Be Skeptical of Stock Buybacks Today

 | Aug 30, 2012 | 2:00 PM EDT
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Conventional wisdom trains investors to see a company stock buyback as a value-creating tool. What better way for a company to reflect confidence in its shares than to buy back shares?

The problem, however, is that the decision to buy back stock is a capital-allocation decision, not an operational decision. And the majority of today's top executives are good operators but are often mediocre capital allocators.

The U.S. stock market is doing very well in 2012. Housing is showing varying sprouts of life, and the euro crisis is leading investment capital to flow from Europe into the U.S. As such, overall equity valuations are generally robust. When a company buys back stock, the value creation is no different from when you or I buy stock: Price paid determines value received. Since equity valuations are so high today, most corporate share buybacks are likely to erode value instead of create it. So I would be very skeptical of a business that is in the midst of a large buyback in this environment.

Many corporate executives exhibit the same emotional tendencies of the average investor. When the market is in an upswing, these executives' attitudes toward investing become more confident, and that leads to buying stock. Often that buying happens when prices are high, making the majority of announced company buybacks value-destroying decisions.

This behavior was on exhibit time and time again before the 2008 financial crisis; over-confident companies bought back shares, only to have to sell stock at a significantly lower price in order to shore up capital when the credit markets froze. The net result was poor capital allocation and loss in intrinsic value for shareholders.

Of course, when done appropriately, buybacks can be incredible creators of value. And on a case-by-case basis, there are businesses that engage in value-creating buybacks. The easiest way for most executives is to simply have a regular buyback policy, the equivalent of dollar-cost averaging for investors.

AutoZone (AZO) may be one of the best examples. For over a decade, this company has been furiously buying back shares every quarter. Executives at AutoZone understood that they had an inherently strong business model with solid cash-flow generation that over time would increase the intrinsic value of the business. So in the span of 10 or so years, AutoZone has bought back more than 60% of its outstanding shares, and shares have climbed from $24 in 2000 to over $360 today.

Advance Auto Parts (AAP) is attempting to do the same thing today, and I suspect that in three, five and 10 years from now, shareholders will be much better off.

Another instance of quality buybacks is of course when shares are temporarily depressed, making a buyback one of the best capital-allocation decisions. Dell (DELL) is a prime example today with shares trading at $11. With the exception of the market selloff in 2008-2009, the last time Dell shares traded this low was pre-2000. The company is pulling in enough free cash to buy back the entire business in less than five years. Founder and CEO Michael Dell sees that, and he's been buying shares for both himself and for the company.

Properly executed, buybacks produce enormous rewards for shareholders: They get to own more of the pie. And if that pie is producing earnings, buybacks are phenomenal uses of capital. Yet value-creating buybacks fall in the minority, and investors should train themselves to look at buybacks with a degree of skepticism.

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