shareholder value should be done properly or not at all. Don't we all wish that were the case.

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