When companies earn a profit, they have to figure out what to do with their newfound cash. Unfortunately, all too often, the same companies that are so good at running a profitable business do a terrible job of making the most of their income. And since it's really your money that's at stake, you can't afford to invest in companies that make bad spending decisions.
A recent report from Thomson Reuters took a look at one of the most important capital allocation decisions a company can make: whether to repurchase shares of its own stock. What it found once again opens the door to arguments about the best way companies should use excess cash.
Reawakening the old debate
For years, academics and market professionals have argued about the best way to return capital to shareholders. Recently, many companies have favored paying larger dividends to shareholders, giving them the choice on how to allocate their capital.
But historically, many people saw paying dividends as an inefficient way of using shareholder capital. With double-taxation of dividends, the alternative of using share buybacks seemed more attractive, as only those shareholders who chose to sell their shares back to the company would realize any kind of tax hit from the move.
What the Thomson Reuters study showed was that companies are doing more buybacks than at any time since before the 2008 financial crisis. Yet more often than not, these companies are making ill-timed decisions. The report cited 84 S&P 500 companies that paid premium prices on buybacks, versus 60 that bought low. Moreover, the stock's subsequent performance bears out the same theory: 72 had what the report characterized as poor returns in the year following the buyback, compared to 57 good performers.
What makes a buyback successful?
The report highlighted one key of strong buyback performance was opportunistic behavior. Rather than simply having a mechanical buyback program always in place, the best companies take advantage of rare value opportunities to pick up shares on the cheap. The report pointed to EOG Resources
By contrast, the report pointed to Ford
Ford definitely isn't the only culprit here. During 2007, General Electric
Why companies can't be trusted
The obvious reason why this phenomenon occurs is that companies have the most money to use on buybacks when they're the most profitable. Typically, that will also be the time when their stock is performing well. Conversely, when times get tough and profits become scarce, investors get nervous and bid down the shares -- yet companies then don't have the cash to take advantage of those bargain prices.
That's why I believe that paying dividends makes more sense from the investor perspective, even if it means taking an extra tax hit. Giving shareholders the right to buy more shares of stock voluntarily puts the onus on you to make smart decisions with your money. Given how much the balance of power already shifts toward corporate management and away from shareholders, the least that companies can do is let you make an informed decision with money that rightfully belongs to you.
Often, the best stocks simply plow their money back into their businesses for further growth. That's the story behind the companies in The Motley Fool's latest special report, in which you'll discover the names of three stocks with huge profit potential over the long haul. It doesn't cost a dime -- but grab it today while it's still available.
Fool contributor Dan Caplinger wants to be the only person spending his money. You can follow him on Twitter here. He owns shares of Berkshire Hathaway. The Motley Fool owns shares of Cisco, Berkshire Hathaway, and Ford. Motley Fool newsletter services have recommended buying shares of Cisco, Berkshire Hathaway, and Ford, as well as creating a synthetic long position in Ford. 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 won't squander your trust.