Share Repurchases - 'Yeah, but…?"
Justin is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
There are plenty of investing myths out there that often form the backbone of headlines or recommendations. Investors need to continually evaluate the empirical evidence and question the embedded assumptions.
Take for instance insider buying. If the CEO is buying and they know the business intimately, then it must be a buy, right? WRONG. Investors should ignore any recommendation that is based on such a theory. How about market sentiment -- Horrible at predicting market tops, but a good tool at identifying bottoms. By selling when the sentiment surveys get elevated, investors are making a key mistake. Whereas, they are well served to buy when they see headlines highlighting sentiment levels at multi-year lows. Today, I would like to discuss one the biggest market misconceptions- share buybacks. Many stock recommendations use the notion of the company buying back stock as a key pillar in their thesis. However, investors should be very cautious of these enticing statements and shouldn’t think that share buybacks can mask business weakness.
Stock repurchase announcements are often precursors to large single-day gains in stock prices, but many times this initial excitement doesn’t translate into market-beating returns over the coming years. Many investors automatically consider stock repurchases to be a catalyst to favorable returns, but we shall see in a data sample below that this isn’t actually the case. Share buybacks serve as a favorable signal to investors that the business is running smoothly. It also is a key tool to increase earnings-per-share at a rate in excess of the growth in operating income. Many large-cap companies with single-digit EBITDA growth will reduce share count by 2-5% and get close to the magical 10% EPS growth threshold. Then they want a PEG (price-to-earnings-to-growth) ratio of 1.5x to 2.0x and viola a 15x or 20x P/E ratio is justified. Why should a company that achieves half its EPS growth via share buybacks be rewarded with a market-beating multiple? It shouldn’t and in fact it should trade at a discount to the market-average.
I looked at large-cap companies (market capitalization in excess of $10 billion) to see how share repurchases affected the stock price. I kept size (large) constant to eliminate the bias from small cap’s historically outperformance. There were 47 companies that reduced share count by 5% or more in calendar 2011 and 39 that increased share count by more than 5%. The total return dates are over the previous one year.
The Share Buyback Group
Not much of a strong correlation! In fact, the median return was +3.9% versus a +1% gain in the S&P 500. So yes, the median stock fractionally outperformed, but it was hit or miss. The number of stocks that outperformed was 24 and the number that underperformed the Index was 23. Investors that correctly identified those companies that would be reducing the quantity of shares would be left with little more than a 50% chance of picking a stock that outperformed the S&P 500.
The best performing stock among the share repurchase group was Seagate Technologies (NASDAQ: STX), which I have highlighted a couple times this year. The stock has now returned to a level close to where I first suggested that investors should tread carefully on the name. The leader in the hard disk drive market has had a stellar year because of supply imbalances and an exceptional pricing environment- not because they reduced their share count by 8%. Many continue to question the long-term viability of this industry, even with only two dominant players. It will be these industry dynamics- pricing and supply- that drive the stock. If the company starts to falter amid deteriorating industry dynamics, investors shouldn’t expect an increased share repurchase announcement to cushion the fall.
The worst performer among those companies buying their stock was Hewlett-Packard (NYSE: HPQ) with a drop of almost 39%. The technology conglomerate, despite making it public that they were actively buying back their stock, wasn’t able to overcome the fact that the company remains in an operational funk. The company’s new CEO, Meg Whitman, is garnering some attention and is making a big splash with moves such as combining the PC and Printing divisions. Still, first quarter results were weak and the stock now sits at a seven-year low.
The Share Increasers
One would then think that the counter-argument, increasing the share count would be really bad for total return performance. (I should note that AIG and EPD were large outliers that have been excluded with share count growth above 100%)
The median total return of the 37 companies that increased their share count by 5% or more was +0.5%, which is just fractionally behind the Index. And just like the share repurchase group, there doesn’t appear to be a direct link. Increasing share allotment for a company is not a death wish for the stock price. Actually more than half, 20, outperformed the Index whereas 19 fell short. Hit or miss!
The best performer? Well, it came from a company that I have never heard of and that just recorded its FIRST profitable quarter in April. Regeneron Pharmaceuticals (NASDAQ: REGN) has increased its market capitalization fivefold in anticipation that their biotechnology candidates, which will start entering the market in the coming months, will quickly fuel operating earnings growth.
The worst performer among those handing out shares is a company that has taken the headlines recently and would really like to turn back the clock to 2007- Morgan Stanley (NYSE: MS). The banking giant has suffered a 40% loss in the last year, but not because they increased their share count by 20%. Instead, it is because of continued weakness in their various banking segments. The Facebook fiasco and subsequent effect on profitability will be the factors that most contribute to stock performance this year, regardless of how the share count fluctuates.
Bottom line
This is just a small data study that indicates investors should tread carefully when they hear share buyback announcements. It is a common pitfall. I often hear people mumbling, “…but they are buying back their stock” as it continues to drift lower. At which point I say, “Yeah, but?” If you can’t love the underlying business or see catalysts that could propel operating income, then steer clear. Simply put, a bad company buying back their stock is a bad investment.
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