2 Stocks That Are Wasting Your Money

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Your company's buying back stock? Hurray! Or should that be "boo"?

According to research conducted by Boston University finance professor Allen Michel, when a company announces it's buying back stock, that stock tends to outperform the market by about 2% to 4% more than it otherwise would have over the ensuing six months.

But over the long term, multiple studies show that buybacks actually destroy shareholder value. CNBC pundit Jim Cramer cites the example of big banks that bought back shares in 2007-2008 -- just before their stocks fell off a cliff. Far from being buy signals, Cramer calls buybacks "a false sign of health ... and often a waste of shareholders' money." Indeed, the Financial Times recently warned: "The implied returns over a period from buy-backs by big companies would have been laughed out of the boardroom if they had been proposed for investment in ... conventional projects."

So why run buybacks at all? According to FT, management can use them to goose per-share earnings, which helps CEOs earn bonuses based on "performance." Also, the investment banks that run buybacks for management earn income and fees from promoting buybacks. But you and me? We miss out on gains unless the purchase price is less than the actual intrinsic value of the shares.

And we're about to miss out again.

Two bad buybacks
StreetInsider.com keeps a running tally of which companies are buying back stock and how much they're spending. SI is too polite to accuse companies of actually wasting shareholders' money, of course -- but I'm not. With SI's help, I've come up with two examples of popular stocks that I believe are squandering shareholder dollars on ill-timed buybacks ... and one that isn't.

Whole Foods Market (NAS: WFM)   There's no denying that Whole Foods has been a huge winner for investors this year. Even after last week's post-earnings slump, the stock has thrashed the Dow Jones Industrial Average's (INDEX: ^DJI) 52-week return, and trounced the S&P 500 index by nearly 40 percentage points in the past year. But Whole Foods faces significant headwinds in its business, which may limit future gains.

For one thing, there's the rising cost of groceries, which pinches profit margins across the industry. Combined with a weak economy, price-conscious consumers, and competition from lower-cost grocers like Walmart (NYS: WMT) and Kroger (NYS: KR) , Whole Foods may struggle to maintain momentum through Great Recession, Part 2. My big worry here is that, in offering to buy back $200 million worth of shares at today's 36 P/E ratio, Whole Foods may be taking future success for granted. Analysts agree that Whole Foods is unlikely to grow much faster than 18% per year over the next five years. Buying into this stock, at this price, may not just cost you your "Whole Paycheck" -- but a good chunk of your portfolio, too.

Pfizer (NYS: PFE)
In contrast to Whole Foods, Big Pharma standard-bearer Pfizer doesn't look particularly pricey at 14 times earnings. If you ask management, that's cheap enough to justify spending as much as $9 billion on share repurchases. But buyer beware: 14 times earnings is actually only a good price if Pfizer can keep its earnings growing at a respectable rate. And so far, it's struggling on that score.

Consensus targets suggest the most investors can hope to see from Pfizer over the next five years is about 3.4% compound earnings growth, as the company works to replace drugs falling off the patent cliff. Seems to me, the stock's valuation would be easier to justify if it could boost that growth rate a tad -- say, by finding itself a smaller, faster-growing company that's got a great drug to sell but could use some financial heft to help stabilize its cashflow stream. (Dendreon (NAS: DNDN) , anyone?)

A better use of cash
Personally, I'm not holding my breath waiting for Pfizer to make the smart move here. If management thinks buying back shares at close to their 52-week high is a good idea... "smarts" may be too much to hope for. But not all hope is lost -- I don't want to end this column on a down note, and in fact, I have spotted at least one company that seems to be spending its shareholders' money more prudently: computer peripherals-maker Logitech (NAS: LOGI) , which recently asked Swiss regulators for permission to keep buying back shares under its $250 million repurchase program.

With $115 million in trailing free cash flow, a balance sheet brimming with $379 million in cash, and no debt, Logitech today sells for around nine times annual free cash flow (ex-cash). Yet, if analysts are right, the company's likely to grow its profits at a 12% clip for the next five years. In late October, investors were thrilled on news that Logitech's second-quarter earnings had thumped Street estimates and its promise to beat estimates again over the remainder of this fiscal year. Logitech shares soared 17% on the news, but they've since given back those gains and now are down by well over half from their highs of the year.

Call me a cheapskate, but I just think it makes more sense to buy back shares when they're selling for "half-off," like Logitech is, than when they're near their highs of the year (as is the case at Whole Foods and Pfizer.) And I'm glad to see that Logitech agrees with me.

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At the time this article was published Fool contributor Rich Smith does not own (or short) shares of any company named above. The Motley Fool owns shares of Dendreon, Wal-Mart, Logitech International, and Whole Foods. Motley Fool newsletter services have recommended buying shares of Whole Foods, Logitech, Pfizer, and Wal-Mart, as well as writing covered calls on Logitech and creating a diagonal call position on Wal-Mart. Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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