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Stock buybacks: what are they good for?

I used to wonder why companies would throw their hard-earned cash into the stock market when it obviously would have been better spent developing new markets, creating jobs, opening new facilities, etc. Then I got an education last year via a part-time gig editing newsletters for Charles Biderman of TrimTabs Investment Research. Biderman has a complex theory built around the supply and demand for stocks that boils down to this: Stock issues like IPOs increase the supply and press down on prices; stock purchases like buybacks and mergers decrease supply and drive prices up. Large shifts in buying are bullish, large shifts in selling are bearish.

Biderman developed a formula for measuring stock supply and demand across the entire U.S. stock market. It’s not perfect, but it’s pretty good at signaling where the market’s going before the retail crowd knows it.

If Biderman’s so clever, why have you never heard of him? Mainly because he sells the results of TrimTabs’ research to hedge funds, institutional investors, pension funds and so forth and isn’t particularly interested in “retail” stock advice. I’m bound by a contract which naturally forbids me from revealing for free what he charges his clients several thousand dollars a year to learn.

I can share a few things I’ve learned about stock buybacks, however:

  • Company insiders have the most intimate knowledge of how their company’s doing: Because stock is as liquid as cash, investing some of their cash in stock is a reasonably safe investment if they know things about sales, earnings and cash flow that will juice their stock price. A buyback can be an announcement of good tidings ahead.
  • Only a small amount of any stock is free to trade: Most sensible investors buy stock and hold it for years; this is especially true of pension funds and mutual funds, which, depending on the stock, can hold a very large percentage of the shares that are not on the market. This means a company can buy back, say, 5 percent of its shares and still affect the prices of the other 95 percent.
  • Stock buybacks usually spike during major market downturns. Corporate financial managers like to buy stuff on sale too, especially when they’re reasonably certain the price will go back up again soon. I’m sure Charles wouldn’t mind me telling you this as a public service: companies have not been buying back their shares in response to September-October selloff. This tells us what we kinda sorta already know: the recession will punish earnings growth, and the markets will punish companies that report earnings reductions. Buybacks are a cinch in a bull market when the trend is your friend, but they are a very risky proposition in a bear market that chews up cash for months on end.
  • Some of Biderman’s research shows up in a regular column at Forbes. From the latest:

    Corporate America is using hardly any of its near-record cash hoard to buy shares. In December, announced corporate buying was only $3.6 billion, the lowest monthly amount in this decade. Particularly worrisome is that new stock buybacks plunged to $15.8 billion in November and December, down 90% from $164.4 billion in November and December 2007.

    Companies have had two full months to digest the autumn collapse in stock prices and they haven’t made their typical decision to throw their cash at their own stock, even when they know doing so will decrease supply and help prices rise. Translation: the bear market seems poised to overwhelm the buybacks’ benefit.

  • Buybacks can happen for the wrong reasons. Flailing companies have been known to use buybacks — rather than building market share, cash flow and profitability — to rescue their stock price. I saw this happen in the newspaper business: Knight Ridder, the now defunct newspaper chain, promised to buy back a bunch of its shares after the markets turned against the industry. People were getting out of the habit of reading newspapers, which was affecting circulation, which was affecting advertising revenue, which was making newspapers less profitable. The market plainly knew this and spanked Knight Ridder’s shares accordingly. A Knight Ridder buyback would have thrown untold millions that might better have been spent on building its business down a stock market rathole. (I’m not certain that KR actually went through with the buyback, but I do remember a buyback announcement).

Bottom line: Buybacks represent a useful data point, but they must be considered in the context of everything else you also know about a company.

2 comments | Permalink | Tags: ,
Tom Mangan posted at 8:28 am January 7th, 2009 |