The bull market is over and the days when everyone was an expert are gone. Merely buying a stock and watching it go up day after day is history. “Buy and hope” is dead.
But that doesn’t mean you can’t make money and get your portfolio back in shape. You can. You just have to separate the fact from fiction. And one of the most dangerous myths that could cost you even more money is that share buybacks are good.
You see, the world is not coming to an end. The economy will recover…eventually. A new bubble will form. And greed will replace fear. It always does. And here’s the best part, a few companies will emerge stronger than they were before. The trick is to identify which ones will make the best of a bad situation.
This is a time when great companies increase their market share. The strong get stronger and well…the weak disappear.
Companies have to make investments to get stronger. They can refurbish factories, develop new products, or aggressively build a brand while advertising costs have dropped significantly. If a company has a mountain of cash, it should be reinvesting it to take advantage of future growth opportunities, reduce costs, and increase efficiency. Frankly, there’s no better time to do it than now.
That’s why it pains me to see the sharp increase in share buybacks recently. A share buyback, or repurchase, is when a company buys its own shares. It’s a way for companies to reduce the number of shares outstanding. Earnings per share will increase because there are fewer shares to divide profits.
It makes sense on the surface. Less shares and same profits equal more profits per share and a higher share price. It seems like they’re doing something good for shareholders. In fact, the markets will usually reward a buyback plan and bid shares up a few percentage points when the plan is announced. But it’s just one of the many stock market myths that are allowed to live on.
Over the past couple of weeks dozens of companies took “advantage” of the market turmoil to announce share buybacks. In some cases, the buyback programs are reaching well into the billions.
Last month Microsoft (NASDAQ:MSFT) set a new record when it announced it would be buying back $40 billion worth of its stock. Following behind are other cash-heavy companies including Intel (NASDAQ:INTC) , Nike (NYSE:NKE), Hewlett-Packard (NYSE:HP), and Oracle (NYSE:ORCL).
All of these buyback announcements were viewed positively by Wall Street. It’s considered a sign of strength to be buying back your own shares.
But Wall Street, as it has been so many times before, is dead wrong. Share buybacks are not positive. There are some benefits, but the long-term benefits are limited.
When a company is buying back shares, it is telling the world, “We cannot find anything better to do with our money.”
It’s just that simple. A company that is buying back shares is doing so because it can’t find any better investments to make. Microsoft isn’t launching any more major projects. Intel is not building any new plants. They’re giving up on growth. And when the economy does recover, these companies will not turn out to be any stronger, more efficient, or more profitable.
Two Big Pharma companies provide the perfect example.
Pfizer (PFE) has repurchased more than $19 billion worth of its shares since 2005. Its share price has steadily slid from $28 to under $17 during that time.
Meanwhile, its core business has gone down the tubes. The company’s pipeline of new drugs is very limited. And a few of its key cash cow drugs are set to go “off patent,” which means generic drug companies will start selling generic versions for much less.
Pfizer’s share buyback has been a big mistake. For $19 billion it could have bought itself a very strong pipeline of new drugs. A few patent-protected blockbuster drugs would keep the cash flowing in for years to come.
One of Pfizer’s competitors, GlaxoSmithKline (NYSE:GSK), isn’t taking the same path. Earlier this week, Glaxo announced it will be halting its buyback program.
Andrew Witty, Glaxo’s CEO, explains, “We're not reserving capital for a rainy day that may or may not come. Opportunities are surfacing with some frequency on the small to medium scale. More of these have surfaced in the last month.”
Glaxo is setting up to start making acquisitions while the markets are in turmoil. It’s not buying its own stock for marginal benefit. And it’s not announcing an extended buyback plan just to get a slight uptick in its share price either. Glaxo is taking its cash hoard and going shopping.
As a result, it will be in a much stronger position when the economy recovers. While the rest of its competitors are buying back their own shares, Glaxo is investing in its future. That’s what I like to see. It’s thinking long-term.
Just imagine if the banks would have thought long-term. Over the past few years some of the biggest share buyback leaders have been the banks. Bear Stearns, Lehman Brothers, and Freddie Mac (FRE) all were buying billions of dollars worth of their own shares. If they would have sat on the cash to bolster their balance sheets, they might have had the reserves to save themselves.
Also, corporations have a knack for buying their own shares at the worst possible times. S&P 500 companies spent $135 billion on share buybacks in 2003 when the market was bottoming. In 2007, when the Dow was setting new all-time highs, they bought $590 billion worth of their own stock. In fact, between 2000 and 2005 companies which bought back their own shares only beat the rest of the market by one percent.
Don’t get me wrong, we can learn a lot from buybacks. Just take a look at ExxonMobil (NYSE:XOM). The oil giant has been a very aggressive buyer of its stock. Over the past three and a half years Exxon bought back just over $96 billion worth of its own shares.
If oil really was going to $200 a barrel or more, wouldn’t the world’s largest oil company who employs thousands of true oil industry experts, spend some of that cash on acquiring smaller oil companies which have made new oil discoveries or have large amounts of reserves? Exxon kept it’s cool throughout the oil boom. And now it’s still in a great position.
That’s exactly what we need to be doing now, keeping our cool and looking at the facts. And the fact is share buybacks don’t tell us much about the long-term prospects of a company or the value of its shares. At Q1 Publishing we try to avoid a lot of the myths that can destroy even a conservative portfolio. So if you see one of the companies you’ve held on to announce they’re buying back shares, it’s time to re-evaluate.
Chief Investment Strategist, Q1 Publishing