2 Stocks That Are Wasting Your Money

According to Boston University finance professor Allen Michel, when a company announces it's buying back stock, that stock tends to outperform the market by 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 buy signals, Cramer calls buybacks "a false sign of health ... and often a waste of shareholders' money." Indeed, 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 earn income and fees from promoting them. But you and me? Unless the purchase price is less than the shares' intrinsic value, we miss out.

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 wasting shareholders' money, of course -- but I'm not. With SI's help, I've uncovered two examples of popular stocks that I believe are squandering shareholder dollars on ill-timed buybacks -- and one stock that isn't.

American Capital (NAS: ACAS)
At first glance, American Capital's recent repurchase of 8.4 million shares looked like the furthest thing from a "bad buyback." This publicly traded private equity firm sells for a cheap 3.8 times trailing earnings, and Wall Street expects it to grow at 15% over the next five years. Best of all, if AmCap ever gets back to paying a dividend to its shareholders... well, if it pays anything like the rates it used to, there could be a big payday in your future.

But that's just the thing: American Capital won't pay dividends at its high past rates, at least not anytime soon. In fact, last we heard, management had basically given up on paying dividends for the foreseeable future. Why? Because AmCap is a bit strapped for cash right now. Revenue has fallen for four years running, and while profitable today, it will be years before AmCap recovers from the massive, $4-billion-plus losses it recorded in 2008 and 2009.

In short, this company really can't afford to pay dividends right now. But this begs the question of why AmCap thinks it can afford spending nearly $60 million buying back its dead-in-the-water shares, and whether that's even a good idea.

Flowserve (NYS: FLS)
Speaking of bad ideas: Flowserve warned investors to expect below-consensus earnings in 2012 last month. In order to head off a selloff, though, management quickly reaffirmed its commitment to share buybacks to support the stock price. After spending $150 million of shareholder dollars buying back stock in 2011, Flowserve announced another round of buybacks in 2012. This means Flowserve could spend as much as $300 million on future buybacks.

There's just one problem: Flowserve doesn't have $300 million. It's got just $227 million cash, against a debt load of $510 million. The company also generates less than $100 million free cash flow annually (despite an income statement that claims $416 million in trailing "earnings") -- and has produced similar income-lagging FCF in four of the past five years. Sound like a stock you would double down on?

If not, then I'm guessing you don't work for Flowserve management.

A better use of cash
Now, I never like to end this column on a down note, and fortunately, I have spotted one company out there, that's spending its shareholders' money prudently: Marvell Technology (NAS: MRVL) .

Marvell makes chips for many things, but earlier this month, fellow Fool Evan Niu told you about one big project in particular: Marvell is building the brains for Google's (NAS: GOOG) latest Google TV. The project is important for Google, which suffered a steep drop in the profitability of its ad business last quarter, and hopes to use its Motorola acquisition as an entree into viewers' TV sets and as a new market for its ads. If it works, this will be good news for Marvell, but it's not the only reason to like the stock.

Selling for 13.5 times earnings, Marvell looks attractive at near-16% long-term earnings growth. Back out its $2.4 billion bank account, though, and it's downright cheap at an ex-cash P/E of just 7.7. Marvell thinks this price is nice, and just upped its buyback authorization to a cool $2 billion. I think it's right to do so.

In fact, I'm so sure Marvell is getting a bargain here that I'm going to grab a (virtual) piece of it for myself. Right now, I'm heading over to Motley Fool CAPS to rate Marvell stock an outperform. Want to see how my bet works out? Follow along.

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At the time thisarticle was published

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