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The trouble with buybacks

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In an almost stealth fashion, stock buybacks have become the preferred method for companies to return value to their shareholders. Consider this fact: Over the course of the 12 months that ended in October 2012, the companies in the Standard & Poor’s 500 spent $277 billion in dividends for their shareholders. In the same time frame, they spent $375 billion — or 35 percent more — on share buybacks. Altogether, the companies in the S&P 500 have bought back $1.4 trillion worth of their own stock since 2008.

A big part of this is that corporations are still flush with cash, and looking for places to park that money. Apple alone has $137 billion in cash on its balance sheets. If businesses aren’t willing to expand capacity and invest in new physical equipment, a good way to plow that money back into the company is to buy back shares.

This ought to be good news for shareholders. The fewer shares of a company that are outstanding, the greater the value of the shares that remain in play. Buybacks should generally result in a higher share price, and that is indeed often the case. Carnival Corporation, the cruise-ship company, announced a $1 billion buyback last week, for instance, and the stock has climbed more than 2 percent since then.

But there are important caveats for investors to be aware of. Buybacks aren’t always exactly what meets the eye. If one of the companies you’re invested in announces a share repurchase plan, here are some things to keep in mind:

The company is increasing earnings per share, not earnings. A dilution in the number of outstanding shares can create upward pressure on the share price, but remember, it’s purely a cosmetic change. The increase in share price has nothing to do with the underlying value of the company. All other things being equal, a stock that rises because of the intrinsic value of the business is going to be in better shape than a stock that rises because of accounting maneuvers.

Sometimes companies fail to follow through on their announced buyback plans. Just because a company has publicly announced a share repurchase plan, that doesn’t put it under any legal obligation to follow through on that plan. Last March, JPMorgan announced plans to buy up $15 billion worth of its own shares, but once the magnitude of the failed London Whale trade became known, the company quickly backtracked. The buyback program was “suspended,” and it still has yet to begin.

Sometimes, a planned stock buyback has to be put off for reasons beyond the company’s control. For instance, in June of 2011, MetLife Insurance announced that it was planning to put $2 billion into buying up its own shares. But when MetLife failed one of the Federal Reserve’s “stress tests” in March 2012, it was put on a list of companies that weren’t allowed to buy back shares or issue dividends, and the buyback plan had to be put on hold. In December, the company announced that it wasn’t expecting to buy back any shares in 2013, either.

Buybacks often just balance out additional stock that has been issued. When a company issues stock options to key executives, those shares are generally just created out of thin air, so they end up diluting the market. Companies sometimes try to counteract this dilution with a buyback plan. In July, for example, eBay announced that it had bought back $355 million of its own shares during the second quarter and was planning to buy another $2 billion worth, simply to offset the additional shares being issued as compensation. The net effect was that the number of eBay shares remained roughly steady.

Sometimes companies need to issue additional stock for other reasons, and the effects of the repurchase get canceled out. Bank of America bought back $3.8 billion worth of its own stock in 2007. But when it went to buy Merrill Lynch during the banking crisis of 2008, it was forced to issue so much additional stock that the number of outstanding shares actually increased over the course of the two years.

Companies don’t know when to do this. In an ideal world, a company would initiate a share repurchase program when it knew its own shares were cheap and worth buying. But in reality, most companies don’t know when their stock is going to go up and when it’s going down any more than the market does.

Hewlett-Packard had a share buyback program in place in 2010, when its stock was trading in the 40s. All those shares are worth about $17 apiece. More distressing still, AIG bought back its shares when the price of its stock was nearly $1,500 in the middle of the last decade. It eventually dropped as low as 10, losing at one point 99 percent of its value.

The big picture shows this. The record high for stock buybacks among the S&P 500 came in 2007, at nearly $180 billion. The market was about to tank, of course; and by the first quarter of 2009, that figure had fallen all the way to $30 billion. At that point, the market was poised to enter a four-year bull run. In the world of share buybacks, too often, it’s buy high and sell low.

For more from Tom Nawrocki, see:

Inside the Dell buyout

The coming return to equity funds

6 market predictions for 2013