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Do Stock Buybacks Actually Work?

By: David Sterman
Posted: 8/23/2011 1:00:00 PM
Referenced Stocks: AIZ;AZN;EPS;LIFE;SHAW

When it comes to stock buybacks, we tend to assume investors will surely benefit sooner and later. In the near-term,shares can find support from a large institutional buyer -- i.e. the company itself -- and in the long-term, earnings per share ( EPS ) should rise by the corresponding percentage the share price has been reduced (off-setting options grants notwithstanding).

But what about the mid-term? What happens to stocks six months after buybacks were announced? Well, it's time to look at a group of stocks I profiled back in February to see how they're doing. Each of these firms committed to buy at least $500 million in stock back, reducing their share counts by at least 5%.


 
How did they do? Not well. Many of these stocks rose higher in the spring, but thanks to the recent market rout, they have all dropped in value since the buying began. In that time, the S&P 500 has dropped about 16%, a benchmark that only five of these companies were able to exceed (although two were among the companies I profiled back in my February article ).

What went wrong? Either the companies were foolhardy in buying back stock ahead of eventually worsening conditions, or they are simply being punished by a sour investor mood that takes volatile (high-beta) stocks even lower. If there is a silver lining, it is that the falling prices will allow companies to buy back an even greater percentage of their share count.

Judging by profit forecasts, these companies appeared to be buying at the right time. In most instances, analysts have (sometimes sharply) boosted their 2011 and 2012 profit outlooks after digesting first and second quarter results. Only biotech Life Technologies (Nasdaq: LIFE ) and construction firm Shaw Group (Nasdaq: SHAW ) have seen business start to slump recently.

 

Looking at this group with a fresh set of eyes, you have to draw different conclusions than the ones drawn six months ago. It's impressive that drug maker AstraZeneca (NYSE: AZN ) , which I recommended back then, has held up well in this tough market, thanks to the perceived consistency of its business model . But this is precisely the kind of stock that is going to miss out on any eventual rally to come, because investors will first seek out the most beaten down stocks. (Drug stocks in general failed to participate in the powerful snapback rally of 2009.)

Assurant (NYSE: AI )
On the heels of early 2011 buyback plans, Assurant has already shrunk its share count by nearly 7% this year. This provider of a range of consumer-oriented insurance plans (i.e. life, disability, life insurance, pre-arranged funeral services, etc.) is likely to suspend the current buyback with the advent of the hurricane season, with plans to resume it after the season has passed. Profits this year have been below 2010 levels, thanks largely to the fact the "specialty" insurance division, which works with buyers of foreclosed homes, had a banner year in 2010 and the business has started to wind down as the foreclosure debacle recedes.

Unless we get an especially aggressive -- and financially catastrophic -- hurricane season, then Assurant looks set to generate record results in 2012, highlighted by a 30% jump in EPS to $5.70, according to analysts at Sterne Agee. Much of those gains are expected to derive from a streamlined health insurance business that is adjusting to new government mandates. Margins in this segment have slumped badly this year, but according to Sterne Agee, should be much firmer in 2012.

It's one thing to note shares are inexpensive at just six times projected 2012 profits. Yet the real disconnect comes on the balance sheet . The company is valued at around $3 billion, but tangible book value exceeds $4 billion (and could approach $4.5 billion by 2013). So any stock buyback efforts are both accretive to EPS and provide great returns from a price-to-book perspective. There's no reason this stock can't eventually support a forward P/E multiple of 8 or 9 (equating to a stock price of $42 to $46, or right in line with the $46 tangible book value -- which stands more than 30% above current levels).

Risks to consider: Washington is likely to keep tinkering with healthcare in the next few years, and in some instances, may look to crimp the profitability of for-profit insurers to an even greater extent. This would impede Assurant's goals of delivering much stronger margins and returns on equity in 2012.

Action to Take --> It's noteworthy that most of the names in the group have seen their EPS estimates maintained or even raised. The falling stock prices means their P/E ratios are now even lower than back in February, making buyback efforts all the more compelling -- as well as a fresh look as a potential investment.


-- David Sterman

P.S. -- Especially in a volatile market, it's important to own companies with strong fundamentals. Here's why we think these 10 stocks are poised to deliver above-average returns for years to come.

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.