3 Stocks With Solid Repurchase Strategies
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Share buybacks have acquired a bad reputation lately, which is understandable considering that many companies have engaged in buybacks for the wrong reasons. On the other hand, stock repurchases are like home made food: Depending on who is doing it, and how it’s done, the results can be delicious.
There are different ways the value of a stock can be increased; one is when the value of the whole company raises over time via growing sales and earnings. The other one, related to buybacks, is when the company is sliced in fewer pieces – fewer shares outstanding – so every individual share is worth more because it´s entitled to a bigger percentage of the company´s earnings and cash flows.
Two conditions need to be met for a buyback to be a positive thing for investors. First, the company must have the financial resources to finance those transactions; sustainable buybacks are those who are funded by internally generated cash flows as opposed to issuing debt or selling assets. It´s very important to analyze the financial position of a business, its historical cash flows and balance sheet strength before deciding if a stock repurchase is in fact a good decision.
The price at which the repurchase is being implemented is the second relevant aspect to consider. A company paying too much for its own stock is not making efficient use of shareholder´s capital; cash distributions via dividends would be a much better option in that case, allowing investors to invest that money in more convenient alternatives.
The first condition – financial strength – can be the most destructive when it´s not met, but the second one – fair valuation – is the one most business managers ignore. That´s why investors value a CEO like Warren Buffett. Being an extraordinary investor as well as a business manager, he has stated a transparent and efficient buyback policy for Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B).
Buffett announced last year that he will be willing to repurchase shares of Berkshire, for the first time in history, as long as the company has more than $20 billion in cash and the stock price is below 1.1x book value. That´s an excellent way to set objective levels for both financial resources and stock valuation before implementing a repurchase, and it also provides visibility about future possibilities to investors.
Unfortunately, Berkshire rose quickly above the stated valuation of 1.1 times book value after the announcement in September of last year, so Buffett didn´t have much time to implement the plan. However, investors in the company can sleep smoothly at night knowing than any stock repurchase will be done under careful consideration of their best interest, and with the aim of maximizing the efficiency of capital allocation at Berkshire.
That´s a sharp contrast to what Netflix (NASDAQ: NFLX) has done. The company was repurchasing shares while the stock was making new all time highs and trading at noose bleeding valuations with a P/E ratio above 200 during the first half of 2011. Even worse, Netflix would end up needing that money to invest in its streaming business a few quarters later, so the buyback decision has been a terrible mistake and very detrimental for the company´s value.
Buffett wasn't able to capitalize on Berkshire´s buyback policy, but that hasn´t stopped him from benefitting from repurchases by investing in companies like IBM (NYSE: IBM), which has been consistently rewarding shareholders with an active buyback policy for a long term.
One of the most valuable brands in the world, with strong technological strengths and a wide geographical presence, the company has produced positive free cash flows through the decades, including recessions and all kind of economic hurdles; this means financial soundness is unquestioned at IBM. Besides, at a P/E around 15, we could hardly state that shares of IBM are overvalued, so the company´s buyback policy fits the requirements to be considered a positive factor for its investors.
Another example of a positive share buyback program is the one implemented by Nike (NYSE: NKE), which recently announced authorization to buy $8 billion in its own stock over the next four years. This comes in addition to a $5 billion program which is expected to expire in 2013, so the company is taking its share repurchase plans quite seriously.
Nike has a fantastic brand which protects its cash flows through good and bad economic times, combined with a differentiated quality for its products and a healthy level of geographical diversification which adds stability to its finances. There hasn´t been a year in the last decade in which Nike reported negative free cash flows, so financial strength is guaranteed here too. The stock is trading at a P/E near 20, which is not an absolute bargain, but still in line with historical averages. The buyback program at Nike does seem like a positive thing for investors.
Many companies have executed buybacks badly over the last years, but that doesn´t mean buybacks are always problematic. In fact, examples like Berkshire, IBM and Nike show that stock repurchases, when done for the right reasons, can be an excellent use for a company´s cash flow in addition to an extra source of returns for investors.
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acardenal owns shares of Berkshire Hathaway and IBM The Motley Fool owns shares of Berkshire Hathaway, International Business Machines, and Netflix. Motley Fool newsletter services recommend Berkshire Hathaway, Netflix, and Nike. 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.If you have questions about this post or the Fool’s blog network, click here for information.