According to research conducted by Boston University finance professor Allen Michel, when a company announces it's buying back stock, that stock tends to outperform the market by about 2% to 4% more than it otherwise would have over the ensuing six months.
But multiple studies show that over the long term, buybacks actually destroy shareholder value. CNBC pundit Jim Cramer cites the example of big banks that bought back shares in 2007-2008 -- just before their stocks fell off a cliff. Far from being buy signals, Cramer calls buybacks "a false sign of health ... and often a waste of shareholders' money." Indeed, the Financial Times recently warned that "the implied returns over a period from buy-backs by big companies would have been laughed out of the boardroom if they had been proposed for investment in ... conventional projects."
So why run buybacks at all? According to FT, management can use them to goose per-share earnings, which helps CEOs earn bonuses based on "performance." Also, the investment banks that run buybacks for management earn income and fees from promoting buybacks. But you and me? We miss out on gains unless the purchase price is less than the actual intrinsic value of the shares.
And we're about to miss out again.
Two bad buybacks
StreetInsider.com keeps a running tally of which companies are buying back stock, and how much they're spending. SI is too polite to accuse companies of actually wasting shareholders' money, of course -- but I'm not. With SI's help, I've come up with two examples of popular stocks that I believe are squandering shareholder dollars on ill-timed buybacks... and one idea for how shareholders could do better.
At first glance, surgical implants-maker Stryker seems a strange subject for an "anti-buyback" article. At 16 times earnings, the company carries a cheaper P/E than archrival Zimmer Holdings
It's what Stryker intends to do with its cash that should concern investors. In October, you see, Stryker reduced estimates for revenue growth, yet at the same time promised to earn more than expected, upping its fiscal 2011 target to approximately $3.72 per share. With profit margins declining, hitting this new target may depend on reducing the share count, boosting per-share earnings.
Cue buyback. Earlier this month, Stryker announced it would boost its buyback plan by $500 million. With the growth rate still estimated at less than 11%, and free cash flow lagging reported net income, the shares don't look cheap enough that I'd buy them. Then again, I'm not on the hook for hitting an ill-considered profits promise. (Promise in haste, repent in leisure.)
Speaking of promises made in haste, did you hear that JPMorgan is increasing its buyback plan, too? It's true. With $8 billion in buybacks already authorized (and apparently spent) for this year, JP announced in December that it's upping its repurchase authorization by a further $950 million.
Good idea? JP's shares cost only seven times earnings, after all, and Wall Street has the stock pegged for 8% growth. That certainly looks cheap. The problem is that it may be "cheap for a reason." By now, you've no doubt heard about the troubles with European sovereign debt, the risk it may default... and the credit default swaps that banks like Bank of America
A better use of cash
Now, I don't want to end this column on a down note, and in fact, I have spotted one company out there that's spending its shareholders' money prudently. It's a name you probably know, seeing as I publicly recommended it just last week: Caterpillar
Doubling down on a program that's already rewarded shareholders richly, Caterpillar says that rather than allow its 2007 buyback program to expire as planned on Dec. 31, the company will extend it for another four years -- reopening a $3.75 billion war chest for opportunistic buys.
I think this is a great idea. At 14 times earnings, a strong 2% dividend yield, and a projected growth rate that tops 23%, the stock's already bargain-priced. If you ask me, this is one buyback program to bank on -- for Caterpillar, and for the investors who choose to buy it as well.
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Fool contributor Rich Smith does not own (or short) shares of any company named above. Ranked in the top 1% of CAPS investors, Rich has publicly endorsed Caterpillar -- and 55 other stocks. Which ones? Find out here.
The Motley Fool owns shares of Citigroup, Medtronic, Bank of America, Zimmer Holdings, and JPMorgan Chase. Motley Fool newsletter services have recommended buying shares of Stryker. The Motley Fool has a disclosure policy.
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