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Stock Buybacks: Bite or Boost?

Do stock buybacks boost or bite shareholders? It’s a good question without an easy answer. But as I’ll explain, buybacks aren’t the panacea that many investors think they are.

For example, just this week in 1930, New York Stock Exchange President Richard Whitney bid $9.6 million of his own money (the equivalent of $134 million in today’s dollars) to purchase 60,000 shares of U.S. Steel stock at $160 per share. The idea was to increase shareholder confidence in the stock and the overall market, in the wake of the 1929 crash. Mr. Whitney invited the media along to photograph his bid. Shortly after that, the stock sank below $150 and bottomed out at $21 two years later.

I’m not saying that every stock with a buyback will suffer the same temporary demise. However, the optimistic lift in price that many stocks enjoy post a stock repurchase announcement is likely a tad too cheerful.

This year is a tremendous year for stock buybacks. Market pundits at Birinyi Associates estimate $500 billion in stock buybacks have been announced as of mid-year. This level compares to $685 billion for all of 2017 and $670 billion in 2016.

Much of the boost arrived post the implementation of the Tax Cuts and Jobs Act of 2017. This act cut the U.S. tax rate on most corporations from 35% to 21%. Foreign profits are still taxed at prior levels, but any corporation with the bulk of its operations in the U.S. will enjoy a dramatic drop in tax payments.

Those lower tax payments will pile up into a mountain of unexpected cash. Since the tax cut, many companies have announced their formal plans for putting that cash to use.

Some of the cash will be spent on employee pay or bonuses. Walmart (NYSE: WMT), for example, will use 20% of its expected $2 billion in tax reduction to pay employees a bonus ranging from $250-$1,000, depending on their years of service.

Other options for putting the cash to use include capital expenditures, such as higher spending on new facilities and factories or expansion projects. Another use is an increase in dividend payments, although most corporations are less inclined to tether themselves to a semi-permanent payout.

The stock buyback is a useful balm for excess cash. It’s flexible, and unlike pesky investments in factories that might take years to generate a return, buybacks immediately boost a company’s earnings per share.

The simple math on this calculation is that spending the cash does not alter the total pool of profits generated by a company. When those profits are split up by fewer shares, the earnings per share jumps.

Buybacks: Don’t Chase the Bait

However, investors need to think longer term about the return they may or may not receive from those buybacks. If the price of the stock sinks after the company buys back its shares, that’s not a very good use of that cash.

In the U.S. Steel scenario above, the buyback was completed by an individual. I doubt he felt satisfied while watching the value of his investment decline. A company making an ill-timed buyback should feel the same.

It’s unsettling that buybacks are hitting records when the stock market is trading at sky-high valuations. Buyback announcements equaled $174 billion in May, the highest level ever according to TrimTabs.

Even more alarming is the recent analysis by Robert J. Jackson, Jr., a commissioner at the Securities and Exchange Commission. Last week, Jackson highlighted his research which shows that insiders sold more of their shares into the temporary lift that often occurs after a company announces a buyback.

While studying trades at almost 400 companies that announced buybacks in 2017 through this year’s first quarter, Jackson found the number of insiders selling doubled following their company’s buyback announcements.

One thing for investors to be acutely aware of is that a buyback announcement is non-binding. Just because a company says it has approved a program to potentially use a specific level of funds to repurchase shares doesn’t mean it will do it. And even if it does execute on the repurchase plan, it may not be the company’s best use of the cash.

Most companies do not publicly announce when the buyback is actually occurring. Only after the end of the quarter do investors know how much stock, if any, was repurchased and at what price.

There are insufficient long-term data on how stocks announcing buybacks perform in the ensuing years. However, there are mounds of data showing that spikes in insider sales often correlate to under-performing stocks. The upshot: don’t make investment decisions solely based on a company’s buyback plans.

As I’ve just explained, it’s hard for investors to discern real value these days. But my colleague Jim Fink, chief investment strategist of Options for Income, has devised a trading system that generates steady income during this time of investment turbulence.

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