In the world of investing, many things work better in theory than in practice.
For instance, executive stock options are now reviled by investors as a way for management to quietly loot the companies they are paid to steward. But before they became popular in the 1980s, they were touted as the solution to the age-old problem of aligning the interests of shareholders and management.
Yes, even before the “decade of greed,” managers were seen as being self-serving and as managing the company for their own benefit rather than for the good of the shareholders. But if top executives were shareholders, then there would be no more conflicts of interest, right?
Well, it sounded good … in theory.
Along the same lines, share repurchases have become popular in recent decades as a tax-efficient alternative to cash dividends. Earnings paid out as dividends are taxed twice, at both the corporate and individual investor levels. But when a company uses that same cash to buy back its own shares in the open market, it can boost earnings per share without creating a taxable event.
And unlike dividends, which are generally paid regularly, stock buybacks can be done sporadically as the company’s cash position allows. Management often is reluctant to raise the quarterly dividend because, if conditions take a turn for the worse, cutting that dividend sends a very bad signal to the investing public. But buybacks can be done quietly behind the scenes and can be stopped at any time without drawing attention.
Again, it sounds good … in theory.
In practice, companies tend to have awful timing, buying their stock when prices are high. Low prices usually come during a market panic, at which point the bad economic outlook causes companies to hoard cash rather than buy back stocks. In the worst cases, they actually have to issue new stock … at low prices that dilute shareholders. Buying high and selling low — this is not exactly a formula for maximizing shareholder value.
But the most insidious aspect of stock buybacks is they often fail to reduce the number of outstanding shares.
How does that make sense? Simple. The company retires shares bought at full price on the open market to soak up new shares issued at a discount to fulfill employee and executive stock options.
It’s highway robbery that is, sadly, perfectly legal.
How bad are the numbers here? Barron’s reported in January that the 500 largest U.S. companies repurchased about a quarter of their equity’s dollar value since 1998. But the number of shares outstanding actually grew more than 7%.
Don’t think that I am against stock buybacks, however. I’m a big fan of them, assuming the stock is reasonably priced at the time and that the buybacks are actually used to reduce share count. But here, we have a mixed bag.
I love all three as long-term dividend payers to drop into your portfolio and forget. But of the three, Walmart has been the friendliest to shareholders. Nearly all of its buybacks have gone to retiring shares, and the company has reduced its share count by a quarter over the past decade.
Microsoft and Intel have reduced their share counts, too. Microsoft has shrunk its share count by 2.6 billion shares, or 23%, in the past decade. But its share repurchases are bigger than that by nearly half, with the rest being used for stock-based compensation. Intel’s performance on this count is also a mixed bag.
But overall, I can’t complain too loudly. Despite some dilution from stock-based compensation, both have still managed to shrink their share count while simultaneously boosting cash dividends.
In any event, the key point to take away from this is that you should take the share buyback numbers you read about in press releases with a good-sized grain of salt. In a vacuum, a share repurchase plan means very little. They must actually reduce share count to be considered “shareholder-friendly,” and they should only be implemented when market prices are favorable.
Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter, and the chief investment officer of investments firm Sizemore Capital Management. As of this writing, Sizemore Capital was long WMT, MSFT and INTC. Sign up for a FREE copy of his new special report: “Top 3 ETFs for Dividend-Hungry Investors.”