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Keep Track of Smart Stock Buybacks

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Many companies use stock buybacks in order to boost their shares and return excess capital to shareholders. Even in an environment where dividend payments are seen as the preferred method of rewarding shareholders, stock buybacks theoretically should achieve the same end of boosting share prices while avoiding the excess tax liability for shareholders that dividends create.

Stock buybacks have gotten a bad reputation, though, because so many companies buy their shares back at the worst possible times. Yet as a recent SmartMoney article suggested, a simple screen looking for those companies that actually spend their money when their share prices are unusually low can make a huge difference in a stock's future performance following a buyback.

The worst of times
A few months back, Fool contributor Morgan Housel took a look atJPMorgan Chase's (NYSE: JPM  ) track record of buybacks. Having bought back billions of dollars of stock in mid-2011 immediately before a 25% drop in its share price, JPMorgan found itself without spare cash to take advantage of the sudden bargain. Then earlier this year, the company authorized an even bigger buyback, yet it suspended it in the wake of the London Whale scandal, thereby again missing a chance to pick up its shares on the cheap.

Nor are banks the only offenders here. A more recent article detailed the share repurchase activity of tech giants. With Hewlett-Packard (NYSE: HPQ  ) , Dell, and Cisco Systems (Nasdaq: CSCO  ) having effectively burned billions of dollars on badly timed buybacks, it's easy to conclude that companies just don't have any idea what they're doing when they authorize repurchases of their shares.

Why not try value?
The saddest thing about these companies is that their buybacks didn't have to be unsuccessful. A little bit of patience would have given them much better opportunities to put their money to work.

For instance, consider Seagate (Nasdaq: STX  ) and Western Digital (Nasdaq: WDC  ) . Both companies have rock-bottom earnings multiples at the moment, as investors fear that the rise of solid-state drives will eventually lead to their hard-disk-drive technology becoming obsolete. Yet what Seagate and Western Digital bears are ignoring is that solid-state drives are still far more expensive than hard drives, and with a big boom in the need for storage coming from the cloud computing revolution, hard drives could well see huge demand for years to come. In that light, the multibillion-dollar stock repurchases that both companies are doing look like a well-timed bet on their continued relevance in the industry.

You can see similar examples from across the economy. Defense companies may be under the gun from potential budget cuts, but with their shares reflecting worst-case scenarios, smart companies are putting their cash to work buying those shares on the cheap. Similarly, SmartMoney also points at health-insurance companies, which are still reeling from the uncertainties involved in the Affordable Care Act and calls for new attempts at health care reform. Yet that isn't stopping many of them from buying back their shares in advance of hard answers to those lingering questions.

Learning from past mistakes
Yet another solution that many people haven't really considered is one that every company can follow: Just wait. Many companies act as if holding cash for even an extra quarter or two would burn a hole in their pockets. Yet by keeping that cash on hand, they can take advantage when opportunity strikes by buying shares right away.

Consider: No one blinks when a company decides to raise some extra money to consider a strategic acquisition. Yet buybacks -- the ultimate "strategic acquisition" in some regards -- get treated as a can't-wait proposition. That's harmful for shareholders, and the best companies look past that thinking to do right by their owners.

So when a company whose shares you own decides to do a buyback, take a look at its current valuation. If management isn't being smart with your company's money, then take a good long look at whether holding those shares could be hazardous to your financial health.

As useful as buybacks can be, dividends are crucial for your long-term financial health. Want to see the best of all dividend-paying companies? Then look no further than our latest special report highlighting nine dividend-paying stocks to secure your future. This report is free to you for a limited time, so click here to claim your investing edge.

Fool contributor Dan Caplinger would usually rather have the dividend. You can follow him on Twitter @DanCaplinger. He owns warrants on JPMorgan Chase. The Motley Fool owns shares of JPMorgan Chase, Western Digital, and Cisco Systems. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy keeps you smart.


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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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