Why Stock Buybacks Are a Warning Sign for Smart Investors

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Why Stock Buybacks Are a Warning Sign for Smart InvestorsLast year, the markets saw a record level of stock buybacks, led by some of America's largest companies. According to S&P's Howard Silverblatt, in the fourth quarter of 2010, S&P 500 companies increased their stock buybacks by 80.6% to $86.36 billion from $47.82 billion a year earlier. The leaders of the buyback pack are ExxonMobil (XOM), Walmart (WMT), and Microsoft (MSFT).

With the exception of ExxonMobil, these companies lack catalysts to propel them upward, and you should view their stock buybacks as an admission of defeat on the part of CEOs who lack the imagination to come up with growth investments. ExxonMobil ought to be able to find places to invest, but it benefits from rising oil prices, so it could still be a good investment.

Why are stock buybacks a problem? Their proponents argue that they return money to shareholders. But as I wrote last October on DailyFinance, many professional money mangers and investors interpret stock buybacks as a sign that company CEO aren't doing their most important job -- finding sources of new growth. If the best idea they can come up with is to funnel money back to shareholders, those company boards should replace the CEOs with people who have better ideas.

Primarily, stock buybacks are a shell game designed to boost CEO pay. Analysts look at the stock buybacks and realize immediately that they will reduce the number of shares outstanding, thus artificially boosting earnings per share. Since many CEOs get bonuses based on EPS increases, by giving money to the shareholders, they indirectly pave the way to higher bonuses for themselves.

According to Silverblatt, of the $86 billion in buybacks, the four biggest sectors are as follows:
  • Information technology (22.3%)
  • Consumer discretionary (15.9%)
  • Consumer staples (15.5%)
  • Health care (14.4%)
As far as individual companies go, here's a quick run-down on the top three stock repurchasers. I've looked at how much they spent on buybacks between 2004 and 2010 (out of an S&P 500 total of $722 billion), the stock performance during those years, whether EPS growth is a CEO bonus driver, and CEO compensation for 2010 and its growth from the year before. My conclusion is that with the exception of ExxonMobil, the CEOs are overpaid and underperforming. But at least these companies don't explicitly tie CEO compensation to EPS growth.
  • ExxonMobil bought back $152 billion worth of stock between 2004 and 2010. Its price rose 43% to $73.12 a share during that time. EPS growth is not a CEO bonus driver, and its CEO compensation fell 15.5% in the most recent year available, 2009 to $27.2 million.
  • Microsoft bought back $97 billion worth of stock between 2004 and 2010. Its price rose 4.5% to $27.91 a share during that time. EPS growth is a not a CEO bonus driver, and its CEO compensation grew 6% in 2010 to $1.3 million.
  • Walmart bought back $35 billion worth of stock between 2004 and 2010. Its price rose 2% to $53.93 a share during that time. EPS growth is not a CEO bonus driver, and in the most recent year available, 2009, its CEO compensation fell 32% to $19.2 million.
I think Exxon has further to rise because it will benefit from global demand for oil. But the other two have been unable to revive growth sufficiently to get their stock prices moving again. Their decision to pour cash into stock buybacks is a clear sign that they can't come up with big enough growth opportunities in which to invest. So you should keep your money away from their stocks.

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