Dear Mr. Burke:
You are known on S.I. as a quality money manager. Would you tell some young people on this thread the methods and techniques that has earned you your reputation?
In addition, I would be interested and I am sure educated if you could review the article by Michael Sivy's skeptical look at stock buybacks as published in the March 1999 Money Magazine.
As you are aware, too much misinformation has been common on the topic of buybacks. Thus, a well-written, logical evaluation from you is extremely valuable.
I certainly appreciate your being here and hope that the rest will benefit from your knowledge and experience.
Please let me hear from you soon.
Sincerely,
Beni Mick Mormony
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Sivy on Stocks
When Buybacks Make No Sense
THE HIGHER THIS pricey stock market climbs, the more reasons investors find to believe that it will keep going up. Here's the latest rationale: U.S. corporations announced last year that they would repurchase a record $209 billion of stock. Such buybacks usually help a company's share price. Even better, the argument goes, by shrinking the supply of stock available, they push up the market as a whole.
Makes sense, doesn't it? In fact, hard evidence that buybacks are a boon can be found in a series of well-known studies, including one done in 1995 by finance professor David Ikenberry at Rice University and another in 1997 by Melissa R. Brown, who was the chief quantitative analyst at Prudential Securities. The studies found that shares of companies that completed significant repurchases outperformed their peers by an average of 2.8% to 4.2% annually for as long as four years.
Now here's the catch. While buybacks have boosted specific stocks-and the overall market-in the past, they won't necessarily have the same effect today. Reason: The most popular stocks' prices are simply too high to benefit from buybacks. Both Ikenberry's study and Browns found that cheap stocks got the biggest boost, while expensive shares received little extra oomph. "Stocks with low valuations got 10 percentage points a year of extra return on average," says Ikenberry. "But buybacks aren't a magic bullet-in some cases, they're value-destructive. His study found that repurchases had a marginally negative effect on stocks with the highest valuations.
Here's the main reason buybacks don't help expensive shares. When a company repurchases its own stock, it forgoes the interest it could have earned on the money used. This cost is partially offset by dividends the company no longer has to pay on the shares it buys. If the net cost is greater than the benefits of shrinking the number of shares outstanding, a company's earnings per share can suffer. Other factors, such as changes in the company's financial strength, come into play as well. But given today's interest rates and dividend yields, shares trading at price/earnings ratios above the mid-20s will get little or no benefit from buybacks.
Buybacks may still make sense for stocks with lower P/Es, especially if the firms are generating lots of free cash and don't have good places to invest it. Paying out the money in higher dividends simply forces many shareholders to pay additional taxes at ordinary income rates. As a general rule, the lower a stock's P/E or the higher its yield, the more beneficial a buyback is likely to be. By this reasoning, Intel (trading at 30 times estimated 1999 earnings) figures to get much less of a kick from its current buyback program than AT&T at a P/E of 21.5. And Philip Morris at 13.8 times 1999 earnings looks more promising than McDonald's at 27.9 times earnings.
Also, before you count a buyback announcement as a plus, take a look at the company's cash-flow and debt levels. There should be more than enough cash coming in to fund the firm's capital investment plans and pay dividends. If not, the company may have to borrow to pay for share repurchases.
The same reasoning applies to the stock market as a whole. With the stocks that make up the S&P 500 trading at an average P/E of 26.6 times estimated 1999 earnings, share repurchases figure to provide very little real benefit. That's particularly true because many companies don't have much extra money on hand. "As of last year's third quarter, internal cash-flow generation stagnated," says senior economist John M. Youngdahl at Goldman Sachs. The result is that companies are having to borrow to maintain the current rapid pace of buybacks. U.S. share repurchases plus dividends paid out now total 135% of total corporate profits, according to Andrew Smithers of Sruithers & Co. in London.
Indeed, as they continue to snap up their own firms' shares in a rising market, executives are defying the basic rule of investing: Buy low, sell high. Companies behaved quite differently the last time stocks reached valuations comparable to today's. In the late 1960s, more companies sold new stock than repurchased shares. But over the past few years, U.S. corporations have stepped up the pace of net purchases from $58 billion in 1995 to an annual rate of $158 billion, based on the latest available Federal Reserve figures.
Why haven't companies reduced share repurchases in the face of rising prices? Probably because top executives have increasingly come to believe-perhaps correctly-that their job performance is measured by the level of their stock. Like most investors, they probably also assume that buybacks are always good for the share price-at least in the short run. In addition, most high-level managers have sizable numbers of stock options, so they have a personal interest in keeping the share price up, even if the company ends up suffering later on.
As for the overall market, today's often misconceived buybacks are really just one more reason to be careful, comparable to the remarkable run-up in Internet stocks and the alarming fad for active day trading by small investors. All such trends argue for maintaining a mildly defensive stance in your own portfolio so that you continue to profit while the boom lasts but don't find yourself overextended the next time the market hits an air pocket.
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