Stock Buybacks: Better in Theory Than in Practice

In the world of investing, so many things work better in theory than in practice.

Executive stock options were originally billed as a way to align management and shareholder interests. Now, they’re reviled by investors as a way for management to quietly loot the companies they are paid to run.

Not only do these puppies massively dilute the value of shares over time, they also suggest the company isn’t focused on the long haul. They incentivize management to fixate on raising the company’s stock price in the short term, at the expense of planning for the company’s long-term future.

Along the same lines, share repurchases — or stock buybacks — have become popular in recent decades as a tax-efficient alternative to cash dividends… but even these have become corrupted.

The reasons for doing buybacks are obvious.

Earnings paid out as dividends are taxed twice, at both the corporate and individual investor levels…

But when a company uses that same cash to buy back its own shares in the open market, it can boost earnings per share without creating a taxable event.

And unlike dividends, which are usually paid quarterly, stock buybacks can be done sporadically as cash allows.

Then there’s the fact that companies view raising dividends as risky because they’re a firm commitment. Management doesn’t want to be in that awkward position of having to slash the dividend later if conditions take a turn for the worse.

Buybacks, on the other hand, occur quietly behind the scenes and can be stopped at any time without drawing too much unwanted attention.

Again, it sounded good…in theory.

But in practice, companies tend to have awful timing.

They buy their stock when prices are high and sentiment is good. But in a market panic, when prices are low, they don’t, or can’t. Money that might have been used for a savvy buyback ends up getting hoarded. And if times get really bad… and the company finds itself short of cash… it might have to issue new shares, effectively selling when they should be buying. .

Buying high and selling low. It’s not exactly a formula for maximizing shareholder value. Still, we saw plenty of it during the 2008 crisis and its aftermath.

But that’s not even the most insidious aspect of stock buybacks…

The worst part is that they often fail to reduce the number of shares outstanding.

Hold the phone… how exactly could a share buyback not reduce the number of shares outstanding?

Simple. The buybacks are essentially used to “mop up” new shares that are created to satisfy executive stock options and employee stock purchase plans.

If that sounds bad, you haven’t heard the worst of it. Those new shares created to satisfy employee stock options and stock purchase plans are sold at a discount… whereas those bought via buybacks are bought at full price. It’s another case of buying high and selling low… and the shareholder is the one that gets screwed.

If that sounds like highway robbery to you… it’s because it is. And, sadly, it’s perfectly legal.

And it’s a bigger problem than you might think.

Let’s take a look at the most recent buyback data compiled by Factset. The companies of the S&P 500 have collectively repurchased a little over 3% of their shares outstanding in each of the past two years. That means that their shares outstanding should have dropped by around 6%.

Except the number of shares outstanding has only fallen by 1.5% over the past two years.

In that vein, only a quarter of stock buybacks actually do their job of increasing shareholder value by decreasing the number of shares outstanding!

But I’ll give you this — not all companies are equally guilty here. There are plenty that are legitimately using their excess cash flow to reduce their shares outstanding.

No funny business with the accounting and no debt-fueled binges. Just solid cash management to the shareholder’s benefit.

But these companies are the exception. Market-wide, the boom in buybacks is mostly a farce, aided and abetted by Wall Street and the financial press.

So, before you get excited about that next buyback announcement, do a little homework on the stock in question. If their actual share count reductions have failed to keep up with their buyback announcements, view the company with a skeptical eye.

Buybacks can also be used to stealthily hide a slowdown in sales. This month in Boom & Bust, Adam O’Dell teams up with renowned short seller John Del Vecchio to expose one of America’s supposedly bluest of blue-chip companies for using share buybacks to mask a major deterioration in its business. You might be shocked that this company has managed to fool even the venerable Warren Buffett!