Buybacks: The Fastest Way to Burn Money

JPMorgan Chase (NYSE: JPM  ) repurchased billions of dollars of its own stock in the middle of last year. That didn't turn out so wise, as shares fell more than 25% later in the year. The company had largely exhausted its authorized share repurchase program after shares bottomed, and couldn't take advantage of its bargain stock price.

CEO Jamie Dimon admitted fault. "Yes, it would have been wise to wait," he said in a conference call last fall. "We're sorry."

Lesson learned?

It doesn't look like it. JPMorgan authorized a new $15 billion buyback program in March after shares surged more than 50% from their November lows. Now that it's losing billions of dollars on a backfiring derivatives bet and its stock has dropped by a third, it's suspending those plans. Buy high, shrug shoulders low. Next!

In a way, this isn't Dimon's fault. The bank has to adhere to new regulatory capital requirements and gain permission from regulators to repurchase stock and issue dividends -- both consequences of the 2008 financial crisis.

But it's still inexcusable. For one, this isn't an isolated incident. From 2000 through the financial crisis, JPMorgan (with leaders other than Dimon) pulled off an almost flawlessly bad record of repurchasing stock when its shares were high, and suspending buybacks when they became cheap:

Source: S&P Capital IQ.

And while banks have to gain permission to engage in share repurchases, no one forces them to hit the "buy" button. When analyzing the economy, John Maynard Keynes said, "The boom, not the slump, is the right time for austerity." That logic should apply to companies repurchasing their own stock -- save money for a rainy day, and spend it when it starts raining. But very few companies actually do that in practice. Instead, it's a circus of buying high, panicking low, and squandering shareholder money.

Buybacks among S&P 500 companies peaked at more than half a trillion dollars in 2007. Then, as shares came crashing down in 2009, they plunged to $185 billion. Now that shares have rebounded sharply, so have buybacks. It's exactly the opposite of what you want to see.

Some examples are just pitiful. Between 1999 and 2008, Citigroup (NYSE: C  ) repurchased $41 billion of its own stock -- almost exactly equal to the $45 billion in taxpayer money it needed under the TARP bailout program. Bank of America (NYSE: BAC  ) bought back $60.3 billion of its shares during that time -- more than it eventually took in bailout funds. Netflix (Nasdaq: NFLX  ) repurchased $200 million of its stock in the first three quarters of last year at an average price of $221 per share, and then just months later sold $200 million worth of shares at prices 70% lower. You'd struggle to come up with a faster way to burn shareholder wealth if you tried, but this stuff has become par for the course in corporate America.

Why are companies so bad at repurchasing their stock? I think there are three big reasons.

First, there's no reason to expect the CEO of, say, a cable company to also be a shrewd value-minded stock investor. Those are two completely different skills. That isn't an excuse for wasting shareholder money, but it helps explain the results.

Two, a lot of management compensation comes in the form of options. That's intended to align management's interest with other shareholders, but it can backfire and focus their attention on keeping stock prices propped up in the short run. One study by Liu Zheng and Xianming Zhou of the University of Hong Kong found that companies that issue the most options to executives are more likely to see "manipulations" of their share price, including being "more likely to conduct share repurchases."

The third is probably the most important. There are two ways to return money to shareholders: dividends and buybacks. Dividends are seen as the more sacrosanct of the two; once issued, companies hate cutting them. Buybacks are viewed as more transitory. Managers can buy back a few shares this year, none the next, a ton the following year... whatever. And investors are usually OK with it. Most dividend-paying companies have a policy of paying $X per share in dividends every quarter, and rarely stray from it. I don't know a single company that does the same for buybacks.

Now, buybacks shouldn't be consistent quarter-to-quarter if companies are good at buying low and selling high. But they're totally not. And so I have some advice for all companies that repurchase stock:                                                                

  • Unless you have a proven track record of repurchasing shares at favorable prices, don't try to time the market. It's OK. Most people can't.
  • Instead, either stick with dividends (almost always better than buybacks), or think about buybacks like you do dividends, repurchasing a set amount of stock every quarter as consistently as you can. Most individual investors are best-served by dollar-cost averaging, investing a set amount of money every month regardless of what the market's doing. Companies bent on repurchasing stock should probably do the same.

No need to apologize, Jamie. Just try not to do it again. And again. And again.

Fool contributor Morgan Housel owns B of A preferred stock. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Netflix, JPMorgan Chase, Bank of America, and Citigroup. Motley Fool newsletter services have recommended buying shares of Netflix. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.


Read/Post Comments (19) | Recommend This Article (38)

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  • Report this Comment On May 23, 2012, at 3:33 PM, slpmn wrote:

    I wasn't aware the big banks need permission to buy shares and pay dividends. I know that was the case while they had TARP money, but thought that ended when they paid it back.

    Also, I'm highly skeptical these companies do buybacks for the shareholders. I think its all about propping up EPS by offsetting the dilutive impactof options and stock grants for executives. In 2011 alone, JP Morgan granted its top 5 execs $40,260,000 in restricted stock and $15,084,600 in fair value of stock options. I don't know how many shares the options cover, but $15 million worth would cover a lot.

    If it was about shareholders, they would just use the buyback money to pay more dividends. Coporate financial and investment theory may argue buybacks and dividends are the same, but I would argue the return on buybacks is just that - theoretical, while the return on dividends is pretty easy to measure.

  • Report this Comment On May 23, 2012, at 5:13 PM, HaMb0 wrote:

    Morgan,

    What about the investors that sold the shares to JPM when the stock was at the high points? From their point of view, JPM was buying at just the right time. I think an alternate view would be that buying stock at the highs rewards investors who see the high, as well as potentially staving off the stock drop by undiluting (is that a word?) their shares. I'd love to hear your thoughts on this alternate point of view if you have a moment.

    Thanks,

    HaMb0

  • Report this Comment On May 23, 2012, at 5:46 PM, CoreAndExplore wrote:

    Morgan, you may have hit on a rather interesting phenomenon: perhaps share buybacks are somewhat predictive when it comes to future performance. I would love to see an analysis showing correlation between above average buyback periods with below average future stock performance. It would make sense, given the fact that insiders rush to exercise as many options as possible when prices are high, thus creating the need for buybacks to offset dilution.

    I agree wholeheartedly with your assertion that shareholders would be far better served if companies initiated consistent buybacks at regular intervals, much like dividends, thereby taking advantage of DCA. Imagine how many shares BAC would have bought back in early 2009 had they adhered to that strategy! Earnings per share would be about twice what they are today I'd imagine, thus boosting the share price substantially from where it is today. Ugh, I'm so tired of the lack of true stewardship in today's companies, it's like they feel entitled to our investment dollars.

  • Report this Comment On May 23, 2012, at 6:00 PM, haysdb wrote:

    I would expect management to care more about

    shareholders than share sellers. Benefiting those selling your stock is like giving a bonus to an employee who has just submitted their resignation.

  • Report this Comment On May 23, 2012, at 7:40 PM, sklogw wrote:

    I've always been disappointed by buybacks, because to me it simply suggests management without imagination.

    Really, you can't think of a better way to invest in your business? Then should you be CEO?

  • Report this Comment On May 23, 2012, at 8:06 PM, NJ7 wrote:

    Wait, aren't we all getting a little too worked up over this? This is a great indicator of fair value!!! Buybacks=sell, sell, sell

    Suspended buybacks=buy, buy, buy

    If only CEOs could be consistently incompetent though...

  • Report this Comment On May 23, 2012, at 10:45 PM, TempoAllegro wrote:

    Agreed that dividends are much better than buybacks.

    However, one rationale in favor of buybacks is that the buyback money is single taxed (the corporation pays taxes on it) as opposed to double-taxed dividends (corporations pay tax on dividend money and then so do investors after disbursement).

    It would seem to me that the best time to do a buyback on a regular interval would be around dividend time - not long before the dividends are to be disbursed (dividend date). Theoretically, the share price would naturally go up on the dividend date as some investors would be reinvesting dividends automatically. So a company could conceivably get a slight discount to that bounce 4 times per year and they would not need to worry about their poor market timing.

    The same dollar cost averaging approach four times a year that works for individual investors reinvesting dividends could easily work just as well for those monkey-brained CEOs who are better off running other aspects of the business.

    There must be some smart companies out there that do this. Does anyone know of a company that is pretty good at buybacks? I would suspect XOM would be decent at it.

  • Report this Comment On May 24, 2012, at 5:30 AM, wax wrote:

    Give me the dividend and I will gladly pay the taxes owed. The fact that it is a double taxing event really doesn't matter to me at all.

    Wax

  • Report this Comment On May 24, 2012, at 7:57 AM, gibbstom13 wrote:

    why don't you take it a step further and analyze the valuation at which the shares were purchased...the share price alone is extremely meaningless.

  • Report this Comment On May 24, 2012, at 8:35 AM, daveandrae wrote:

    Morgan-

    You're a better writer than this.

    Not only is hindsight "20/20", not only are you indirectly discouraging investors from buying a Dow Jones Industrial stock that is, right now, selling at a discount to its tangible net asset value, yields more than the historical inflation rate of 3% and yields a tremendously attractive 16.23% in earnings power to ones cost basis on 2013 earnings estimates, but there are some companies, not many, but a few, that have an impeccable record when it comes to share repurchases.

    McDonald's has been buying back its stock ever since I became a shareholder at 13 in 2003. Next time, could you please think about writing something just a little bit more positive.

    Thank you. :-)

  • Report this Comment On May 24, 2012, at 9:09 AM, TMFMorgan wrote:

    Some companies,yes, but that doesn't contradict most doing a poor job with buybacks. And JPM trading cheaply isn't an excuse for management fumbling buybacks.

    Thanks!

    -Morgan

  • Report this Comment On May 24, 2012, at 3:14 PM, captainvalue wrote:

    What about buying back stock only when certain valuation metrics are reached?? Buffett chose 1.1 book. He obviously thinks that is a very low valuation for Brk. Banks could easily use a P/book target as well - at least as a first screen as to when to repurchase shares. If JPM only repurchased shares when P/B was no more than 1, they would've bought back shares in late 2002, maybe mid 2005, mid 2008, and then more recently. Amazingly, those dates match the lows on the price chart. Not rocket science here folks. I think it is a pretty good bet that a rationally determined valuation target will lead to reasonably good results over time. Not perfect, reasonably good.

  • Report this Comment On May 25, 2012, at 7:55 AM, daveandrae wrote:

    Morgan-

    For the most part, I agree with you. Here is where we disagree.

    1. There are more than 3,000 individual stocks listed on the NYSE. If Morgan Housel is not intelligent enough to construct an equity portfolio of, say, five outstanding businesses that have an impeccable buyback history, than it is YOU, not the company's management, that is doing the "poor job."

    2. By 2013, which is only seven short months away, at current market prices, JPM stock will be yielding 16.23% in earnings power, compared to 8.63% for the s&p 500, 2% for bonds and 0% for cash. Everything else, in my opinion, is NOISE. Noise that you, Sir, had better learn to tune out if you're going to be successful in this business.

    I can still vividly recall when Apple sold at the exact same valuation, or a market price of 12 in the early 2000's with NO takers. You should have seen the responses when I inquired about investing in it..."Dog!", will be "out of business in less than 12 months"...without a "bailout" from Microsoft, the company would already be bankrupt, .blah, blah, blah. And mind you, this was AFTER, not before, the Nasdaq had fallen from 5,000 to 1200.

    Ten years later, here we are all over again. Only now it is Apple who is buying back stock at market prices of 550+ a share.

    This is what makes investing so difficult. Not only does the business cycle keep repeating itself, but every dirt cheap, blue chip stock, is surrounded not by a few, but by a zillion reasons not to buy it.

    In my fourteen years of experience in this business, I have learned the hard way that, say, five years from now, it is far more probable as opposed to possible, that the annualized rate of return from JPM stock will resemble its 16.23% earnings yield in spite of your opinion of its management.

    Good day.

  • Report this Comment On May 25, 2012, at 10:27 PM, TENOFWANDS wrote:

    OBVIOUSLY, these buybacks need to be hedged with an equivalent SHORT POSITION.

  • Report this Comment On May 26, 2012, at 2:09 PM, ChrisBern wrote:

    Morgan--great article. Just a few weeks ago I finished an MBA research paper on this very same topic, and the facts support your case. Using S&P 500 buyback figures dating back to 1998, and linear regression analysis, my research came to a few conclusions: (a) over the long run (e.g. from 1998-2011), buybacks were well-timed i.e. companies bought back more shares when shares were cheaper and vice-versa--past research generally shows this as well, (b) but over the last 5 years (9/30/2006 - 6/30/2011), not only were buybacks positively correlated with valuation, but valuation was by far the biggest influencer of buybacks. Meaning over that 5-year period, companies bought by far the most shares when stocks were most expensive and vice-versa, and that other independent variables such as profits didn't even influence buyback volume over that period of time. The model had an r-squared of .84 and valuation had a p-value less than 0.0001! (I used PE10 for valuation.) So the numbers support your case and show that it was as if companies WAITED for shares to become expensive before buying.

    I'd add a 4th possibility as to why this has been the case over that 5-6 year period: when shares have been cheapest over that time period, the economic picture has looked murky with the financial crisis/Europe/etc. So companies feel they need to hoard cash during those dismal time periods, and then when stocks go up in value, the economic outlook looks rosier, and they release all of that hoarded cash as they don't feel the need to bunker themselves up as much. I think this is a psychological hangover from the crisis, as this hasn't historically been the case. Anyhow just wanted to support your research with hard statistical fact analysis!

  • Report this Comment On May 28, 2012, at 7:18 AM, ghostchile1 wrote:

    Lest we forget...the old USAir in 2002 (before the Am West merger) embarked on a mighty stock buyback. The stock started at $60/share and $1B200M later, it stood at $5. A second bankruptcy happened later. Ghostchile1

  • Report this Comment On May 28, 2012, at 9:16 AM, ghostchile1 wrote:

    A small edit about the USAir buyback...it was started by then CEO Steven Wolf in 1998 as a $500 million program. USAir, at that time, reported over $2B in liquidity The stock buyback was expanded as the share price fell. By 2003, Wolf was gone, $1B200M was gone and USAir was in its second bankruptcy.

    Ghostchile1

  • Report this Comment On May 31, 2012, at 2:49 PM, rmoreira wrote:

    Instead of increasing the dividend, or share buybacks, why not just decide an amount and issue a special dividend for that amount. Then you don't have to worry about an increase as a percent of revenue.

    Ron

  • Report this Comment On May 31, 2012, at 6:05 PM, MHedgeFundTrader wrote:

    This is far and away the world’s premier banking institution. Estimates of the huge trading losses by the London “whale”, initially pegged at $2 billion, have since skyrocketed to $6 billion. I’ll ignore the Internet rumors that speculate about a $30 billion hickey. As you well know, almost everything on the net is not true, except what you read in my own newsletter.

    Back in the 1980’s when I was at Morgan Stanley, the inside joke was to look for nice office space for ourselves whenever we visited clients at (JPM). The expectation was that they would take us over when Glass-Steagle ended, as they were both the same institution before the Securities and Exchange Act broke them up in 933. When the separation of commercial and investment banking finally came in 1999, Morgan Stanley had grown far too big to swallow and the egos too big to manage.

    I’ll tell you another way to look at this trade. (JPM) lost 4.7% of its capital, so Mr. Market chewed 30% out of its capitalization. Sounds a bit overdone, no? The bad news is already in the price. A large part of the offending position has already been liquidated.

    I have analyzed the specific trade that got (JPM) into so much trouble, the now infamous “Investment Grade Series 9 Ten Year Index Credit Default Swap.” The chart of its recent performance and its hedge is posted below. It was in effect a $100 billion “RISK ON” trade that came to grief in early May.

    Few outside the industry are aware that this was a $6 billion gift to two dozen hedge funds who are now shouting about record performance. It is, after all, a zero sum game. Didn’t Bruno get the memo to “Sell in May and go away”? He obviously doesn’t read The Diary of a Mad Hedge Fund Trader either.

    Even if the worst case scenario is true and the $6 billion numbers proves good, that only takes a 4.7% bite out of the bank’s $127 billion in capital. It is in no way life threatening, nor requiring any bailouts. These shares at this price are showing an eye popping low multiple of 7X earnings, and have already been punished enough. Getting shares this cheap in this company is a once in a lifetime gift, and twice in a lifetime if you count the 2009 crash low.

    You don’t have to run out and bet the farm right here. Scale in instead, and if the market drops, you can always cost average down. If Greece forces us into major meltdown mode, we can also hedge this “RISK ON” trade through taking more aggressive “RISK OFF” positions, like selling short the (FXE), (SPX), (IWM), (GLD), or the (SLV) by buying puts.

    Mad Hedge Fund Trader

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