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Use care buying into a company's buyback fever

Use care buying into a company's buyback fever

July 5th, 2011 by CHRISTINA REXRODE, AP Business Writer in News

NEW YORK (AP) - When companies buy their own shares, they usually tout it as a benefit to shareholders.

The logic behind that is simple. If companies are buying, they must believe the share price is going to rise. Their confidence influences investors to bid the shares higher. Investors get higher returns and own more of the company because there are fewer shares circulating. And the company can later reissue shares at a higher price. Everyone ends up happy.

In fact, there's little evidence that buybacks increase share prices over the long term. Companies tend to buy when they believe their stock is undervalued. But while there might be an initial gain when a buyback is announced, the share price usually declines in the following years. That's because the underlying reasons that the stock was depressed haven't gone away. Repurchases also don't lower share count for very long because companies keep reissuing stock to pay employees or make acquisitions.

"Media and analysts talk about buybacks like they're a great thing," says James Early, a senior analyst at Motley Fool. "But they're just as often a raw deal for shareholders."

Companies usually buy their stock like most investors, on the open market. Buybacks are on the rise this year after slowing during the financial crisis. Best Buy Co., Wal-Mart Stores Inc., IBM Corp. and JPMorgan Chase & Co., were among the 447 companies that announced $285 billion worth of buybacks this year through June 24, according to research firm Birinyi Associates. That's more than seven times the $38 billion in the comparable period in 2009, when stock prices were depressed, but still below the $404 billion announced the same stretch in 2007.

Why the rush to repurchase? Many recession-weary companies are loath to make long-term commitments like hiring new employees or expanding operations or product lines. Companies are generating significant cash flow because they've cut costs. But they aren't seeing enough of an increase in demand for their goods or services to justify expansion.

Buybacks are one easy way for companies to spend the cash they've hoarded, analysts say. There's also no requirement that a company follow through and buy shares after announcing a buyback plan, says Rob Leiphart, an analyst at Birinyi, which has tracked buybacks since the 1980s. If a company backs out of a repurchase, it will often go unnoticed.

Early on, a buyback can cause a stock to rise. TrimTabs Investment Research estimates that companies that announce buybacks outperform the market by 0.7 percent the next day, and by 1.2 percent in the first 100 days. But Leiphart says companies in the S&P 500 that did not announce a repurchase in 2010 did better than those that did. The stocks of companies that did not announce buybacks rose by three percentage points more, on average, than those that did.

One reason the gains don't last: Companies tend to repurchase shares when they are confident, have extra cash and think their stock price is low. But if a company has limited growth prospects, faces low future demand for its product or there are price pressures in the industry, its stock will likely fall.

In some cases, buyback announcements are used to distract investors from bad news released around the same time, says Howard Silverblatt, senior index analyst at the S&P. The stock might have declined after negative news but then jumped after a buyback was announced

That won't fool investors for long.

"If you're using buybacks to hold up your stock, that's a holding pattern short term," says Silverbatt.

One example: Three days before it announced a buyback in May, Tyson Foods Inc. reported flat net income and warned about price increases in one of its biggest expenses, feed. Its stock fell 6 percent. Then the day Tyson announced the share buyback, its stock rose 4.6 percent - not enough to make up for the losses from the bad news. Tyson's chief financial officer Dennis Leatherby said the company is using its cash to pay down debt and reinvest in its businesses. He defended the stock repurchases as "an appropriate use of our excess cash and strong liquidity."

The argument that buybacks help drive per-share earnings higher is also flawed. When companies buy their own stock, they typically retire those shares. Fewer outstanding shares should boost earnings per share, a widely used measure for valuing stocks.

But companies are constantly giving out stock options or issuing stock to raise money or buy another company, so share count often ends up holding steady or rising, explains Michael Mauboussin, chief investment strategist at Legg Mason Capital Markets.

Oil giant Exxon Mobil Corp. spent more than $16 billion to buy 230 million shares during the 12 months that ended in March, according to data compiled by FactSet. That alone would reduce share count by 5 percent. But Exxon's share count actually increased 5 percent above pre-buyback levels over that period, to 4.93 billion, after the company issued 460 million shares for its purchase of XTO Energy.

S&P's Silverblatt says that only 94 of the 305 S&P 500 companies that bought back shares in the first quarter actually decreased their share count by at least 1 percent over the quarter. Share count actually increased by 1 percent or more at 65 of those companies.

Sara Senatore, an analyst with Sanford C. Bernstein, says that buybacks can be a good idea if the money can't be put to better uses, like reducing debt or investing in new equipment. Buybacks can also be smart if the stock is truly undervalued, she says. That isn't always easy to predict.

In 2009 when share prices were obviously cheap, companies made fewer buybacks to conserve cash. In 2007, $863 billion in buybacks were announced, nearly seven times more than in 2009, according to Birinyi.

Senatore says Chipotle Mexican Grill Inc. is one of the few companies that got it right. The burrito maker began buying shares when they were trading around $40. The stock now trades at about $315. From the fourth quarter of 2008 through the first quarter of 2011, Chipotle spent $244 million, including fees, to buy back about 2.9 million shares.

At today's prices, those shares are worth more than $913.5 million. That's a lot of burritos.