Are Stock Buybacks Important?
The Dynamic Wealth Report
June 14, 2010
I was recently researching a company for another article. As a matter of
habit, I always take a look at the last few months of the company’s
press releases. You’d be surprised just how many people skip this step…
It’s like cooking an omelet for breakfast, but not putting the pan on
the stove.
You’re skipping a vital step that can result in disaster. Besides, you
never know what you’ll discover. While I was digging up my research, I
came across an interesting press release… “Ormat Technologies Announces
$50M Stock Buyback”.
To be honest, I skipped right over it.
Companies are always initiating stock buybacks. It wasn’t something I
wanted to dig into. But then it dawned on me… stock buybacks could
influence stock prices.
By using a stock buyback to purchase stock on the open market, the
company is removing a source of supply, effectively reducing the number
of shares outstanding.
Assuming demand for a company’s stock is fairly constant, the removal of
supply should push the value of a stock higher. It’s interesting in
theory… and makes logical sense. But, does it hold up in the real world?
Are stock buybacks important?
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Before I give you my thoughts on the subject, let’s dig a little deeper.
Most investors would agree a manager’s top job is the allocation of
capital. It’s a fancy way of saying managers decide what to do with the
business cash. Some managers are better at it than others.
Take Warren Buffett for example.
He’s a stellar manager of company cash. The billions of dollars of cash
flow Berkshire Hathaway generates are wisely reinvested in other
business opportunities. Buffet’s been able to generate incredible
returns of more than 20% annually for decades!
Other corporate managers aren’t quite as savvy.
Just look at the management team at Time Warner… when they bought AOL. They spent billions buying AOL. They ended up ejecting the company a few
years later at a big loss.
While mergers and acquisitions are sexy… and new products are exciting…
managers also have the option to send cash to shareholders. This is the
activity I like the best.
Often managers return cash to shareholders in the form of dividends.
I
love getting paid to make an investment. Most dividends are small, a few
percent at most. But every once in a while, you’ll find one that’s off
the charts!
One investment I’ve made is paying out dividends over 27%!
Think about that for a moment… For every $100 I’ve invested, I get $27
back in dividends every year. In the last 18 months, the stock has
almost doubled in value and I’m still collecting my nice dividend.
While dividends are nice, some managers implement stock buyback
programs.
Many would argue buybacks are better for investors than dividends. If
you receive a dividend, you need to pay taxes on it. It reduces your
overall return.
Stock buybacks work a little differently.
By purchasing stock on the open market, the company is effectively
pushing the price higher. By driving up the value of the freely traded
stock, shareholders get the benefit of an increase in price. And they
can decide when to sell… if ever.
With a stock buyback, the price goes up (hopefully more than the
dividend amount) and everyone is happy. By controlling your exit, you’re
able to better manage your tax liability… increasing overall returns.
There’s a big problem though.
In 2007 when the stock market was peaking, companies spent almost $600
billion on stock buybacks. In late 2008 and 2009, you’d think companies
would be grabbing shares at rock bottom prices. Unfortunately, buybacks
dropped to a pathetic $31 billion in the first quarter of 2009… when
prices were the lowest.
Not many companies are able to step up and buy back shares at the right
time. Managers tend to buy when stock prices are high… not when they’re
low.
As I dug deeper in my research, I realized something important.
Stock buybacks are just one arrow in the quiver for a good management
team. Standing alone, they don’t improve an investment. However, used in
conjunction with accelerated debt payments, dividends, and smart
corporate growth strategies, stock buybacks can and do enhance company
value.
While I’d never suggest buying a company solely because of a stock
buyback, I’m always happy to see one in place.
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