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Should You Bet Against Buybacks?

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The essence of contrarian investing is to find out what the dumb money is doing, and do the opposite. Yet when corporations buy back their own stocks, are they taking advantage of their superior knowledge of their own company, or are they simply wasting shareholders' money?

A rash of buybacks
Lately, companies are definitely back in the buyback mood. Just in the past month or so, several big companies have announced major plans to buy back their stock. Take a peek:

Stock

Date Announced

Amount of Buyback

1-Year Return

Northrop Grumman (NYSE: NOC  )

6/17

$2 billion

37.4%

Dollar Tree (Nasdaq: DLTR  )

6/21

$500 million

50.1%

CVS Caremark (NYSE: CVS  )

6/14

$2 billion

2.5%

Netflix (Nasdaq: NFLX  )

6/11

$300 million

194.2%

Monsanto (NYSE: MON  )

6/9

$1 billion

(36.6%)

Wal-Mart (NYSE: WMT  )

6/4

$15 billion

7.1%

Source: Online Investor, Yahoo! Finance.

I've included recent returns on these stocks to illustrate a point: All too often, companies end up buying stock only after their prices make huge runs higher. Netflix is the obvious example, having nearly tripled in value in the past year.

To be fair, some of these companies have authorized past buybacks at lower share prices, which proved to be a smart move. Yet the question remains: At this moment in time, do these stocks have the strength to continue to advance enough to make buying their own shares the best investment available for spare company cash?

Bad timing
Many companies have a fundamental problem with buybacks that explains their bad timing. In general, companies have the most profits and spare cash to spend on buybacks during good times, when they're performing well. Yet those good times are exactly when investors feel the most confident about that company's stock; therefore, its share price is likely to be expensive at those moments.

Conversely, the perfect time to buy back stock is during a crisis, when a company's prospects are uncertain. Unfortunately, most companies are busy responding to the crisis at those times, unable or unwilling to spend precious cash on buybacks when it may be needed for other purposes.

One particularly vivid example of this phenomenon is General Electric (NYSE: GE  ) . Between 2004 and 2007, the company spent $27 billion buying back shares. Then, in 2008, the shares collapsed, as the company's GE Capital financing unit suffered along with the entire financial sector. Eventually, the company was forced to raise capital by issuing preferred shares to Berkshire Hathaway, under terms that certainly would have made management wish it hadn't used all that cash on buybacks earlier in the decade.

Bucking the trend
Of course, not every company squanders capital at bad moments. Monsanto, for instance, is clearly taking advantage of a tough time for the fertilizer and seed maker to pick up its own shares at a rare bargain price. Value investors can more readily understand a decision to buy low, rather than chasing past performance.

Another example of good capital management is Wynn Resorts, which has bought back shares cheaply, and then offered new shares at higher prices, several times in the past. Although it doesn't have a perfect record, there are several occasions in which CEO Steve Wynn has offered new shares near market peaks, only then to buy them back at much lower prices down the road. That capital allocation expertise translates to extra money for the company. Although one might argue that it exploits shareholders, there's nothing forcing investors to buy expensive shares at secondary offerings, or sell them back to the company cheaply during buybacks.

Dealing with extra cash
Before a company buys back its shares, it needs to determine whether that move is its best use of capital. If the answer is a confident yes, then the buyback probably makes sense. Otherwise, alternatives like paying special dividends can return control of extra corporate cash to shareholders, who can then decide whether to reinvest in additional shares, or take the money and run.

Buybacks aren't universally bad or good. Whether it's a smart move for a company depends entirely on the particular stock in question. However, the idea that they're automatically a good thing for shareholders fails to understand the fundamental reasoning behind buybacks. Just because a company announces a buyback doesn't make its stock attractive.

Nobody's gonna be happy with buybacks if the market crashes. Ilan Moscovitz describes the coming financial meltdown.

Fool contributor Dan Caplinger hasn't much been in a buyback mood. He owns shares of General Electric. Berkshire Hathaway, Monsanto, and Wal-Mart Stores are Motley Fool Inside Value recommendations. Berkshire Hathaway and Netflix are Motley Fool Stock Advisor choices. Motley Fool Options has recommended a synthetic long position on Monsanto. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletters today, free for 30 days. Never bet against the Fool's disclosure policy.


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Dan Caplinger
TMFGalagan

Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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