A great Sunday New York Times article headlined Sacrificing the Future for a Mirage is about one of my new favorite subjects -- stock buybacks. The Times cited ill-advised, poorly timed stock buybacks from Yahoo! (YHOO), 3M (MMM) and McDonald's (MCD) as examples of moves that added little to no value to those companies.
Robert Colby of Core Equity Valuation has done some recent research on share repurchases and told the Times that his findings "confirm my suspicion that while buybacks are not universally bad, they are being practiced far more broadly and without as much analysis as there should be."
As I wrote last week, properly done buybacks can be a powerful builder of shareholder value. In fact, a portfolio of companies that bought back stock at low multiples to earnings, EBIT and book value has handily outperformed the S&P 500 over the past 17 years by a wide margin.
However there simply aren't that many companies buying back stock at great prices and building value. Using all three valuation metrics above, only about 130 stocks qualify each year for such a portfolio. The rest of buybacks are done at premium valuations and might not be the best use of shareholders' cash.
The Worst Move: Borrowing Money for Buybacks
I also ran a few tests recently and found that one of my favorite theories holds water: Companies that borrow money to buy back shares at high multiples to earnings lag the market over time.
In my mind, there's almost no excuse for buying back stock using borrowed money. (And I consider using cash on hand to buy back shares while borrowing money for other corporate purposes as the same thing.)
This is just a horrible practice, and I can't think of a single valid argument for doing it. A stock might get a short-term bounce that satisfies short-term shareholders, but that comes at the expense of long-term investors.
Nonetheless, I did a screen and found more than 60 publicly traded companies with price-to-earnings ratios of 25 or higher that reduced their share counts over the past year while also increasing their debt levels. In other words, these companies were borrowing money at today's low rates and using the cash to buy back stock in addition to other corporate purposes:
While it might make sense for managements to borrow money at low prices to grow their businesses, they should also remember that their firms must eventually repay or refinance those loans.
That means companies need to generate sufficient cash flow from any borrowed money to service the interest and repay the debt at maturity. I'm not convinced that buying back shares at a 4% earnings yield (given that my screen set a P/E floor of 25) will accomplish that goal.
By the way, the chart above has some companies' debt increases in percentage terms listed as "N/A." That simply means that a firm had no debt a year ago, but decided in the past 12 months that it needed to take on debt.
That's a huge red flag for potential investors, as it suggests management was more concerned with a short-term "pop" from a stock buyback than with a firm's long-term growth and financial health. (The "Buyback Rate" column shows what percent of shares outstanding companies repurchased in the trailing-twelve-month period.)
The Bottom Line
Using borrowed cash to buy back stock at high multiples seems like a poor long-term strategy for managing a business.
Frankly, I don't think I want my money invested with a management that has such a short-term focus.
I got at least one e-mail every day last week following some earlier columns about stock buybacks (click here, here and here). Readers pointed out exceptions or special conditions for one stock or another that I had listed.
Keep in mind that my columns often show the result of raw screens, so you still need to do your homework. Never buy or sell based on a screen alone without doing some additional research.
For those of you who pointed out exceptions to me via e-mails, thanks for doing a great job on your homework. Please keep sharing your findings with me, as a screen is just a starting point for smart investors!