Equity Investment – Beware of Buyback

November 28, 2011 / Karen Smith

Those who invest in the stock market do so to make money – this is a given. What is also a given is that the stock market is an anticipatory instrument.

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Investors and traders buy shares of companies because they expect future growth in these companies. We use different metrics to measure this growth – revenue growth, gross margin percentages and, perhaps most importantly, growth (or lack of it) in the earnings per share. What is a company to do when “times are tough” and growing its EPS is challenging? Buy back some shares!

There appears to be an increasingly common pattern among our U.S. corporations. We have all heard that they are holding record amounts of cash. In more certain times, they would deploy this cash in expanding into new businesses or building new plants. Perhaps they would find ways to invest in research and innovation of new products and services. Instead, we have companies buying back shares at an astounding rate. This year alone, $445 billion has been authorized in buybacks, the most since 2007.

What advantage do share buybacks give a company? The principle behind buybacks is simple. With fewer shares in circulation, earnings per share can rise even if the company’s underlying growth is lackluster. While the effort is intended to give support to current shareholders, it doesn’t always work out that way. Zimmer Holdings, a medical device maker in Statesville, NC, bought back $500 million worth of its own shares last year. This was more than twice what it spent on research and development. Due to this buyback, EPS growth came in at 10%, even though operating income and revenue grew by less than 5% in 2010. Misleading?! Investors have not rewarded this strategy for Zimmer, as its shares have dropped 32% in the last five years.

In addition, we now have many companies buying back shares at the same time they are laying off employees. For example, Campbell Soup said it would buy back $1 billion in stock and announced five days later it would be eliminating 770 jobs. Hewlett Packard announced a $10 billion buyback in July, then reduced its workforce by 500 jobs in September.

As consumers, we all know the phrase “buyer beware”. For those of us who invest in equities, we might need another phrase as well… “Beware the Buyback”!

Karen Smith
OptionsANIMAL Instructor