2 Stocks That Are Wasting Your Money

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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 idea for how they could do better.

ConocoPhillips (NYS: COP)
What's bigger than a bread box, smaller than ExxonMobil (NYS: XOM) , and will likely become smaller still? That's right, Fool. It's ConocoPhillips. Valued at just $97 billion and change, Conoco is the (distant) third largest U.S. oil major behind Exxon and Chevron (NYS: CVX) . And now, the company seems intent on shrinking even further, as it's just announced a buyback of $10 billion worth of its own shares. Is that a good idea?

I don't think so. Call me a penny-pincher if you like, but even at a mere 9.4 times earnings, I don't consider Conoco a bargain. For one thing, its P/E isn't that much cheaper than Exxon's (and it costs more than Chevron.) For another, Conoco's not even as profitable as its P/E makes it look. The company generated only $7.2 billion in trailing free cash flow over the past 12 months, which isn't a match for the $11.1 billion in GAAP profits it earned during the period.

Conoco's also more heavily leveraged than either of its U.S. rivals, with more than $21 billion net debt. Factor that into the valuation, and this supposed "9 P/E stock" actually sells for an enterprise-value-to-free-cash-flow ratio of 16.5. That's a pretty penny to pay for a business that analysts on Wall Street think has peaked and won't grow earnings much at all for the next five years. If I were in Conoco's shoes -- and had its checkbook -- I think I'd put this cash to better use by paying down debt, not buying overvalued shares.

Yum! Brands (NYS: YUM)
Speaking of stocks with bloated balance sheets and too-healthy appetites for their own shares ... our next candidate for an ill-considered buyback is Yum! Brands. SI has the Pizza Hut hawker down for a $750 million buyback expansion, which, when added to the leftovers from the company's last repurchase authorization, tallies up to about $1 billion in planned buybacks.

Now, Yum! is not in quite as bad shape as Conoco. Its debt load is lighter, for one thing. Its free cash production is a bit above reported net income for another. But the company is still cash-poor, and even valued on its superior free cash flow number, the EV/FCF ratio on this one works out to about 21.5 (versus a P/E ratio of 22.4). That seems pretty aggressive for a company that analysts have pegged for sub-13% long-term growth. For the record, I believe that the other two big "Chinese growth" stories in the restaurant industry -- McDonald's (NYS: MCD) and Starbucks (NAS: SBUX) -- are even more grossly overvalued that the pizza purveyor. But we're not playing for a relative win here, folks. We're looking for an absolute bargain -- and Yum! ain't it.

A better use of cash
But if not Yum!, then whom should we want to buy? I don't want to end this column on a down note, and in fact, I have spotted one company out there that's spending its shareholders' prudently: biotech giant Amgen (NAS: AMGN) .

Last month, Amgen announced a "modified Dutch auction" tender offer to repurchase up to $5 billion worth of its shares. Better than your usual "intent to repurchase" announcement (which may or may not actually result in a buyback,) a tender offer permits Amgen shareholders to pick a price at which they will offer to sell shares back to the company -- in this case, anywhere from $54 to $60 a share. Amgen will review the offers, then figure out how many shares it can buy at the lowest offered price with S5 billion -- and do it. No "ifs," "ands," or "buts." So long as enough shareholders show up with shares to sell, "$5 billion of Common Stock at the purchase price determined by Amgen will be purchased." [Emphasis added.]

And if you ask me, Amgen will be getting a good deal on the shares (the tender ends tomorrow, by the way). With $5 billion in trailing free cash flow, Amgen's probably going to be picking up these shares for about 10 times FCF -- not bad for a 7%-plus grower paying a 1.9% dividend yield. Looks like a good deal for Amgen, and for everyone else as well.

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At the time this article was published Fool contributorRich Smithdoes not own (or short) shares of any company named above. The Motley Fool has adisclosure policy.Not all Fools agree on all things, at all times. And in fact, The Motley Fool itself owns shares of Starbucks and Yum! Brands.Motley Fool newsletter serviceshave recommended buying shares of Chevron, McDonald's, Starbucks, and Yum! Brands.Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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