U.S.A., Inc.: Another Historic Misallocation

This week, the Financial Times reported that U.S. companies are announcing share buybacks at a rate unequaled since Lehman Brothers' bankruptcy. Surely, this is a clear sign of growing confidence of the corporate sector, as well as a catalyst for further stock market gains. However, today's buybacks also perpetuate companies' gross misallocation of shareholder capital. After selling their own shares low, they're buying them high.

This is not a good entry point
Let's be quite clear about the underlying economics of these transactions. Share repurchases are picking up now that the market has already doubled off the March 2009 low. Meanwhile, that low occurred immediately before company share issuance hit a cyclical high.

On the topic of buybacks – as on most others relating to investing -- it's useful to seek the counsel of arguably the greatest capital allocator of all, Berkshire Hathaway CEO (NYSE: BRK-B) Warren Buffett. In his 1984 Letter to Berkshire shareholders, he wrote:

When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.

Surely you want to buy low and sell high -- right?
By that standard, S&P 500 companies as a group won't be doing their shareholders any favors with these repurchase programs. The chairman of GMO, Jeremy Grantham, reckons that the index is worth roughly 910, suggesting that it's now priced at a 47% premium beyond its fair value. If that's true – and Grantham's track record suggests he knows a thing or two about value -- companies should be eager to sell shares, instead of ramping up their buying.

Unfortunately, the pattern is familiar: With the previous cyclical bull market under way, share buybacks for the S&P 500 accelerated in the second half of 2004, capped off with a sharp spike during the first two quarters of 2007 – just as the stock market was peaking. Similarly, there was a spike in share buybacks during the second half of 1999 through the first quarter of 2000, as the technology/ large-cap share bubble was having its last hurrah.

Five companies to watch closely
Not all companies have the same record in regard to buybacks and repurchases -- although very few demonstrate consistently good results on this front. The suspect companies in the following table bought back huge bunches of shares during 2006-2007:

Source: Author's calculations, based on data from Capital IQ, a division of Standard & Poor's.

That's right -- even the finance whizzes at Goldman Sachs (NYSE: GS) are guilty. During the go-go years of 2006 and 2007, the bank repurchased nearly $17 billion in shares. Then it turned around and issued roughly $12 billion of common stock from Q4 2008 through Q2 2009, during the worst of the bear market. (Let's not forget that very costly preferred offering to Warren Buffett, either.) That isn't God's work, Mr. Blankfein -- it's a capital sin.

This business genius got it right
Executives from these companies could take a lesson from a master capital allocator from yesteryear: Dr. Henry Singleton, the founder and former CEO of Teledyne (NYSE: TDY). Singleton was a real genius -- he won the William Lowell Putnam Mathematical Competition while at MIT – and an outstanding businessman. Warren Buffett once said that Singleton had the best operating and capital deployment record in American business.

When Teledyne's shares were richly priced, as in the 1960s, Singleton would never have dreamed of buying them back. Instead, he used them as currency for acquisitions. However, once the secular bear market of the 1970s had laid waste to equity valuations, Singleton became an active buyer of Teledyne shares. Between 1972 and 1984, he tendered for the shares eight times, ultimately reducing the number of shares outstanding by roughly 90%. The stock, which changed hands for less than $6 in 1972, was worth more than $400 in 1987 on a split-adjusted basis.

Shortly before he died in 1999, Henry Singleton told Leon Cooperman, an investor and former Goldman Sachs partner, that too many companies were doing share repurchases, and that there must be something wrong with them. If he were around to witness this market, I think he might sound the same warning today.

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