With Buybacks, Look Before You Leap

Repurchases Routinely Give Shares a Lift,
But the Effect Could Be Ephemeral

Buying high and selling low: That sounds dumb. But call it a "share repurchase program" (or stock buyback), and people get excited.

Stocks regularly jump up 3% to 6% on the announcement of a buyback, and it's easy to see why they should.

Done right, buybacks are a boon. They reduce the number of shares outstanding, spreading the company's future profits over a smaller base — thus increasing earnings per share. Over time, firms that repurchase their shares have beaten the market by about three percentage points a year. Unlike dividends, buybacks generate no tax bills for ongoing shareholders.

Above all, share repurchases prevent cash from burning a hole in management's pocket. Long ago, Benjamin Graham pointed out a paradox: The better a company's executives are at managing its businesses, the worse they are likely to be at managing its cash. Great businesses produce piles of wampum — and, to management, idle cash is the devil's workshop.

Three decades ago, with oil skyrocketing and profits gushing in, energy companies squandered billions of dollars on one bone-headed diversification after another. Mobil bought Montgomery Ward, the dying retailer. Arco acquired Anaconda Copper just before metal prices collapsed. Exxon even got the bright idea of manufacturing typewriters.

In the latest oil boom, the energy giants have favored buybacks over misbegotten empire building. So far in 2008, ConocoPhillips has spent $5 billion buying back stock; Chevron, $3.6 billion. From the end of 2004 through this June 30, says analyst Howard Silverblatt of Standard & Poor's, Exxon Mobil has soaked up an astounding $102.2 billion worth of its own shares.

Big oil is not alone. All told, the companies in the Standard & Poor's 500-stock index have bought back shares valued at more than a half-trillion dollars' worth of their shares in the past year.

Unfortunately, firms don't always buy stock back when it is cheap. In fact, you would have an easier time teaching a platypus to play the clavichord than getting a manager to admit his stock is overpriced. Every three months, Duke University economist John Graham surveys hundreds of chief financial officers. During the week of March 13, 2000, the absolute peak of the market bubble, 82% of finance chiefs said their shares were cheap, with only 3.4% saying their stock was "overvalued." More recently, buybacks hit their all-time quarterly high of $171.9 billion in September 2007, just before the Dow crested at 14000.

Mistimed buybacks can be deadly. In 2006 and 2007, Washington Mutual spent $6.5 billion on buybacks. In January 2007, with the stock at 43.73 per share, chief executive Kerry Killinger called the repurchase program "a superior use of capital." Also in 2006 and 2007, Wachovia sank $5.7 billion into buybacks at an average price of more than 54. Citigroup spent $8.3 billion to repurchase stock in 2006 and 2007 at share prices of about 50. In April 2008, all three banks were so capital-starved that they had to raise cash by selling shares for a fraction of what they had recently paid for them — WaMu at 8.75, Wachovia at 24, Citi at 25.27 a share.

Another warning: Contrary to popular belief, buying back stock isn't like canceling a postage stamp. Rather than being "retired," most repurchased shares sit in the corporate treasury — and they can be yanked back out for just about any reason.

Look again at Exxon Mobil, which has repurchased 2.8 billion shares, carried on its books at their cost of $131 billion. But their current market value is $229 billion. If ExxonMobil decided to get into, say, the soap and diaper business, it could buy all of Procter & Gamble, the fifth-biggest stock in America, and have $10 billion in stock left over.

No, I don't believe Exxon Mobil is about to do anything that dumb. But less canny outfits could — and will. Buy into a company that doesn't retire shares after it repurchases them and you are playing with fire.

Back in 1999 and 2000, tech companies wildly overpaid to buy back stock, while stodgier firms like Philip Morris repurchased shares dirt cheap. A buyback probably makes sense if the stock is less than its average price/earnings ratio of the past five years.

Finally, the historical outperformance of buybacks comes from an era when not everybody was doing them. From now on, long-term returns are bound to be lower. Before you invest, ask whether the stock would look cheap even without the buyback. It's hard enough to avoid buying high and selling low on your own account. Why run the risk that someone else will do it for you?