Tuesday, September 23, 2014

The Buyback Annoyance

Stock buybacks have been the craze over the past couple of years. Ever since the Fed has flushed the economy with cheap money, corporations have been using the funds to invest in their businesses to grow, spend on mergers and acquisitions, raising or issuing special dividends, and of course, the buyback annoyance - buying back its own company stock. While a majority of the investors and traders see that as a good thing, I see it mostly as an annoyance that does not achieve much more than some financial engineering.

The Buyback Annoyance

For the readers who are unfamiliar, buybacks - also called share repurchase, is where a company decides to purchase its own shares from the marketplace, thus reducing the number of outstanding shares. The reduced number of shares in the market is good for the key-stats in annual reports as it shows an increasing earnings-per-share (EPS) value and increases the value of the remaining shares in the market. Don't get me wrong...there is a place for buybacks in the marketplace. Without any buybacks, shareholders would see their stock value depreciate as companies routinely issue more shares thus making the value of each share just a little bit less valuable. But my annoyance has been with the degree with which we see the buybacks occurring.

As a long-term investor, I'd rather see companies invest the surplus money in either: paying down debt, growing its business or acquiring new business segments to expand the horizons. Even issuing a one-time dividend would do better for long term shareholders. It has to be noted that companies resist committing to a bigger dividend increase, as dividend increases are normally considered permanent. But the buyback is attractive for the executives, board members and upper management - as they lavishly reward themselves with stock options. A short term fix and some financial engineering drives up the stock price providing the execs with more profits. This is the reason why you see a majority of senior execs selling their positions taking their profit off the table in the current market condition.

Instead of investing or paying down debt, if the company is buying its own shares and the insiders are selling, should you be buying?
The buyback movement reached fever pitch in 2013. In fact, I am of the opinion that buybacks are one of the main contributing factors for the all-time stock market highs. The following chart shows the list of largest buybacks in the market today. In fact, investors and traders can even target the companies that have a higher buyback plan by using an ETF - PowerShare Buyback Achievers Fund (PKW).


Stock Buybacks

One company that has resorted to financial engineering for quarter after quarter is International Business Machines Corp (IBM) - and its only a matter of time before patience runs out. The company has seen declining revenues and cash holdings, while debt has continued to pile up. The company has been squeaking out quarters resorting to layoffs to keep the shareholders happy - and for the sake of the IBM shareholders, I hope management changes this path that they are heading down on.

On the other hand, General Electric (GE), with all the cash available, has been investing heavily into growing their business. GE is cutting losing business segments that are not lucrative anymore such as the appliance business, which it sold to Electrolux for $3.3B recently, and spun-off Synchrony Financial (SYF) - its retail finance arm. Instead, GE is now returning to its industrial roots and expanding into new horizons such as oil & gas exploration and pipeline infrastructure tech, green energy investments such as wind, solar and fuel cells etc. These are lucrative businesses and I fully support the management in their decision as a shareholder. Note that GE, like others, has a share repurchase plan - esp in 2013, GE has bought a lot of its own shares after selling its stake in NBC.

A plethora of companies have a history of buying at highs and selling at lows. This goes against any logic when it comes to good financial sense. When times are good and companies are flush with cash, like the current environment, the management authorizes buying its own shares and during lean times - after market crashes and/or recessions, the companies cut back on share repurchases. So, the question for the retail investors is: Instead of investing or paying down debt, if the company is buying its own shares and the insiders are selling, should you be buying? It comes as no surprise that smart investors such as Warren Buffett through his holding company Berkshire Hathaway holds a huge cash position (totaling $55B) in the current market condition - waiting for the right opportunity.

Conclusion

As a long term dividend growth investor, I'd rather invest in companies like GE than IBM. While IBM is a favorite amongst dividend growth investors, and for that matter, has a better track record than GE (which saw dividend suspension during the recent crisis), the future for GE looks brighter. My focus as a dividend growth investor is to own great companies and share the growing profits while I own them, instead of selling the shares and exiting the investment before I see any profit.

Full Disclosure: Long GE. My full list of holdings is available here.

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