Techniques for Advanced Investors Be Wary of Buybacks
When a company purchases its own shares, should you follow its lead?
by Linda Keslar
When Eli Lilly & Co. announced in May it would buy back $2 billion in its own stock by year end, the stock fell $1.38 to $63.50. Investors, it seemed, interpreted the buyback as Lilly's desperate attempt to shore up its declining shares, which had dropped 9% since April over anxieties that the company would lose substantial revenue when the patent for Prozac, its blockbuster antidepressant, expires in 2001, and over lack of progress on Evista, an osteoporosis drug in testing as a cancer treatment.
Lilly's management likely expected more investor enthusiasm. It used to be that when a company announced plans to repurchase its stock, Wall Street responded with a thumbs-up and, more often than not, the share price rose immediately and continued to rise over the next few years. One reason was simple supply and demand. When a company buys back its shares and retires them, fewer shares outstanding mean earnings per share get a boost. "That's ultimately reflected in the stock price," says David R. Fried, editor of The Buyback Letter. "A buyback also usually means a company thinks its shares are undervalued. So it spends to buy back that stock, as opposed to putting money into capital investment, research and development, advertising, or something else."
But, as Lilly found, a buyback is no longer a sure ticket to a higher share price. Changes in the market and in companies' motives may be making buybacks a less bullish indicator. Before investors snatch up shares on news of a buyback, they should try to ascertain what is prompting the move."There are myriad reasons why a company may buy back shares, so the tool has become slightly less reliable as a way to predict positive future stock performance,"says David Klassen, head of U.S. fund management for Chase Asset Management's Vista mutual funds.
RAGING BULL
Over the past few years, companies have been repurchasing shares in the open market at a feverish clip. In 1997 alone, more than 1,300 companies pledged to spend a record $189.9 billion to buy back their own stock, according to Securities Data Corp. The surge continued through the first five months of 1998, with $89.5 billion in stock buyback plans announced, including huge programs by Intel ($7 billion), General Motors ($4 billion) and IBM ($3.5 billion).
Before the 1980s, a company's decision to invest cash in its stock was viewed with skepticism. At best, a buyback seemed a business' admission that growth prospects were slim. At worst, it was seen as a way to manipulate stock prices in the company's favor, according to David Ikenberry, professor of finance at Rice University. But buybacks began gaining legitimacy in 1982 after the Securities and Exchange Commission imposed regulations on the number of shares a company could buy and the timing of the purchases. Since then, buybacks have been seen as a way to spare shareholders the high income tax rates imposed on dividends. Instead, companies boost earnings per share, and investors' profits are taxed at the lower capital gains rates. Coca-Cola, for example, has repurchased 966 million shares during the past 15 years, turning 14% annual gains in profitability into 18% growth in earnings per share in the past 12 years.
A study by Ikenberry and his colleagues found that on average, the stock price of companies repurchasing shares during the 1980s outperformed the rest of the market by 12.1% for the four years following a buyback announcement. "Undervaluation was a big piece of the puzzle," says Ikenberry. "What we saw was that corporate management benefits all of us if the company is successful in reacquiring its shares at a bargain."
But the recent wave of buybacks is taking place as price/earnings multiples are reaching all-time highs. Companies-aware they are not legally obligated to complete a buyback-may just be trying to stave off market jitters. Ikenberry suggests that when evaluating a buyback, investors steer clear of stocks nearing their 52-week lows, which management may be trying to bolster.
Another important consideration, says David Klassen, is whether the share pool will shrink. Companies now are using buybacks to offset the share dilution caused by the exercise of employee stock options. In making a buyback announcement, a company might report whether gathered shares will be permanently taken off the market. Investors should check with the company's investor relations office to determine if management intends to retire the shares or put them in what's known as treasury stock, which can be reissued to support stock option plans, profit sharing, or other uses.
Keep in mind, too, that a company may cancel a buyback plan at any time. According to Michael Weisbach, professor of finance at the University of Arizona, companies generally purchase 75% of shares within three years of announcing a buyback plan. But SEC data shows that nearly two-thirds of companies never complete proposed buybacks. One reason companies back out is merger activity, where accounting rules make buybacks less attractive on paper. Chrysler halted its buyback program after announcing its merger with Daimler-Benz, and Nationsbank and First Chicago NBD also terminated repurchase programs due to mergers.
But for now, buybacks still tend to be a positive signal. Fried, for one, cautions investors to "think twice" before selling shares in a company that has implemented a stock buyback plan. "The company knows more about its future than you do," he says.
>>Except in the case of VVUS where the management dont know if they are cuming or going.. |
