Should You Buy Companies That Buy Back Stock?

Source: Getty Images

Investors have been favoring companies that are repurchasing their own shares. Over the past year, the S&P 500 is up about 19 percent, whereas the Powershares Buyback Achievers ETF (NYSEARCA:PKW) is up 26 percent.

Investors like to buy shares in companies that are repurchasing their own stock for a few reasons. First, when a company repurchases its own stock, management is sending a signal to the market that it believes that its shares are undervalued. This confidence is often seen as a bullish indicator.

Second, a stock repurchase program is a more efficient way for a company to return capital to shareholders than dividends, which are taxed. Third, a buyback program creates demand for a company’s stock, and this often puts a floor under the stock’s share price.

Nevertheless, you should never buy shares in a company just because it is buying back a lot of stock, just like you should never buy shares in a company just because it is paying a large dividend. While these are promising signs, they are not guarantees. For instance, before the financial crisis, financial companies were aggressively buying back their own shares. Citigroup (NYSE:C) bought back a lot of stock at over $500 per share (split adjusted), and it now trades at less than $50 per share.

Not only should you evaluate a company prior to buying its stock, but you should look at a couple of other attributes of the buyback. First, is the buyback actually reducing the number of outstanding shares? Many times, a company will buy back stock while at the same time it awards stock options to its top executives. Without a buyback program, these options would dilute existing shareholders, meaning that once they are exercised, there are more shares outstanding.

A buyback program can mask this. When you look for this, don’t just make sure that the company’s float (the number of outstanding shares) is shrinking, but make sure that this float shrink is commensurate with the size of the buyback. So for instance, make sure that the company isn’t buying back $1 billion in stock to mask $800 million in awarded options.

Second, make sure you know where the company is getting the money it needs to repurchase its shares. Given the low interest rate environment, a lot of companies have been borrowing money to buy back their own shares. This isn’t necessarily a bad thing. If a company can borrow money at 3 percent and its stock trades with a P/E ratio of 16.7 — giving it an earnings yield of 6 percent — then the buyback makes sense.

But keep in mind that interest rates can rise, and if they do, a company that is operating in this way will have a difficult time rolling its debt over. Thus, today’s gain could mean tomorrow’s pain. Ultimately, if a company is doing this, make sure that they do so in moderation, and more importantly, make sure that they cease the buyback if the stock price rises too high.

Third, the financial advantage of buybacks over dividends only exists if you take a very simplistic approach and only measure the net amount of capital returned to shareholders. For instance, a company that raises its dividend may also see its stock price rise as yield hungry investors flock towards this company. Thus, prior investors get the gain of the dividend and the capital gain.

That isn’t to say that the buyback is a bad thing — it’s just that buybacks aren’t categorically superior to dividends. The best approach is probably a middle ground: Look for companies that pay a dividend and buy back stock. Integrated oil companies such as Exxon Mobil (NYSE:XOM) and railroad companies such as Union Pacific (NYSE:UNP) are excellent examples of companies that to this. These two companies favor buybacks, but a third of the total capital they return to shareholders is in the form of a dividend.

Buybacks can be very tempting for a company. Large companies that are profitable in a low interest rate environment have easy access to capital. When done in moderation — as in the case of Exxon Mobil — the buyback can be valuable. But a company such as Autozone (NYSE:AZO), which pays no dividend, and which aggressively borrows money in order to buy back stock, is asking for trouble. If there is a recession during which interest rates rise and during which the company’s profits fall, it could be in serious trouble.

Ultimately, as an investor you cannot rely on buybacks for returns, and you should avoid companies that do this. Buybacks are part of a toolbox that executives have to generate long-term returns for shareholders. Find those companies that wisely buy back their shares. Look for companies that slow down, or even stop their buyback programs when their stocks rise.

Better yet, find companies that double down in a bear market. Companies that are smart and conservative about their buybacks are not just creating value by maximizing float reduction, but they are also signaling to investors that they are likely well managed in other ways, and that their stocks can be bought by long-term investors.

Disclosure: Ben Kramer-Miller is long Exxon Mobil.

More From Wall St. Cheat Sheet: