2 Stocks That Are Wasting Your Money

Your company's buying back stock? Hurray! Or should that be "Boo!"?

According to Boston University finance professor Allen Michel, when a company announces it's buying back stock, that stock tends to outperform the market by 2% to 4% more than it otherwise would have over the ensuing six months.

But over the long term, multiple studies show that buybacks actually destroy shareholder value. CNBC pundit Jim Cramer cites the example of big banks that bought back shares in 2007-2008 -- just before their stocks fell off a cliff. Far from buy signals, Cramer calls buybacks "a false sign of health ... and often a waste of shareholders' money." Indeed, the Financial Times recently warned: "the implied returns over a period from buy-backs by big companies would have been laughed out of the boardroom if they had been proposed for investment in ... conventional projects."

So why run buybacks at all? According to FT, management can use them to goose per-share earnings, which helps CEOs earn bonuses based on "performance." Also, the investment banks that run buybacks earn income and fees from promoting them. But you and me? Unless the purchase price is less than the shares' intrinsic value, we miss out.

And we're about to miss out again.

American Capital  (NASDAQ: ACAS  )
Last month, business development firm American Capital -- a subject of frequent controversy on these pages -- announced it had just completed a massive, 8.8 million-share repurchase on the open market. At first glance, this looks like quite a good deal. AmCap says it spent $103 million on the shares, or about $11.72 apiece. With its shares now sitting north of $13, that works out to a tidy 12% profit already.

Indeed, you might even think AmCap should buy more. Management puts its net asset value at $17.39, or about 33% above today's price, suggesting there's more upside ahead. But here's the thing: All this assumes that AmCap's assets are worth what management says they're worth. They might be. After all, over at Berkshire Hathaway, boss Warren Buffett recently offered to pay as much as 1.2 times the book value of his own firm in another buyback announcement. But on the other hand, management is hardly unbiased on these kinds of questions. So how can shareholders know for sure they're getting good value for their money?

It's hard to get "under the hood" and examine AmCap's assets directly. But logically, if they're worth what management says they're worth, then over time, they should produce profits for the company, and those profits should show up on the income statement -- and here's the problem.

Over the past 10 years, AmCap has netted a whopping $327 million -- total -- in profits from its business. That's less than $33 million a year, giving the company about a 124 P/E based on its historical rate of earnings. Suffice it to say, this detracts from management's credibility regarding how much its shares are worth... and whether it should be spending your money to buy back more of them.

Boeing (NYSE: BA  )
In contrast, Boeing's announcement that it's hitting the restart button on a $3.6 billion share repurchase program (and upping its dividend to boot) would ordinarily merit praise. Unlike AmCap, Boeing's been consistently profitable over the past decade, raking in about $2.3 billion annually -- and making nearly twice that over the past 12 months, en route to the company's most profitable year ever.

Priced at only 13 times earnings, growing at 12%, and paying a 2.6% dividend, Boeing shares look like a value investor's dream. But here's the problem: Vastly profitable, Boeing is currently engaged in contentious contract negotiations with its SPEEA engineers' union, pleading poverty and demanding concessions from the union. Announcing a share buyback in such a context seems a slap in the face to the SPEEA, and has been hurting the company's chances of avoiding a labor strike. Considering that Boeing must have these engineers on the job to fix much-publicized problems with its Dreamliner aircraft, this buyback seems ill-considered, and particularly ill-timed.

Smith & Wesson (NASDAQ: SWHC  )
Now, I don't like to end this column on a down note, and fortunately, this week I don't have to. On one hand, you might think gun maker Smith & Wesson has even bigger problems than Boeing, what with the entire U.S. government (seemingly) now gunning for new strictures on weapons sales.

On the other hand... you'd be wrong. Historically, threats of legislation haven't really hurt the gun industry financially. And having been around the block a few times already (the company was established in 1852), Smith & Wesson knows an opportunity when it sees one.

Last month, S&W announced it is buying back up to $35 million worth of its shares. The company generates nearly that much cash in an ordinary year. And considering that S&W sells for just 11 times earnings, is growing earnings at 30%, and has no net debt, I think the shares offer great value -- for Smith & Wesson, and for the rest of us.

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Read/Post Comments (9) | Recommend This Article (1)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 22, 2013, at 9:27 PM, ahdl wrote:

    I don't think the cumulative 10-year earnings is the best metric by which to evaluate American Capital for a number of reasons, including the fact that that period included an extraordinarily severe financial crisis which necessitated writedowns which are now, in many instances, being reversed. But it's worth noting that your recommendation S&W has lost a cumulative ~$35 million over the same period--obviously far worse than ACAS's positive earnings.

    By all means make a case against ACAS, but do so on relevant metrics, using a consistent yardstick.

  • Report this Comment On January 22, 2013, at 9:31 PM, ahdl wrote:

    p.s. I use FY ending Apr of each year in the above statement; if you use most-recent TTM figures instead SWHC looks better, with basically no profit or loss over the past decade--again, though, no world-beater.

  • Report this Comment On January 22, 2013, at 9:36 PM, JTMcGee wrote:

    I never get tired of foolish articles about ACAS, and now it looks like we have two authors making fools of themselves.

    This follows an article titled "Avoid This Company" by John Maxfield in October 2012 http://www.fool.com/investing/general/2012/10/09/avoid-this-...

    And another article again by Mr. Maxfield in Februrary 2012 titled "The Truth Behind American Capital's Share Buyback"

    http://www.fool.com/investing/general/2012/02/07/the-truth-b...

    Anyone capable of following a conference call, reading their debt presentation in July, and looking at the stock price will realize that Fool writers have gotten this one wrong time and time again.

    As a shareholder I look forward to American Capital continuing to "waste" my money with repurchases. The fact that Fool writers cannot take the time to understand the company tells me that the spin-off in 2014 will create tremendous value for shareholders. This one is simply misunderstood by investors and commentators alike.

  • Report this Comment On January 22, 2013, at 10:27 PM, TMFDitty wrote:

    @ahld: That's a totally valid criticism, and thanks for pointing it out. The truth is that when valuing SWHC I rely more heavily on free cash flow -- a metric I'm not sure is as relevant for ACAS.

    Profitwise, you're right that SWHC has lost money over the last 10 years. But it's generated positive free cash flow (about $70M total) over the period, and especially these past few years.

    TMFDitty

  • Report this Comment On January 23, 2013, at 10:29 AM, Kingla wrote:

    For some reason Smith and Maxfield just don't like ACAS and for no valid reasons other than the financial meltdown which almost put them under 5 years ago. Since that time their performance and execution has been stellar and have rewarded shareholders immensely. The foolish authors have been consistently wrong but refuse to give it up.

    Their diatribes should be ignored.

    Hockeyzan

  • Report this Comment On January 23, 2013, at 10:58 AM, villainx wrote:

    Yeah, the criticism with buybacks may be valid, but holding ACAS as an example is misguided. Smith insistence on ACAS as a negative example is pretty awful.

  • Report this Comment On January 23, 2013, at 4:26 PM, indiobravo wrote:

    Comparing ACAS in 2013 with big banks in 2007-08 is as foolish as citing a clown as Cramer. You Fools are terribly fool.

  • Report this Comment On January 24, 2013, at 8:02 AM, boxertdog1 wrote:

    Many of the BDC's barely survivied the crash of 2008. ACAS is probably the hardest to understand as they have taken a path that uses up all their tax losses while they rebuild the company. Stock buybacks at a discount that is bigger than your profit margins makes sense over time. I am accumulating shares in my retirement acc and look forward to a quarterly dividend down the road.

  • Report this Comment On January 24, 2013, at 10:06 AM, NotMyBusinessBut wrote:

    Adhl, JT, et'al ..

    As I have so often proven before, The Fool writers are not interested in anything but page views, and nothing gets page views than writing misleading and incorrect nonsense, such to infuriate longs and other knowledgeable people to produce a response .. thus more page views.

    It's only about the page views.

    NMB

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