The Last Time This Happened, Stocks Tanked 50%

I’ve noticed a lot of large companies in the S&P 500 have been repurchasing shares. Is this a good use of capital or something more concerning? Wouldn’t it be better for shareholders if the company used the money to declare dividends?

A year ago, Chief Income Strategist Marc Lichtenfeld shared his opinion on share buybacks versus dividends.

Marc made the case that he would rather see cash returned to shareholders in the form of dividends, giving them the opportunity to decide if a stock is a good value and if they should buy more shares.

[ad#Google Adsense 336×280-IA]The short answer to your question is, I agree.

Management’s motivation behind buying back stock is not always aligned with the best interests of shareholders. And here’s why…

The Real Beneficiaries of Stock Buybacks
Stock buybacks reward top-level executives, even underperforming ones, more than dividends do.

How can that be?

Executives receive a good portion of their compensation through restricted stock and/or stock options.

If they want to maximize their equity packages, executives need to push up the price of their stocks.

A stock buyback, more often than not, at least temporarily increases the stock price. That’s good for executives looking to cash out their restricted stocks or options. The price appreciation is also good for investors. But sometimes companies pull a fast one…

Not All Is What It Seems
Sometimes, after a company has completed a share repurchase, the number of shares outstanding remains the same as before. This happens when a company issues stock options or restricted stock to its employees at the same rate it’s buying back shares. Qualcomm (Nasdaq: QCOM) is a great example.

Over the past five years, Qualcomm has spent $13.6 billion buying back 238 million of its shares. Unfortunately for Qualcomm’s shareholders, the company’s fully diluted share count has actually gone up. It’s nearly 2% higher than it was in 2010!

What happened?

The company awarded employees and executives stock and options grants worth more shares than it bought back. Shareholders would have been better off if the company had declared dividends instead of lining management’s pockets.

Timing Is Everything
The idea of a company timing the market when buying back shares makes no fundamental sense to me. I want C-level executives of the companies I invest in to spend their time managing the business, not managing or valuing their stock price. If they want to play trader, they should resign and go join a proprietary trading firm.

History shows us that the management teams of publicly traded companies are not good traders. They tend to buy high. They don’t buy when the market is down.

Take a look at the current state of buybacks. The market is making all-time highs and so are company share repurchases. Economic firm Birinyi Associates says buyback announcements reached $141 billion in April.

If that trend continues, we will likely see repurchase announcements top the $863 billion we saw in 2007. That’s before the market crashed and stocks fell roughly 50%. As Marc pointed out a year ago, where were the repurchases in 2009 and 2010 when stock prices were decimated? I’m not calling a market top, but it is worth noting. Sometimes history has a nasty habit of repeating itself.

The timing of a share repurchase can also be more nefarious. Besides coinciding with the expiration of stock options, companies can and do use stock buybacks to paint a rosy picture for investors. Even if the fate of the business is teetering on a cliff.

Remember Lehman Brothers’ last share buyback? It was announced in late January 2008. Management said it would buy back nearly 19% of the company’s outstanding shares. Shareholders cheered, and the stock jumped more than 3% on the day of the announcement.

Fast-forward to five months later. After buying back hundreds of millions of dollars’ worth of stock, Lehman reported a $2.8 billion quarterly loss. Ouch. It got worse when the company also announced it would have to raise money through a dilutive equity offering.

In an act of pure madness, Lehman spent $765 million buying back stock during the first quarter of 2008 at an average price of $59.05 per share. By the time of Lehman’s equity offering announcement, its stock had fallen to under $23.00 per share. All the share buybacks in the world could not prop up the stock. The rosy picture Lehman had painted in January had faded to grey. Great trade, guys!

Unfortunately for Lehman’s stockholders, the unexpected dilution was not the end of it. Less than nine months later, the firm filed for bankruptcy, and equity holders lost just about everything. In hindsight, I bet those investors would have preferred a larger dividend.

Dividends Reward Shareholders
Again, I agree with Marc. Dividend declarations reward shareholders. Stock buybacks often reward management. If CEOs want to increase their pay package, they should concentrate on bettering and growing the business, not buying back stock. Improving business fundamentals results in a rising stock price, aligning executives’ interests with those of investors.

Good investing,



Source: Wealthy Retirement