Stock Buybacks: Proof Wall Street’s Financial Engineering Is Backfiring

Stock BuybacksThink twice before investing in companies that do stock buybacks.

A recent CNBC report suggests that companies that haven’t spent a penny on stock buybacks have outperformed those that have.

Companies in the S&P 500 that have engaged in the largest buybacks—including Big Lots, Hewlett-Packard, Macy’s, Xerox, and Kohl’s—are underperforming those that haven’t, according to an analysis of FactSet indexes since 2005. (Source: “Companies that do buybacks do worse over time,” CNBC, March 28, 2016.)

Combined stock repurchases by U.S. public companies have recently reached record levels, as profits are near an all-time high.

Almost 60% of the 3,297 publicly traded non-financial U.S. companies have bought back their shares since 2010, according to Reuters. (Source: “As stock buybacks reach historic levels, signs that corporate America is undermining itself,” Reuters, November 16, 2015.)

The CNBC report suggests that stock buybacks carry both positive and negative signals about the health of a company.

Stock buybacks are a vehicle for returning excess cash to shareholders, without the commitment usually associated with a dividend. While they can be a good strategy if management thinks the company’s shares are undervalued, buybacks also mean less money left for companies to use on capital expenditures and other investments. (Source: CNBC, op cit.)

International Business Machines Corp. (NYSE:IBM) has spent $125 billion on buybacks since 2005, and $32.0 billion on dividends, more than its $111 billion in capital spending and research and development (R&D) during the same period. (Source: Reuters, op cit.)

Pharmaceuticals maker Pfizer Inc. (NYSE:PFE) spent $139 billion on buybacks and dividends in the past decade, compared to $82.0 billion on research and development and $18.0 billion in capital spending. (Source: Ibid.)

A repurchase cuts the number of outstanding shares, thus increasing earnings per share (EPS). However, it can also hike the price-to-earnings (P/E) ratio because manipulating the number of shares outstanding does not create additional earnings.

The market as a whole seems to buy into the logic of the share buyback increase, which lifts EPS, even as the return on assets overall plummets. (Source: CNBC, op cit.)

Mark Fahey, the author of the CNBC report, believes the recent boom in buybacks is less a positive consequence of excess cash and more a sign that management have low expectations for their companies’ future fundamentals.

“Investors should be careful about putting too much faith into companies that rely on buybacks to pump up their own stocks,” he wrote. (Source: Ibid.)