Share Buybacks

The Most Profitable Contrarian Investment Strategies for 2010 and Beyond
The 2010 Investment U Conference is underway! And even if you couldn't make it, now you can "bring home" more than 30 breakthrough presentations from the conference... Order the Deluxe MP3/Video Library for $99 to listen and view on your computer, or the Premier CD plus MP3/Video Library for $149 to listen to and view anywhere.

Share Buybacks: Why Companies Buy Back Shares and Which Ones Are Doing It Right

by Matthew Weinschenk, Investment U Research
Wednesday, December 12, 2007: Issue #741

Editor’s Note: Matt Weinschenk is one of our lead “behind the scenes” researchers here at Investment U. With a degree in economics and an affinity for stock valuation, he’s also a CFA Candidate. (The Chartered Financial Analyst designation is arguably the most challenging – and practical – qualification in the analyst community.) Matt recently attended a special meeting in New York. And his notes, which we think you’ll find profitable, are below.

Two weeks ago, some of the world’s savviest investors converged on New York City for a special meeting at the Time Warner Center. The occasion: The 3rd Annual Value Investing Congress.

I was fortunate to be in attendance, surrounded by David Einhorn, founder of Greenlight Capital, and Mohnish Pabrai of Pabrai Investment Funds, who many consider the next Warren Buffett.

The three-day event came at an interesting time…

Between presentations, news would pass through the crowd of another lender’s big write-down or a cash injection from Abu Dhabi. There was talk of the new FAS 159 accounting regulations, the credit ratings of bond insurers and other technical matters…

But one presentation, focusing on share buybacks, offered the most important – and profitable – “takeaway” of the conference. To be sure, Leon Cooperman, CEO of $3.5 billion-hedge fund Omega Advisors, Inc., had everyone taking notes…

Share Buybacks Can Make You Rich

For decades, studies have shown that companies that repurchase 5%-10% of their shares outperform the market. Value investors consider buybacks one of the most reliable signals of an undervalued stock.

But buybacks aren’t what they used to be…

In the first quarter of 2001, companies spent $31 billion on share repurchases. In the second quarter of 2007, they spent a record $157 billion. That’s because more companies are using excess profits to buy back shares instead of just raising the dividend.

It’s a case of quantity rather than quality.

4 Reasons Why Companies Buy Back Shares

According to Cooperman, there are four reasons companies buy back their stock, and only one that helps shareholders…

1) When executives are paid with stock options instead of cash, the company dilutes shareholder value. So management can initiate a buyback to avoid shareholder complaints. But it’s really just a roundabout way to pay themselves bonuses.

2) When those executives redeem their options for shares, management can buy the shares back at better prices than they would have received otherwise. Cooperman rightly calls this “very nefarious conduct.”

3) Rather than get locked into a raised dividend, the company wants a one-time share repurchase to return value to shareholders. But Cooperman pointed out that if a stock yields 2%, buying back a share costs 50 years of dividends! This type of buyback accounts for the vast majority of today’s repurchases.

4) If management determines shares are undervalued, it can start a buyback program to remove shares from the market… and long-term investors are rewarded with leveraged returns. (When a company reduces the number of shares, each remaining share represents a greater percentage of the company and a greater percentage of future earnings.)

Clearly, you’ll want to find companies doing #4. But here’s the rub: Of the $157 billion in recent buybacks, Cooperman said only a fraction of them make sense. So how do you find the “good ones”?

How to Find the Right Companies Buying Back Shares

Just answer the four simple questions Cooperman’s designed:

Is management buying back shares at a discount to the true value of the company?
Is this a growing business that will be worth more over time?
Will the buyback positively impact earnings per share?
Since share buybacks use up cash (or add debt) on the balance sheet, does the company still have enough operating cash on the books?

Cooperman found two companies in particular that pass his test right now:

The first is Schlumberger Ltd (NYSE: SLB), which has bought back almost $2.5 billion in shares since 2003. The stock has gone from under $20 to about $100 in just four years.

The second is Loews Corporation (NYSE: LTR), which also buys back its shares for the right reasons. The stock has gone from $14.19 to $48 in four years. And since 2006, the company’s bought back $1.1 billion in shares. In fact, it’s repurchased 25% of the company every decade since 1970.

It’s not time to give up on the buyback as an indicator of value. You just have to filter a bit of the noise to find management teams with your interests – and bottom line – in mind.

Good investing,

Matt

Today’s Investment U Crib Sheet

In Issue #686, you’ll find a few more companies that could easily “expand, revive or start repurchasing their shares.” Of course, another lucrative strategy is to track unusual insider activity…

When corporate officers start loading up on company shares – with their own money – you’ll be hard-pressed to find a more bullish signal. Trouble is, not all insider activity is created equal…

To find out how to differentiate “good,” “bad” and “indifferent” insider activity, take a look at Alexander Green’s message, Insider Activity: One of the Very Best Investing Signals You Can Get… And How To Use It.