Buying High and Selling Low

Stock buybacks have occurred at a faster pace this year than last year. According to the Wall Street Journal, “Companies in the S&P 500 increased share repurchases by 29% during the three months through January 2014 compared with a year earlier”. During a stock buyback, a company purchases outstanding shares at current market prices and pays stockholders cash for their shares. The repurchased shares are placed in the company’s treasury stock, which means they are no longer considered outstanding shares. According to the Wall Street Journal, “In theory, buybacks are nearly equivalent to dividends as a way to return cash to shareholders”. Both cash dividends and stock buybacks provide investors with a cash payment based upon the number of shares they own. Cash dividends, which are decided upon by the company, are usually a small fraction of share price. On the contrary, stock buybacks occur at market prices that are determined my market forces. Although investors prefer stock buybacks when stock prices are high, corporations should prefer repurchasing their own stock when it is cheap. However, companies are performing stock buybacks while stock prices are very high – this rewards investors while the company takes unnecessary risk.

Besides returning cash to shareholders, companies have other incentives to conduct stock buybacks. With less shares outstanding, stock buybacks artificially increase earnings per share (EPS). According to the Wall Street Journal, “By reducing shares outstanding, repurchases flatter earnings per share, making stocks look more attractive. During the reporting season that just ended, earnings growth slowed to a crawl and likely would have been negative without buybacks”. A company’s business model should prioritize producing goods and services. A successful business model will exhibit continuous growth in earnings. When organic growth slows, however, companies can propel stock valuations through stock buybacks. Although buybacks can inflate EPS and push up a company’s stock price, it can be a risky strategy that can cause problems in the future.

Despite the bull market and lofty stock prices, companies have been conducting a record amount of stock buybacks. According to the Wall Street Journal, “Buybacks and bull markets are self-reinforcing”. During a bull market, companies feel pressure to keep increasing EPS (and subsequently increasing stock price) and to put all of their cash to use. Unfortunately, spending too much on stock buybacks benefit the short run while causing damage in the long run. According to the Wall Street Journal, “If share repurchases consume too much of companies’ excess profits, the underlying businesses might end up starved, which could lower future returns”. Although companies might wish to perform buybacks and boost EPS in the short run, it can be a waste of cash that would otherwise be spent to increase EPS in the long run. Companies should be careful in how much money they spend on share repurchases, which are not essential to day-to-day business operations. Corporate spending should prioritize other expenditures before stock buybacks.

Ironically, companies would get more bang for their buck if they conducted buybacks when they feel least comfortable (i.e. during bear markets when stock prices are low). According to the Wall Street Journal,

During the previous bull market, buybacks peaked in the same quarter the stock market did. Less than two years later, during the quarter in which tock prices bottomed, companies spent 83% less on buybacks. That is despite the fact they would have gotten far more earnings-boosting effect at those low prices for each dollar spent.

When done at the right time (i.e. when stock prices are low), stock buybacks can be more effective and less risky. In order to time buybacks right, management must be patient and not give into short term temptations. Although it can be tough (or even impossible) to determine the exact value of a stock, companies should be able to tell if their stock price is roughly overvalued or undervalued. Even when stock prices are low and stock buybacks would make  sense, the economic climate and outlook might be more negative causing companies to make conservative decisions. Stock buybacks might be hard to time, but I think it is pretty clear that companies should avoid buying high and selling low.