Stock buybacks: Buy high, sell low
With shares at rock-bottom prices, it's time for companies to start shopping in their own bargain basements.
(breakingviews.com) -- Companies repurchased huge chunks of their own stock when prices were peaking. Buybacks for S&P 500 companies hit a high of $150 billion in the fourth quarter of 2007, according to Thomson Reuters.
The market crash put an end to this: Companies in the index should buy back around just $10 billion in the current quarter. This is a shame.
In theory, buying back stock makes good sense. If a stock is significantly undervalued, doing so can offer a better return on investment than other uses of capital. And unlike a dividend, investors don't expect repurchases to continue indefinitely - so it's potentially more flexible way to use windfall profits without creating unrealistic future expectations.
The problem is that, in practice, corporate executives are terrible market timers. Just look at Starbucks (SBUX, Fortune 500). In 2007 the coffee chain spent close to $1 billion to buy back stock at an average price of around $30 a share. It isn't currently repurchasing any, even though its stock is currently trading under $10.
Indeed, many buybacks over the past several years were driven by other concerns. It's telling that while repurchases exhibit strong cyclicality with stock prices, dividends don't. Many companies used repurchases to mop up option grants to employees.
Others took out huge loans to buy back stock because interest costs are tax deductible - in the belief this made their balance sheets more "efficient". Corporate activists pushed companies into such repurchases, claiming (often with justification) that managers would blow the cash on dubious projects and empire building.
Of course, holding off on buying back stock is understandable for many companies who would struggle to raise capital in the credit markets today. And the market difficulties present other opportunities for which having cash in the bank is handy.
Buying rivals and squeezing out synergies may be more compelling than buying your own stock, for example. This was one justification for Microsoft's (MSFT, Fortune 500) recent decision to slow its buybacks.
Yet this is precisely the right time for companies with strong balance sheets and cash flow to buy back stock. The S&P 500 trades at 12.4 times estimated earnings, or about 30% cheaper than in 2007 when companies went buyback crazy.
Some have taken the lesson to heart. DirecTV (DTV, Fortune 500) has diverted lots of money from investment projects to buy back stock. And software group Oracle (ORCL, Fortune 500) increased its repurchase program in the past quarter rather than buy rivals - even if it has a better acquisition record than Microsoft.