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When companies earn a profit, they have to figure out what to do with their newfound cash. Unfortunately, all too often, the same companies that are so good at running a profitable business do a terrible job of making the most of their income. And since it's really your money that's at stake, you can't afford to invest in companies that make bad spending decisions.
A recent report from Thomson Reuters took a look at one of the most important capital allocation decisions a company can make: whether to repurchase shares of its own stock. What it found once again opens the door to arguments about the best way companies should use excess cash.
Reawakening the old debate
For years, academics and market professionals have argued about the best way to return capital to shareholders. Recently, many companies have favored paying larger dividends to shareholders, giving them the choice on how to allocate their capital.
But historically, many people saw paying dividends as an inefficient way of using shareholder capital. With double-taxation of dividends, the alternative of using share buybacks seemed more attractive, as only those shareholders who chose to sell their shares back to the company would realize any kind of tax hit from the move.
What the Thomson Reuters study showed was that companies are doing more buybacks than at any time since before the 2008 financial crisis. Yet more often than not, these companies are making ill-timed decisions. The report cited 84 S&P 500 companies that paid premium prices on buybacks, versus 60 that bought low. Moreover, the stock's subsequent performance bears out the same theory: 72 had what the report characterized as poor returns in the year following the buyback, compared to 57 good performers.
What makes a buyback successful?
The report highlighted one key of strong buyback performance was opportunistic behavior. Rather than simply having a mechanical buyback program always in place, the best companies take advantage of rare value opportunities to pick up shares on the cheap. The report pointed to EOG Resources (NYSE: EOG ) as one example of this behavior, but another would be Berkshire Hathaway (NYSE: BRK-B ) . Last year, Warren Buffett said that the company had authorized the use of buybacks whenever the stock fell below a 10% premium to book value. Although the company only bought back a small number of shares, that approach had the desired effect of creating a floor under the stock price. That's not the only reason I have a bullish CAPScall on Berkshire, but it has helped me keep my resolve.
By contrast, the report pointed to Ford (NYSE: F ) as an example of a stock that has tended to buy back more stock when prices are high. For instance, the automaker did huge multi-billion dollar buybacks from 1999 to 2001, when shares traded near all-time highs. Yet after the stock fell 90% by the time of the financial crisis, the company made no buybacks at all.
Ford definitely isn't the only culprit here. During 2007, General Electric (NYSE: GE ) and Cisco (Nasdaq: CSCO ) were among the select set of companies to spend $10 billion or more on share repurchases. Yet even as their shares plunged during the bear market, their share repurchases fell dramatically, with Cisco cutting buybacks by two-thirds and GE making a cut of more than 80%.
Why companies can't be trusted
The obvious reason why this phenomenon occurs is that companies have the most money to use on buybacks when they're the most profitable. Typically, that will also be the time when their stock is performing well. Conversely, when times get tough and profits become scarce, investors get nervous and bid down the shares -- yet companies then don't have the cash to take advantage of those bargain prices.
That's why I believe that paying dividends makes more sense from the investor perspective, even if it means taking an extra tax hit. Giving shareholders the right to buy more shares of stock voluntarily puts the onus on you to make smart decisions with your money. Given how much the balance of power already shifts toward corporate management and away from shareholders, the least that companies can do is let you make an informed decision with money that rightfully belongs to you.
Often, the best stocks simply plow their money back into their businesses for further growth. That's the story behind the companies in The Motley Fool's latest special report, in which you'll discover the names of three stocks with huge profit potential over the long haul. It doesn't cost a dime -- but grab it today while it's still available.