Share Buybacks: Invest the Right Way

In its long history, International Business Machines Corp. (NYSE: IBM) has been a pioneer in several technology areas. But the company surprisingly also has led the way when it comes to financial engineering. IBM has been actively and consistently buying its own stock for 20 years, foreshadowing a trend that became popular in the 21st century.

In 1993, IBM had 2.3 billion shares outstanding. Today, there are 1.1 billion, a reduction of more than 50 percent.

When companies repurchase their stock, it reduces the number of shares outstanding, thereby boosting earnings per share (EPS), even though actual profits don’t change. It also makes each remaining share more valuable and lowers the stock’s price/earnings (P/E) ratio.

Investors like companies that repurchase their own stock. The S&P 500 Buyback Index, an index that measures the performance of 100 stocks with the highest buyback ratios in the S&P 500, was up almost 42 percent in 2013, versus 32 percent for the Standard & Poor’s 500.

But that good news can mask negative underlying trends. IBM is an excellent example. Its annual revenues are lower than they were five years ago, and they’ve grown just 13 percent over 10 years. Plus, yearly capital spending and research & development have been roughly flat for nearly a decade, at between $10 billion and $11 billion.

On the plus side for IBM, its actual income, profit margins and dividend payouts all have increased significantly over 10 years. And EPS has jumped 335 percent. IBM evidently is focused more on profitability (and perhaps its stock price) than on growth.

IBM’s announcement this week that it will sell its low-end server business to Lenovo for $2.3 billion marks the latest step in the long-term strategy of moving away from low-margin hardware to increasingly focus on higher-margin services and software.

Over the last 10 year! s, IBM shares have returned an average of 7.5 percent per year, compared with 7 percent for the Standard & Poor’s 500. However, IBM has lagged the benchmark over one, three and five years.

Still, IBM has been a respectable long-term investment, although it has been notably weak over the last year or so, primarily because of concerns about its future growth prospects.

Unlike slow-growth IBM, some companies deliver it all: share buybacks and organic growth. Consider AutoZone Inc. (NYSE: AZO).

This leading automotive-parts retailer not only churns out consistent double-digit EPS. Revenues have climbed 64 percent over 10 years while net income has almost doubled, cash flow has soared and profit margins have expanded. Aided by a 58 percent shrinkage in shares over the 10 years, AutoZone’s EPS has jumped 438 percent.

Over 10 years, AutoZone stock has returned an average of 19.2 percent annually. It also has outperformed the S&P 500 by wide margins over one, three and five years.

Your Buyback Checklist

In 2013, total share repurchases of US companies exceeded $750 billion, an annual result exceeded only in 2007. Corporate America has been criticized for hoarding cash and using too much of it to buy back its shares (as well as boosting dividends) instead of investing for growth.

While buybacks may be a good way to please shareholders in the near term, the argument goes, they undermine the companies’ prospects and the economy in the long run.

The counterargument is that corporate managements are justifiably concerned about the relatively slow economy, and consequently it’s better to repurchase shares than make business investments that may not work out.

However, it must be noted that company decisions concerning investment vs. buybacks may be affected by self-interest: Management compensation often is linked to EPS and/or stock-price performance, both of which are enhanced by share buybacks. Of the 30 companies in the ! Dow Jones! Industrial Average, for example, 26 include EPS as a metric used to determine executive pay.

The Federal Reserve’s easy monetary program has encouraged many companies to borrow money at low rates to repurchase shares. This makes sense for companies with rising revenues and organic profit growth.

However, it’s more questionable for companies with less attractive fundamentals. Indeed, one reason for stock buybacks is that they help struggling companies to meet EPS targets. Shareholders can be left with a high-debt, low/no-growth company because management reached EPS targets by borrowing to shrink shares outstanding rather than developing new growth opportunities.

The environment for buybacks should remain healthy in 2014, given moderate economic growth, attractive borrowing rates and the benefits of higher EPS. Still, it must be recognized that the equity market is less attractively valued than it was a year ago. And rising interest rates would make it more costly to borrow money for stock repurchases.

If the economic recovery accelerates (still a big if), capital spending and other investments increasingly would replace some share-buyback activity.

If you’re looking for individual stocks that are benefiting from buybacks, put these three items on your checklist:

First and most importantly, scrutinize the company’s actual share count over time. You need to ensure that it’s actually declining. Second, be sure the company is generating real growth of revenues and profits, aside from share buybacks. Third, avoid shares of companies that are taking on excessive debt to fund buybacks.