Many CEOs often find themselves in this uncomfortable spot: Earnings are lagging, sales prospects are lackluster, and the stock just keeps languishing. But while the cure usually calls for something innovative or some serious long-term planning, companies often also find themselves indulging in a popular quick fix — stock buybacks.
It’s a simple enough theory: You use excess cash to buy back shares, and thanks to the power of math, you improve earnings per share — without actually having to improve earnings!
Indeed, the Apples (NASDAQ:AAPL), Exxons (NYSE:XOM) and Microsofts (NASDAQ:MSFT) of the world have spent literally billions of dollars on share buyback programs, though the practice isn’t just reserved for the big boys. In the past week, Agilent Technologies (NYSE:A) authorized a $500 million repurchase plan while Clearwater Paper (NYSE:CLW) approved a $100 million program.
In fact, as the Wall Street Journal points out, the practice is absolutely booming, and only becoming more popular:
In the 18 months between April 2011 and October 2012, the most recent period for which data is available, companies in the S&P 500 retired a net eight billion shares through buybacks, according to FactSet. At the end of the third quarter last year, about 300 billion shares were outstanding for S&P 500 companies, the lowest quarter-end total since the middle of 2009.
But investors should keep a few things in mind before getting excited when a company announces a stock repurchasing program.
As mentioned before, you’re boosting EPS by reducing shares, not growing earnings through actually improving the business. That doesn’t necessarily mean shares won’t improve as a result — in many cases, they do — but buybacks can only cover up so much for so long. Peter Tuz, portfolio manager with Chase Investment Counsel, hits the nail on the head of the dilemma:
“The market needs to be led by real growth that’s more than the tepid growth most of us are expecting. Financial engineering is good, but it’s not as good as real growth.”
And, of course, sometimes buybacks just don’t work. The company’s inherent problems are too much, the top and bottom lines shrink too much, and the stock tanks regardless.
Then, you’re left with a double whammy. You see, companies traditionally don’t just buy their stock the second they realize earnings are flat; they pull the trigger when they believe their stock is “cheap” — after all, that’s just good business sense. When a company buys back shares only to see them go lower (proving that the company can’t even properly value its own shares) … well, you can see how that’d be a bitter pill for shareholders to swallow.
Ask anyone who owned Hewlett-Packard (NYSE:HPQ) back in 2010, when the company was buying shares at a price of $40 to $50.
It’s more bitter still when said cash could’ve been used to directly enrich shareholders via dividends — especially when the company has both heavy cash holdings and healthy cash flow.
So what’s the takeaway?
Share repurchase programs are clearly here to stay for 2013. In fact, you’re probably going to see more and more headlines about them in the next few months as companies try to repent for weak earnings. Your job is to keep your eyes wide open; don’t just take buybacks as a given good.
Do your research. If a company has a history of making smart buybacks (buying low, with the stock eventually gaining afterward) and has the cash to do it, it might be worth believing in. But if the company has a poor history of ill-advised buybacks — or if the business itself just looks shoddy — don’t assume salvation is on its way.
It probably isn’t.
Marc Bastow is an Assistant Editor at InvestorPlace.com. As of this writing he is long AAPL, MSFT and XOM.