Submitted by Wall St. Daily as part of our contributors
In the past few weeks, scientific-testing equipment company,
Agilent ( A ), announced a $500-million stock
Metal components and products maker, Precision
Castparts ( PCP ), unveiled a
$750-million stock repurchase program.
Not to be outdone, khaki pants maker for the masses,
Gap ( GPS ), announced a $1-billion repurchase
Shareholders should be rejoicing, right? After all, stock
buybacks imply that management believes their stock is cheap. And
cheap is good.
More significantly, conventional wisdom holds that stock
buybacks reduce the total number of shares outstanding. And if you
spread earnings over fewer shares - voila! - earnings per share
increases, making the stock more valuable.
The only problem? Conventional wisdom isn't always right. And in
honor of Myth-Busting Monday , it's time to prove why
stock buybacks aren't always bullish.
Less Than Meets the Eye
Riddle me this…
If stock buybacks reduce shares outstanding, then how
is it that (according to Dow Jones Indices) the 500 largest U.S.
companies spent roughly $1 trillion on share purchases since 1998 -
and yet the actual number of shares outstanding grew by 7%
over that period?
Or that, despite record periods of stock purchases, FactSet
noted a 2.7% year-over-year quarterly increase in share counts for
S&P 500 companies going back to 2005.
The number crunchers must have made a mistake, right? Nope.
It's just simple math. Although companies repurchased gobs of
stock over each respective period, they ended up issuing more than
they bought back.
Some shares could have been issued to fund an acquisition, or to
raise additional capital via a secondary offering. And more still
could have been issued to provide shares for employees exercising
stock option grants.
Long story short, as Andrew Lapthorne, Head of Quantitative
Analysis at Société Générale, says, "Share buybacks get
misinterpreted. Many people see them as a return to shareholders."
When, in actuality, many serve to prevent a dilution of
The takeaway? Before we blindly consider a buyback announcement
a bullish indicator, we need to dig deeper.
Trust, But Verify
Even if a company announces a buyback, it's not required to
follow through. And a meaningful amount of executives renege (about
25% each year since 1985, according to Birinyi Associates
Accordingly, we should verify management's track record of
making good on their buyback promises. It's easy to do so at
Morningstar.com. The site allows us to view five years' (or five
quarters') worth of "weighted average shares outstanding."
If that number is flat or rising, management is either not
following through, or they're issuing a boatload of shares,
However, if the number is consistently declining, then it is,
indeed, a bullish indictor.
How bullish? Studies vary, so let's go with the most
conservative out of Credit Suisse Quantitative Research. It found
that companies that consistently buy back shares return almost 2%
more per year than companies with less regular or erratic buyback
Every extra percentage point in profits counts, so I'm not about
to argue with an extra 2% per year. Candidly, though, I'd prefer
more profits than that. Wouldn't you?
The good news is, we can get it. We just need to add another
indicator to the mix.
A Better Bullish Indicator: BuybacksAndInsider Buying
Like I said before, a repurchase program signals that management
thinks shares are undervalued. But if executives truly believe
shares are cheap, wouldn't they start buying shares in their
personal accounts, too?
Turns out that if they do, shares perform even better.
A study by Professor Shrikant Jategaonkar at Southern Illinois
University at Edwardsville found that stocks subject to both
repurchases and insider buying outperformed other stocks
in the sample - by 29 percentage points over four years.
Stocks subject to just repurchases only outperformed by about
nine percentage points.
That's 10 times better than just focusing on stock buybacks
based on the Credit Suisse finding above.
Bottom line: In theory, buybacks are good for investors. But in
practice, we need to make sure management is actually reducing the
share count before we treat it as a bullish indicator. For the best
results, we should also insist on insider buying.