How Investors May Be Getting Misled by Buybacks

If you're puzzled why the U.S. stock market has risen so fast in a slow-growing economy, consider one of its star performers: DirecTV.

The satellite TV provider has done a great job slashing expenses and expanding abroad, and that has helped lift its earnings per share dramatically in five years. But don't be fooled. The main reason for the EPS gain has nothing to do with how well it runs its business. It's because it has engaged in a massive stock buyback program, halving the number of its shares in circulation by purchasing them from investors.

Spreading earnings over fewer shares translates into higher EPS -- a lot higher in DirecTV's case. Instead of an 88% rise to $2.58, EPS nearly quadrupled to $5.22.

Companies have been spending big on buybacks since the 1990s. What's new is the way buybacks have exaggerated the health of many companies, suggesting through EPS that they are much better at generating profits than they actually are. The distortion is ironic. Critics say the obsessive focus on buybacks has led companies to put off replacing plants and equipment, funding research and development, and generally doing the kind of spending needed to produce rising EPS for the long run.

"It's boosted the stock market and flattered earnings, but it's very short term," says David Rosenberg, former chief economist at Merrill Lynch, now at money manager Gluskin Sheff. He calls buybacks a "sugar high."

Over the past five years, 216 companies in the S&P 500 are just like DirecTV: They are getting more of a boost in EPS from slashing share count than from running their underlying business, according to a study by consultancy Fortuna Advisors at the request of The Associated Press. The list of companies cuts across industries, and includes retailer Gap, supermarket chain Kohl's, railroad operator Norfolk Southern and drug distributor AmerisourceBergen.

The stocks of those four have more than tripled, on average, in the past five years.

Companies insist that their buybacks must be judged case by case.

"The vast majority of our shareholders are sophisticated investors who not only use EPS growth but other important measures to determine the success of our company," says Darris Gringeri, a spokesman for DirecTV.

But Fortuna CEO Gregory Milano says buybacks are a waste of money for most companies.

"It's game playing -- a legitimate, legal form of manufacturing earnings growth," says Milano, author of several studies on the impact of buybacks. "A lot of people (focus on) earnings per share growth, but they don't adequately distinguish the quality of the earnings."

So powerful is the impact, it has turned what would have been basically flat or falling EPS into a gain at some companies over five years. That list includes Lockheed Martin, the military contractor, Cintas, the country's largest supplier of work uniforms, WellPoint, an insurer, and Dun and Bradstreet, a credit-rating firm.

It's not clear investors are worried, or even aware, how much buybacks are exaggerating the underlying strength of companies. On Friday, they pushed the Standard and Poor's 500 stock index to a record close, up 178% from a 12-year low in 2009.

"How much credit should a company get earning from share buybacks rather than organic growth?" asks Brian Rauscher, chief portfolio strategist at Robert W. Baird & Co, an investment company. "I think the quality of earnings has been much lower than what the headlines suggest."

And it could get worse.

Companies in the S&P 500 have earmarked $1 trillion for buybacks over the next several years. That's on top of $1.7 trillion they spent on them in the previous five years. The figure is staggering. It is enough money to cut a check worth $5,345 for every man, women and child in the country.

There is nothing necessarily nefarious or wrong about buybacks per se. It doesn't seem that managements are trying to cover up a poor job of running their businesses. Even without factoring in a drop in share counts, earnings in the S&P 500 would have risen 80% since 2009.

The problem is that many investors are pouring money willy-nilly into companies doing buybacks as if they are always a good thing, and at every company.

A fund that tracks companies cutting shares the most, the PowerShares Buyback Achievers Portfolio, attracted $2.2 billion in new investments in the last 12 months. That is nine times what had been invested at the start of that period, according Lipper, which provides data on funds.

For their part, the companies note there are all sorts of reasons to like them besides EPS.

WellPoint points out that it has increased its cash dividend three times since 2011, a big draw for people looking for income. Cintas says that it's timed its buybacks well, buying at a deep discount to stock price today. And DirecTV says investors judge it also by revenue and cash flow, both of which are up strongly.

What's more, companies seem to genuinely believe their shares are a bargain and they'd be remiss for not buying, though their record of choosing the right time is poor.

The last time buybacks were running so high was 2007, right before stocks fell by more than half.

There are signs the next $1 trillion in buybacks for S&P 500 companies could also prove ill-timed. Stocks aren't looking so cheap anymore. After a surge of nearly 30% last year, the S&P 500 is trading at 25 times its 10-year average earnings, as calculated by Nobel Prize-winning economist Robert Shiller of Yale. That is much more expensive than the long-term average of 16.5.

Many investors assume shrinking shares automatically make remaining shares more valuable. The math is seductive. A company that has $100 in earnings and 100 shares will report $1 in earnings per share. But eliminate half the shares and the same $100 is spread over 50 shares, and EPS doubles to $2.

But that doesn't make the shares more valuable.

Shares aren't just a claim on short-term earnings. They are an ownership stake in an entire company, including R&D programs and plants and equipment needed to boost productivity long into the future. Critics say it's no accident companies are spending lavishly on buybacks at a time when investment in their capital stock, or assets used to produce earnings, is the weakest in decades.

"It's just like your car depreciating or your home depreciating -- you have to invest," says Gluskin Sheff's Rosenberg, "The corporate sector is barely preventing the capital stock from becoming obsolete."

One result: U.S. productivity, or output per hour, increased just 0.5% last year, a pitiful performance. It has grown by an average 2% a year since 1947.

It's unclear whether the kind of investor who dominates stock trading now cares about the long-term consequences of buyback mania. Buybacks are one of the few sure-fire ways to push a stock higher in the short term, and investors these days are very short term.

They "don't care what happens in three or five years," laments Rauscher, the Baird strategist. "The market has become less of an investor culture, more of a trading one."

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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 March 12, 2014, at 12:17 PM, ejazz2095 wrote:

    Since when did Kohl's become a supermarket chain?

  • Report this Comment On March 12, 2014, at 4:23 PM, JohnCLeven wrote:

    I disagree entirely.

    First of all, EPS growth via buybacks is not intrinsically better or worse than EPS growth via expanding overall size of the business.

    A buyback simply increases the % ownership of every shareholder in the existing business.

    Whether or not a buyback is better or worse than organic growth (and by that mean which is a better allocation of shareholder capital) is a function of 1) How profitable is the current business? 2) How profitable (or unprofitable) is organic growth likely to be compared to our existing operations, and 3) What is the valuation of the current business.

    At the end of the day, it makes ZERO economic difference whether your farm generates a 10% increase in wealth for you because 1) the farm got 10% bigger in acres, but your % ownership stayed the same, or 2) generated 10% increase in wealth for you because your % ownership grew 10% in a farm that grew 0% in size. Either way, the future cash flow attributable to your economic interest in the farm grew at 10%. That's all that matters.

    Many, mature, cash-rich businesses reach a stage where they can no longer organically grow shareholders capital at attractive rates of returns. Thos occurs when businesses try to expand too far BEYOND their competitive advantages.

    A real life example is Wal-Mart who tried, and utterly failed to expand beyond North America. In doing so, they destroyed alot of shareholder capital. If Wal-Mart had instead, used the same about of capital to buy back shares (aka increase the shareholders % ownership in the amazing North American business) they would have created much more value.

    However, when the invetiable day comes, that a wonderful business franchise reaches the point where they can no longer "get bigger" profitably, the shareholder friendly thing to do is to increase the buybacks, so long as the business is not radically overvalued.

    If McDonald's (a stock I own) leadership team realizes that they can no longer grow the McDonald's franchise, organically, at attractive rates of return, I would MUCH rather they use excess capital (my capital) to increase my ownership in the existing, highly profitable) McDonald's resturants, (a sure thing) than instead use my capital to do something dumb or risky, like make a costly aqusition, or dabble with new resturant concepts. (more like gambling.)

    Sorry for ramblin, but it's important to understand that.

  • Report this Comment On March 13, 2014, at 9:57 AM, padrefigure wrote:

    I agree completely and will add this thought. A mature companyhas two ways to funnel money to shareholders--dividends and stock buyback. For the longterm shareholder, stock buybacks are more tax efficient. From the standpoint of the firm, a stock buyback is simply a transfer of cash to equity. The value of the firm remains the same. Conceivably, the firm could reverse the transaction in the future by issuing new shares and converting them to cash. With dividends, the cash leaves the firm and the value of the firm declines by the amount of the dividend.

    With regards to the investment in plant, equipment, inventory, personnel, etc. this may seem like a bold proclamation, but every business could improve value creation by going on a fiscal diet. Look at companies like Danaher and Toyota and you will see that they produce more per unit of input (square foot of manufacturing, number of people, days of inventory, etc.) today than ever in their history. And if you ask the managers of these businesses, they will tell you that they have just begun to scratch the surface of what is possible.

    So to conclude, EPS by itself does not determine the value of the firm. Concluding that stock buybacks are bad because they inflate EPS is shortsighted.

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