(FORTUNE Magazine) - Call it the large-number problem writ small, or the illusion of the modest stock price.

To a retail investor, it's easy to look at, say, shares of Microsoft (Research) at $27 and think, "Hey, it should be easy for the stock to climb $4." But that ignores the fact that Microsoft has ten billion shares outstanding, so that seemingly minor increase would actually require the creation of $40 billion in market value.

Of course, the key figure isn't the stock price or the number of shares, it's the company's total market capitalization. And when you're talking about $280 billion, as in this case, it's easy to see why raising the stock price is so daunting. It's a problem for all megacap stocks.

Still, the issue of share quantity is worth considering these days because something rare is occurring: The number of shares outstanding on major exchanges has actually been dropping. Total shares in the S&P 500 fell by about four billion in 2005, according to Standard & Poor's Compustat.

That's a result of a new record in share repurchases last year: more than $325 billion among S&P 500 companies. That obliterated the previous mark, $197 billion, set in 2004 (a year in which companies still issued more new shares than they took in).

The share reductions were especially marked among the largest of the large -- including Microsoft, which is in the midst of a $30 billion buyback. Of the 30 companies in the Dow Jones Industrials, 25 cut their share count in the 12 months ended in early March, according to David Fried, president of Fried Asset Management and editor of the Buyback Letter. The leaders included DuPont (a 7.5 percent reduction), Disney (5.9 percent), and Microsoft (5 percent). "This is really wild," Fried says. "I haven't seen this in the ten years I've been doing this."

Do share buybacks lead to higher stock prices? That's debatable. Supporters cite the fact that repurchases usually mean the company is flush and is looking to return cash to shareholders. Buybacks can -- but don't always -- lift earnings per share by spreading the same earnings across a smaller number of shares. And buybacks can indicate management's belief that its stock is undervalued.

Charles Biderman, the CEO of TrimTabs Investment Research, argues that net share reductions augur well for the market. If stock supply falls, he says, while demand stays steady, prices are likely to rise.

The opposing argument starts with the idea that buying back stock is a confession that management can't find a way to use its money to grow the business. Moreover, managers often buy their shares when prices are highest, says Nicholas Colas of Rochdale Research. Indeed, companies are gobbling up way more shares today than they did when prices were low in 2002.

Finally, buybacks are neutral in most cases, argues Al Ehrbar of consulting firm Stern Stewart, because they're equivalent to a one-time dividend; absent other factors, if a company pays out 5 percent of its cash to buy back 5 percent of its shares, it has simply swapped one currency for another.

But reality doesn't always follow theory, says David Ikenberry, a finance professor at the University of Illinois who has been studying buybacks for more than a decade. "If you allow for the fact that stocks sometimes become misvalued," he says, "then share repurchases may be a good idea."

Among other things, Ikenberry's research suggests that buybacks can give a powerful boost to companies with high-quality earnings. A paper Ikenberry co-authored last year analyzed 7,725 repurchases between 1980 and 2000. It concluded that for companies with higher earnings quality (which he defined as the relative quantity of cash flow compared to one-time gains or accruals), buybacks boosted returns by 36.9 percent over four years. The companies with the lowest-quality earnings got no stock-price benefit from their buybacks.

At least one investor has consistently profited by investing in buybacks. The stocks David Fried selected in his Buyback Letter have returned an annualized 16.3 percent since 1997, according to the Hulbert Financial Digest, compared with 7.9 percent for the S&P 500.

But a buyback is simply the starting point for Fried. He first screens for companies that are net buyers of their own shares and then zeroes in on those with strong cash flows. He narrows the field further by looking for companies selling at low price/earnings multiples. FORTUNE spotlighted two of Fried's picks last year: Home Depot, up 16 percent since then, and AutoZone, up 12.8 percent, compared with 9.6 percent for the S&P.

These days, Fried remains a big fan of Home Depot (Research). The home-improvement giant has reduced shares by 3.3 percent over the past 12 months, but he says it is still trading at a discount, with a P/E of 12, vs. 14 for rival Lowe's. Fried is enthusiastic about Home Depot's strong cash flow. "They're very focused on their core business," he says, adding that he is optimistic about Home Depot's Internet expansion.

Fried is also bullish about Intuit (Research). The maker of tax-preparation and other financial software tools has seen handsome growth. The IRS initiative last year allowing taxpayers to file returns electronically for free if they use a basic tax-preparation software gave Intuit a big boost, helping send use of Intuit's online products up 58 percent.

Though the IRS has tightened the rules, Intuit continues to attract new Internet filers. The company is expecting continued double-digit increases in revenues and earnings per share. And it raised its full-year sales and profit forecasts in March. Intuit's P/E of 20 is fairly modest for a growing tech company. It has managed to lower its share count by 10 percent over the past two years, Fried says. With the company vacuuming up its own shares at that rate, he says, this is one stock in which investors should follow the managers' lead.

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