Buybacks Can Predict Profits

Biotech behemoth Amgen (Nasdaq: AMGN  ) announced Tuesday that its board authorized a buyback of as much as $5 billion worth of stock. Yep, $5 billion. And that's in addition to the buyback of nearly $1 billion it announced previously. Management says it's a reflection of the board of directors' belief in the company's future, but should you believe it? More importantly, can you profit from it?

Share buybacks should cause a stock's price to rise -- theoretically. Since Wall Street and investors focus on a company's earnings per share figure each quarter, reducing the number of shares outstanding should boost the EPS number (for those who have forgotten, EPS is determined by dividing net income by shares outstanding). Thus Amgen buying back $5 billion of its stock (currently trading around $62 a stub) should enable the company to buy up some 80 million outstanding shares. Add in the 15 million shares from the prior buyback, and you're talking some serious share retirement.

Ah, but there's the rub! Companies don't have to buy back all of the shares they say they're going to buy. In fact, they can outright cancel a buyback without buying up a single share of their stock. Equally important, they can dilute the value of the buyback by issuing options. Indeed, buybacks are many times done simply to offset the dilution created by stock options in the first place. Not a very effective use of owners' earnings.

But oftentimes, just announcing a share buyback has the salutary effect of causing the stock's price to rise. That's because a buyback announcement signals management's belief that the stock is undervalued, and quite frequently it is. Investors then buy in, raising the share price and negating its undervalued status. That's one reason why stock buybacks are not completed.

In the first week of December alone, there have been 19 buyback announcements: Defense contractor Raytheon (NYSE: RTN  ) announced a $700 million buyback, while tractor maker Deere (NYSE: DE  ) announced a $1 billion buyback. At RealtimeTraders.com, you can see a list of all the companies that announce stock buybacks. Just check the "Stock Buybacks" listed in the calendar section. You'll find Kellogg (NYSE: K  ) , Gap (NYSE: GPS  ) , Kraft (NYSE: KFT  ) , and Yankee Candle (NYSE: YCC  ) , among others, have all announced share buybacks this month.

So how can an investor profit from this information? RealtimeTraders.com provides four months' worth of buyback announcements. In August, there were 50 buybacks announced. In a completely unscientific analysis, I looked at just the first 10 buybacks announced that month and found the companies averaged a 21.5% gain while the S&P 500 gained an average of only 7.4%. Of the 10 companies, there were eight advancers and two decliners. Of those two, one is in danger of being delisted from the Nasdaq since its auditor quit and it was late in filing its quarterly reports. Of those that advanced, only one, Cal-Maine (Nasdaq: CALM  ) , failed to beat the market.

Did investors have to buy right away on the announcement? No. Of those 10 companies, many stocks experienced a decline initially (but then again so did the market), and it took most about one month, or a little more, to begin their advance. The market had recovered in about three weeks. Only one company began its ascent right away, while two stocks took three months to start their climb. Even the two losers initially advanced before falling hard.

I did a quick look at the list of companies that announced buybacks in September, too. The first five companies on the list advanced an average of 12.9%, while the market averaged only 5.7%. There were three advancers and two decliners, a somewhat higher ratio than before, but the average advance was 24.2% and the average decline was 4%. The advances started a little bit sooner than they did in the last group, about two to three weeks after the announcement. That's probably a reflection of the rising market.

How about those companies mentioned above that announced buybacks this month? Five are lower than when they made the announcements, while one -- Yankee Candle -- is up less than 2%. Might these be values waiting to be snatched up?

I don't recommend using a buyback announcement as an automatic "buy up" signal for investors, but I do think you can use it as a starting point for further research. As investors, we like to buy stocks at a discount; it gives us our margin of safety. A share buyback announcement is one way of sifting out companies that management feels are value-priced. Digging deeper into the companies that do make such announcements, though, can perhaps show you which ones will be the most profitable investments.

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Fool contributor Rich Duprey does not own any of the stocks mentioned in this article.


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