Conventional wisdom says that share buybacks, when done appropriately, put money in shareholders' hands, since a reduced share count means an increase in earnings per common share. Yet, as is often the case with Wall Street and many corporate chiefs, this view is long on convention and short on wisdom.
First let's get some facts straight. Share buybacks are only a prudent use of capital when they represent the best possible alternative to other sources of capital. So, for example, a company loaded down with high-rate debt would probably do better using excess cash to pay off the debt, rather than using it to buy back stock. And if a company is blindly buying back stock at any price to soak up share dilution caused by excessive issuance of stock options, buybacks aren't effective. In fact, they can destroy value if the company is buying high.
On the other hand, at times it can be prudent for a company to take on low-cost debt and use the proceeds to buy back stock that is generating a greater return than the cost of that debt. These are capital-allocation decisions, and most managers are good at managing -- but not so good at allocating the capital.
Another prudent time for companies to buy back stock is when they are applying the first lesson learned in Investing 101: buying low and selling high. Good capital allocators do this habitually. As Buffett quips, "Why try to jump over seven-foot hurdles when you can walk over one-foot hurdles?" Company insiders (hopefully) know more about their business than just about anyone else, so when the opportunity presents itself to invest in their own backyards at cheap prices, why would they go looking at more difficult opportunities?
Most insiders know their company better than anyone, so when their company's shares are cheap, and no other investment opportunities exist that are superior from a risk/reward standpoint, then they will back up the truck. Homebuilder NVR
In 2002, the company's net income was $331 million with around 7 million shares outstanding; by 2006, profits were $587 million with 5.6 million shares outstanding. Even with the decline in profits in 2007 to $334 million, NVR's share count declined as well, to just over 5 million -- resulting in respectable earnings per share of about $54. This seems to have worked well for NVR, even through a weakened housing market, and the company is holding up nicely relative to the likes of Hovnanian
All aboard the value train
NVR is one sound example of creating value via share buybacks. Another great example is railroad operator Burlington Northern
Sometimes good, sometimes bad
As with any investing school of thought, share buybacks are not automatic value creators. In the piece to follow this one, I will illustrate how Wall Street banks, in their infinite wisdom, managed to perfect the art of buying high and selling low. Prudent buybacks can create tremendous value for patient investors, but buying back shares only to sell them off at lower prices leads to a tremendous erosion of wealth.
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Fool contributor Sham Gad runs Gad Partners Funds, a concentrated value-centric investment partnership modeled after the 1950s Buffett Partnerships. He eats his own cooking and will buy back your old dollar bills for two shiny quarters. He and the Fool both have stakes in Berkshire Hathaway. The Fool has an untouchable disclosure policy.