Buybacks Aren't Always Bullish. Here's How to Know When They Are Worth It. -- Barrons.com

By Bill Alpert

Wall Street has become used to cheering when companies announce a stock buyback program.

The veteran stock researcher Bradley Safalow thinks we should be more mindful. The companies with the largest buyback programs within the S&P 500 have underperformed the market over the past decade, he reports in a recent note to subscribers of his PAA Research.

"Stocks buybacks are a sugar rush, good for a fleeting pop in the share price, but much like most candies, tend to do more damage over the long term," writes Safalow.

Companies in the S&P 500 index have repurchased $3.5 trillion worth of their shares in the past four years. But thanks to the explosion in stock-based compensation, only a small portion of those companies have reduced their share counts by more than 4%.

For many businesses -- especially those with debt or long-term challenges -- buybacks are a disastrous use of capital, he argues. Managers are pouring shareholders' capital into a value trap.

Safalow tells Barron's that he encountered some of those companies among those he has warned against in his sometimes-bearish research. The for-profit education firm ITT Industries and the discount retailer Big Lots! spent more than $1 billion on buybacks before they each filed for bankruptcy.

In 2012, S&P Global created an index of the 100 companies in the S&P 500 with the largest buyback programs, as a percentage of their market value. This S&P 500 Buyback Index lagged behind the S&P 500 in the last decade -- and most glaringly in the growth stock explosion since 2020.

That outperformance of growth stocks explains some of the poor performance among the S&P buyback barons. Apart from mega-buyback programs at a few megacaps like Apple, Microsoft, and Google parent Alphabet, growth companies don't invest in stock buybacks -- they have got business opportunities that beckon their capital.

But the rest of the buyback bummer comes down to management.

Stock-based compensation has swelled in recent years; abetted by companies' success in getting Wall Street to ignore stock-based compensation in calculating "adjusted" earnings. Stock compensation has exceeded 15% of operating cash flow, at most tech and consumer discretionary companies. Stock buybacks help mask those costs, notes Safalow.

And it turns out that corporate managers and boards are bad at buying stock. Just like the rest of us, they wade in when the stock is expensive, then pull back when the stock has become cheap. Academic research has verified this. So has the experience of savvy investors like Leon Cooperman.

"Most management teams have demonstrated the total inability to understand what their businesses are worth," said Cooperman in 2011 "They're buying when the stock is up, and have no courage to buy when the stock is down."

Like Cooperman, Safalow believes companies should be loading up on their stock only when it is significantly undervalued.

The companies AutoZone, Dillard's, and Build-a-Bear Workshop have been prudent buyers of their shares, says Safalow. Their stocks have handily outperformed the S&P 500 and the Russell 2000 in the last five years, despite tough conditions in their industries.

In mid-December, Safalow issued a list of other companies whose buybacks seem to contribute to stock outperformance. He calls them Buyback Outliers.

To find these exceptions to the rule, he looked for companies which consistently repurchase their stock, but have stepped-up buybacks when the stock was weak. They have generated free cash flow and high returns on capital. And their share-based compensation is muted.

Historically, their stocks have performed comparably to most indexes.

Safalow's list includes big names like the cable operator Charter Communications, the financial firms Global Payments and SLM Corp, and the retailer Williams-Sonoma. Among the smaller firms are the craft website Etsy and the sport-vehicle maker Polaris.

Safalow says he may write to the boards of these companies, to urge them to continue their prudent behavior.

If they don't, they had better watch out. Safalow will regularly revise his Nice List of these buyback outliers.

Write to Bill Alpert at william.alpert@barrons.com

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December 30, 2024 00:30 ET (05:30 GMT)

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