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Sometimes It's Better for Stocks to Go Down

By Rupert Hargreaves - Sep 16, 2013 at 10:51AM

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Investors shouldn't be worried about falling share prices, as sometimes lower is better.

When Warren Buffett bought up 5% of IBM's (IBM -0.98%) stock for Berkshire Hathaway during 2011, he made a strange statement. The Oracle of Omaha said he would like IBM's shares to "languish" for a few years. Fortunately, Buffett has now got his wish, as IBM's stock has recently taken a tumble, down 15% from its yearly highs and nearing a multiyear low.

The fall in IBM's share price is somewhat unwarranted. The declines started back at the end of Q1, when the company reported that revenue had fallen 5% for the quarter . The sell-off then continued throughout the second quarter when the company announced that Q2 revenue had declined a further 3% and net income had fallen 17%. However, this decline in net income mostly came down to a one-off restructuring charge: Excluding these charges, net income gained 3%. The company also raised its full-year 2013 outlook within the Q2 earnings release. 

In fact, this recent decline is positive for all of IBM's long-term investors, as the company will now be able to do what it does best: buy back stock at even better prices, as Buffett explains in this excerpt from his 2011 letter to shareholders:

Let's do the math. If IBM's stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.

So, if we assume that IBM buys back $3 billion worth of stock during the third quarter, at an average price of $190 per share, the company will remove 15,789,473 shares from the market. Whereas if the company  spent $3 billion buying back stock at the second quarter's average price of $205, the company would only buy back 14,634,146 shares -- 7.9% fewer shares than were acquired at the lower price.

Falling revenue and rising EPS
What's more, Philip Morris (PM -0.58%) has recently bounced off 52-week lows, and for a company that is so dependent upon buybacks to boost earnings, long-term holders should see a significant boost to their equity holdings over this quarter.

Philip Morris' declines are not localized. In fact, peers Altria, Reynolds American, and Lorillard have also experienced serious pullbacks. These declines have been widspread among dividend-paying stocks recently as investors trade out ahead of the Federal Reserve's "tapering" of its long-term asset purchases, which is widely expected to begin this month.

Still, Philip Morris has been hit harder than most. The company's Q2 earnings were hurt by a strong U.S. dollar and falling sales within Europe, causing the company to cut full year estimates.

Having said that, if we assume that Philip Morris buys back $1.5 billion worth of stock during the third quarter at an average price of $85 per share, rather than the average of $93 per share seen during the second quarter, the company will acquire 17,647,058 shares -- 9.4% more than it would have acquired at the higher average of $93.

As tobacco stocks face falling earnings, buybacks look like the best way to boost EPS. Philip Morris has bought back almost 25% during the past five years.

The old dog injects more energy
Dividend investors will also be glad to see the shares of AT&T (T -0.27%) "languishing" and offering a 5.2% yield. After spiking to a high of $39 per share during April, the stock has now collapsed more than 16% from its peak.

AT&T recent decline has been a mix of a general dividend stock sell-off, as mentioned above with Philip Morris, and its underperformance when compared to peer Verizon. AT&T has been engaged in a losing war with Verizon for the most lucrative end of the highly lucrative smartphone market, and for this investors have been punishing the stock.

That said, not only does this decline mean a higher yield, but it also means that the company will be able to repurchase more stock, resulting in higher earnings. AT&T's $11 billion buyback is one of the biggest announced this year, and if executed at April's stock price of $39, it would have reduced the company's total number of shares outstanding by 5.5%. However, at the lower price of around $34 per share, the company will be able to reduce the total number of shares outstanding by 6.2%.

For the long term investor with cash in companies that are buying back stock, it pays to be patient and enjoy falling share prices, as in the longer term, you will end up being better off.

Fool contributor Rupert Hargreaves has no position in any stocks mentioned. The Motley Fool owns shares of International Business Machines and Philip Morris International. 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 Motley Fool has a disclosure policy.

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Stocks Mentioned

International Business Machines Corporation Stock Quote
International Business Machines Corporation
$137.71 (-0.98%) $-1.36
AT&T Inc. Stock Quote
AT&T Inc.
$18.38 (-0.27%) $0.05
Philip Morris International Inc. Stock Quote
Philip Morris International Inc.
$99.92 (-0.58%) $0.58

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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