by Alexander Green, Chairman, Investment U
Monday, June 25, 2007: Issue #686
There are several metrics my colleagues and I use at Investment U to identify undervalued stocks. One of my favorites is share buybacks.
There are several reasons this is such a powerful signal
Number one, management is telling you that the best use of cash on hand is not building more factories or buying up competitors. It’s simply retiring company shares. Some people might grumble that the decision is an easy one. After all, management is using the firm’s money, not its own.
But let’s not be too hasty. If management decides to spend hundreds of millions of dollars buying back company shares with company money and it turns out to be a bad decision (which would be readily apparent within a few months), it could easily mean curtains for their careers. So Chairmen and Chief Executives don’t take this decision lightly.
Why Share Buybacks Are Vital
The second major reason share buybacks are vital is they increase earnings per share. How? When you take the same earnings and divide them by a smaller number of shares outstanding, you get stronger growth in earnings per share.
Better growth in earnings per share translates into higher stock value. After all, share prices follow earnings.
For example, eight months ago we began buying Amazon.com in the Oxford Trading Portfolio, due in part to an aggressive buyback program. Analysts were stunned to see how quickly the company’s earnings per share shot up. We weren’t. And our shares have climbed 132% in the eight months since we got in.
Of course, it’s far too simplistic to believe a company can make a share buyback announcement and all you have to do is plunk for a few shares yourself. (If only life were so simple.)
Only Certain Share Buyback Programs Pay Off
Some companies announce their intention to buy back shares and then don’t follow through. If business conditions change, interest rates rise, or cash flow decreases, you may find that the repurchase program never gets completed. (Companies with rickety repurchase agreements right now include Allergan, Expedia, American Greetings and Sonic Restaurants.)
The other thing to watch is the exercise of stock options. If a company is only buying back enough shares to offset the dilution that occurs when executives exercise stock options, you’re not going to see the stock buyback boost earnings per share.
But, generally speaking, share repurchase programs are a good thing. And right now, with money cheap and corporate earnings strong, buybacks are occurring at record levels.
Last year members of the S&P 500 spent $432 billion on stock repurchases. And according to Standard & Poor’s, this year’s buybacks are on track to outpace last year’s.
This is not only due to low interest rates and robust earnings. Corporations are so flush with cash right now they need a place to put it to work. Of the non-financial companies in the S&P 500, 137 have more cash than debt on their balance sheet.
Rather than return that cash to shareholders in the form of taxable dividends, why not plow it back into the stock and give the stock a boost? That way there are no taxes to pay until the shares are eventually sold.
I’m looking at a number of companies right now that could easily expand, revive or start repurchasing their shares. Among these are CACI International, Disney, FedEx, HealthSpring and Quest Diagnostics.
If you’re looking for companies that may soon make repurchase announcements, each of these stocks deserves a closer look.
Today’s Investment U Crib Sheet
- On Thursday, Franklin Resources (NYSE: BEN) announced an aggressive repurchase program, extending its 2007 shopping spree. Franklin has bought back 4 million shares of its stock since April, and plans to buy another 10 million. Shares have climbed more than 52% over the last 12 months.
- Like repurchase programs, insider transactions can hand you a significant edge. But not all insider activity is created equal. Here’s why, plus the one type of trading that indicates business is strong and that shares may soon be headed higher.