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Beware the Return of the Buyback


Why the rebound in stock repurchases may not be a bullish sign.

Do you need a sign that stocks still could have further to fall? Buybacks are back.

In the past few weeks, dozens of companies including Colgate-Palmolive (CL), AstraZeneca (AZN), (AMZN), UnitedHealth (UNH), and IAC Interactive (IACI) have announced new or expanded share repurchase plans. On Friday, Altria (MO) spinoff Phillip Morris International (PM) announced a plan to spend $12 billion repurchasing shares over the next three years.

Buybacks began their rebound late last year. Standard and Poor's reported that share repurchases surged 44% from the second quarter to the third quarter of 2009 and that growth is expected to accelerate throughout this year.

Some shareholders love a buyback announcement. Theoretically, when a company buys a big chunk of its own stock, the number of shares outstanding decreases, which boosts earnings per share. Some see it as a sign the company believes its shares are undervalued if it's willing to put its own cash to work with them. In general, buybacks are seen as a sign of economic health, both at the company level and within the broader market -- investors are pleased to see that companies are again spending cash from their balance sheets, something they've been loathe to do since the credit crisis began.

In reality, though, companies often use buybacks to offset share dilution through employee stock options or stock-based acquisitions, so there are no guarantees that buybacks boost EPS. Merely the announcement of the buyback can send shares higher, but there are no commitments to investors about when the plan will be executed, or at what price. Unlike dividends -- which must be paid out quarterly and are only lowered during particularly difficult times -- buybacks are dubious in nature and companies aren't required to follow through with them after they've been announced.

But the biggest problem with buybacks is that many companies have proven to be particularly poor market timers. Buybacks are intended to show signs of financial health and stability, which is also when share prices are high and potentially overvalued. They avoid the investment when the shares are at their most attractive levels.

This is why it's somewhat troubling to hear that buybacks are on the rebound. Perhaps some investors and chief financial officers need a reminder of the recent past.

The volume of stock buybacks peaked in 2007, when the Dow reached its all-time high of 14,164. Shares repurchased by corporate treasurers during that year, worth a total of $598 billion, are well under water.

The five largest banks collectively spent $100 billion buying their shares between 2003 and 2007. By 2008, of course, those banks reached such dire straits that the government was forced to bail them out by more than that amount. Of those banks, Wells Fargo (WFC) and JPMorgan (JPM) are trading at around the same levels as they did in 2003. The other three banks are well below those levels.

In January 2008, Lehman Brothers announced that its board of directors authorized a plan to repurchase 100 million shares. In November 2007, AIG said it intended to spend $8 billion on its shares. Fortunately, it halted this program just a few months later.

The statistics are ugly, but stock buybacks aren't a definitive indicator that shares are reaching new highs. Mark Hulbert writes today at MarketWatch that the recent spate of announcements is a bullish sign.

It certainly is a great sign that companies are compelled to spend money again. But investors should ask if it's in their best interest to do so in the form of buybacks instead of dividends or acquisitions. When announced a $2 billion stock repurchase plan on January 28, its shares hit $126.03. A year ago, they traded for half that amount.
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No positions in stocks mentioned.
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