With Buybacks, Look Before You LeapRepurchases Routinely Give Shares a Lift,
But the Effect Could Be Ephemeral
Buying high and selling low: That sounds dumb. But call it a "share repurchase program" (or stock buyback), and people get excited.
Stocks regularly jump up 3% to 6% on the announcement of a buyback, and it's easy to see why they should.
Done right, buybacks are a boon. They reduce the number of shares outstanding, spreading the company's future profits over a smaller base — thus increasing earnings per share. Over time, firms that repurchase their shares have beaten the market by about three percentage points a year. Unlike dividends, buybacks generate no tax bills for ongoing shareholders.
Above all, share repurchases prevent cash from burning a hole in management's pocket. Long ago, Benjamin Graham pointed out a paradox: The better a company's executives are at managing its businesses, the worse they are likely to be at managing its cash. Great businesses produce piles of wampum — and, to management, idle cash is the devil's workshop.
Three decades ago, with oil skyrocketing and profits gushing in, energy companies squandered billions of dollars on one bone-headed diversification after another. Mobil bought Montgomery Ward, the dying retailer. Arco acquired Anaconda Copper just before metal prices collapsed. Exxon even got the bright idea of manufacturing typewriters.
In the latest oil boom, the energy giants have favored buybacks over misbegotten empire building. So far in 2008, ConocoPhillips has spent $5 billion buying back stock; Chevron, $3.6 billion. From the end of 2004 through this June 30, says analyst Howard Silverblatt of Standard & Poor's, Exxon Mobil has soaked up an astounding $102.2 billion worth of its own shares.
Big oil is not alone. All told, the companies in the Standard & Poor's 500-stock index have bought back shares valued at more than a half-trillion dollars' worth of their shares in the past year.
Unfortunately, firms don't always buy stock back when it is cheap. In fact, you would have an easier time teaching a platypus to play the clavichord than getting a manager to admit his stock is overpriced. Every three months, Duke University economist John Graham surveys hundreds of chief financial officers. During the week of March 13, 2000, the absolute peak of the market bubble, 82% of finance chiefs said their shares were cheap, with only 3.4% saying their stock was "overvalued." More recently, buybacks hit their all-time quarterly high of $171.9 billion in September 2007, just before the Dow crested at 14000.
Mistimed buybacks can be deadly. In 2006 and 2007, Washington Mutual spent $6.5 billion on buybacks. In January 2007, with the stock at 43.73 per share, chief executive Kerry Killinger called the repurchase program "a superior use of capital." Also in 2006 and 2007, Wachovia sank $5.7 billion into buybacks at an average price of more than 54. Citigroup spent $8.3 billion to repurchase stock in 2006 and 2007 at share prices of about 50. In April 2008, all three banks were so capital-starved that they had to raise cash by selling shares for a fraction of what they had recently paid for them — WaMu at 8.75, Wachovia at 24, Citi at 25.27 a share.
Another warning: Contrary to popular belief, buying back stock isn't like canceling a postage stamp. Rather than being "retired," most repurchased shares sit in the corporate treasury — and they can be yanked back out for just about any reason.
Look again at Exxon Mobil, which has repurchased 2.8 billion shares, carried on its books at their cost of $131 billion. But their current market value is $229 billion. If ExxonMobil decided to get into, say, the soap and diaper business, it could buy all of Procter & Gamble, the fifth-biggest stock in America, and have $10 billion in stock left over.
No, I don't believe Exxon Mobil is about to do anything that dumb. But less canny outfits could — and will. Buy into a company that doesn't retire shares after it repurchases them and you are playing with fire.
Back in 1999 and 2000, tech companies wildly overpaid to buy back stock, while stodgier firms like Philip Morris repurchased shares dirt cheap. A buyback probably makes sense if the stock is less than its average price/earnings ratio of the past five years.
Finally, the historical outperformance of buybacks comes from an era when not everybody was doing them. From now on, long-term returns are bound to be lower. Before you invest, ask whether the stock would look cheap even without the buyback. It's hard enough to avoid buying high and selling low on your own account. Why run the risk that someone else will do it for you?
Archive for September 8th, 2008
If You Bet on the Election,
Don't Use Real MoneyTheories about Picking Stocks
Based on the "Presidential Cycle"
Don't Hold Up to Scrutiny
Every four years, as the clatter of the presidential campaign reaches a crescendo, Wall Street adds its voice to the din. Financial pundits spew forth one nostrum after another, often contradictory, never documented with evidence and always tailor-made to spur investors into making more trades. If you haven't yet heard "The stock market prefers Republicans," you will soon hear "The stock market prefers Democrats" or "Gridlock is good for investors."
Now that we know it's McCain and Palin against Obama and Biden, let me tell you three things about the "presidential cycle" in stock returns. There's not much to it, most of what you hear about it is wrong and there's no reliable way to make money on it.
From 1926 through the end of August, according to data from the market researchers at Ibbotson Associates in Chicago, the Standard & Poor's 500-stock index has done distinctly better under Democratic presidents (9.2% annually after inflation) than under Republicans (4.6%). While large stocks fared well in Democratic administrations, small stocks have skyrocketed, returning 16.5% a year after inflation, versus just 2.2% annually under Republicans. On the other hand, bonds have done much better in Republican than Democratic administrations (4.8% versus negative 0.4% annually, after inflation).
Why do stocks do better under Democratic presidents? Robert Johnson, a former finance professor who now helps run the CFA Institute (which trains financial analysts world-wide), has studied the phenomenon and found an explanation that has nothing do with party. In years when the Fed tightens the money supply by raising interest rates, the market does poorly; when the Fed eases by cutting rates, the market does well. Rate cuts are most common in the third year of presidential administration — helping explain why stocks have a significant tendency to do roughly twice as well in Year 3 of presidential terms as in years 1, 2 or 4.
Once you account for the market impact of the Fed's actions, the apparent predictive power of the presidential cycle evaporates; if you don't know whether the Fed will have to raise or lower interest rates, it doesn't matter which party is in power.
What about the nearly universal belief that "gridlock is good"?
Some pundits base that claim on numbers dating back to 1901. Dig into the data, however, and you discover that the gains from gridlock come entirely from a single year: 1919, when Woodrow Wilson, a Democrat, had to cope with a Republican House and Senate (and his own failing health). But it's absurd to give gridlock the credit for the Dow's 30.5% rise that year. Instead, it was the end of World War I, in the final weeks of 1918, that propelled the market to one of its best years ever.
The Stock Trader's Almanac, a popular reference book on Wall Street, reports that since 1949, the Dow has gone up by an annual average of 19.5% when the White House was Democratic and Congress was Republican. But that form of gridlock has occurred in just six of those 60 years, all under Bill Clinton, and in only 10 years in the past century. Such a thin slice of history is no basis for an investing strategy.
Overall, gridlock isn't good for investors. Since 1926, the S&P 500 has gained an average of 6.3%, after inflation, whenever one party controlled the White House and the other held the majority in both houses of Congress. That's less than the 6.8% annual average for the period as a whole.
What, then, should you do? The big margin of outperformance by small stocks under Democratic administrations might be worth betting on if you think Obama will win. But I wouldn't bet big on small-caps; they've beaten large stocks by such a wide margin lately that they are hardly a steal.
This time around, the credit crisis has made banks so reluctant to lend and borrowers so shaky that the Fed's recent rate-cutting push has hit the economy with all the impact of a piece of overcooked fettuccine. If the Fed has been rendered at least temporarily ineffectual, whoever is elected president may be forced to boost government spending in order to kick-start the economy. About all we can confidently say, then, is that this is unlikely to be a good time to add a lot of bonds to your portfolio.
Sometimes the most important thing for an investor to know is what not to do. Vote with your ballot; do not vote with your portfolio.