I frequently get questioned about how to account for stock buy backs and dividends when analyzing a company. I am going to save dividends for another article and just concentrate on stock buy backs. I will start this discussion with a great quote from Dr. William Lazonick of University of Massachusetts:
"Here we have all these companies obsessed, basically with keeping their stock prices up, and saying the best thing that they can do with their money is spend billions of dollars on stock. And my view of that is, any company that says that they have nothing to better do with their money, the CEO should be fired."
While many will say that this is an extremely strong statement, I believe that Dr Lazonick is not that far off from the truth.
There are many ways that companies can use their cash that helps the long-term success of the company. Among these are:
- R&D for new products - This helps the company have a competitive advantage in its market in the future.
- Increased pay and benefits for employees - While we don't want our companies to give foolish salaries we do need them to have happy employees that are loyal to the company's success. In nearly every company - turnover is expensive.
- Invest in the infrastructure of making their products - Apple [stckqut]AAPL[/stckqut] has made a science of this technique. It regularly helps its suppliers with acquiring the manufacturing tools required to produce great products. Apple also will commit to large orders and effectively buy up the supply of emerging technology.
- Acquire new products and technology through mergers and acquisitions - Effectively, the more cash on hand a company has, the more flexibility the company has in doing deals that can dramatically accelerate new products and new markets.
If we re-examine Dr. Lazonick's quote, it now begins to make sense. A stock buy back plan basically means the company has run out of ways to effectively invest in the long-term prospects of the company. Rather, it is trying to shore up its stock price in the short term. Is this in the best interest of its shareholders or just the stock options of the executive committee?
Many times this shoring up doesn't even work that well. According to Fortuna Advisors: "...research shows high return companies create the most value for shareholders when they deploy more capital in growing their operations rather than giving it back to shareholders."
Recently, the Wall Street Journal pointed out that many times the buy back programs don't even change the amount of stock outstanding. It seems that it is not uncommon that the buy back is offset by stock grants to favored employees.
I hope that you listen to the quarterly comments of the CEO of each of your holdings. When you are listening to those comments and he or she discusses stock buybacks as a way to boost value to the shareholder, you should be actually hearing, "We have a lot of money burning a hole in our pocket and we are not smart enough to profitably use it, so we are doing a stock buy back!" Or, maybe the CEO is saying, "I dare you to fire me based on the advice of Dr. Lazonick!"
The goal of my book, The Confident Investor, and this site, is to help you find great companies and then grow your investment in those companies by using other people's money (GOPM). I don't pay attention to the buy back announcements of companies. I assume they are doing the buy back simply because it is the popular thing to do. I refuse to reward them for this activity but I am pragmatic enough to not penalize them.