By JACK HOUGH
American companies are gobbling up their own stock. Investors who view that as a buy signal, however, should consider that some repurchases bode much better than others for future stock performance.
Companies that buy back stock reduce their outstanding share count. That can boost earnings per share, making shares more valuable -- at least in theory.
Among companies in the Standard & Poor's 500-stock index, repurchase spending totaled at least $437 billion last year, a 46% increase from 2010, estimates Howard Silverblatt, senior index analyst at S&P.
That is enough money to devour, say, all of Apple (AAPL) Inc.
Stock buybacks boost earnings per share only if they are larger than stock issuance, of course. Historically, that hasn't often been the case, but in recent quarters the supply of shares has been shrinking, Mr. Silverblatt says. By his math, during the current quarterly earnings season, 97 of the S&P 500 members will enjoy a boost to earnings per share of at least 4% from repurchases alone.
All of this might seem like a broad buy signal. Companies lately have spent about twice as much on stock as on dividend payments, and who better to know when shares are a good deal than company managers?
But buybacks don't always predict handsome stock returns, because companies have a poor record of buying low, says David Rolfe, chief investment officer of St. Louis-based Wedgewood Partners and manager of the RiverPark/Wedgewood Fund.
"Returning cash to shareholders is fine, but shareholders should ask, what's the darn price?" Mr. Rolfe says. He points to Cisco Systems Inc., Hewlett-Packard (HPQ) Co.
Managers also have shown a knack for abandoning repurchases at the wrong time. Buyback spending among S&P 500 companies hit a record high in the third quarter of 2007, near the market peak. It shrank 86% over the next seven quarters as share prices tumbled. In other words, the last buyback boom profited mostly those investors who chose to sell into it.
The key for investors is to use repurchases as a buy signal only when the managers doing the spending view their shares as an undervalued investment. Why else would managers use buybacks? Some use them to offset the shares that are added when employees exercise their stock options (as pay in disguise, in other words).
Studies in recent years also have linked increased buyback activity with companies whose executive pay is tied to earnings per share, and with companies that otherwise would have missed Wall Street's quarterly earnings targets.
The best kind of repurchases are ones that managers opt for simply because they view shares as cheap. One option for investors who wish to identify such cases is to search among recent repurchases for low valuations. Three studies from 1995 to 2009 did just that, using the price/book ratio, which compares a company's stock market value with the accounting value of its assets. Each study found that the combination of repurchases and modest valuations tends to predict better stock performance than repurchases alone.
S&P 500 companies have a median price/book ratio of 2.4, according to Thomson Reuters data. A screen for recent share repurchases and price/book ratios below 1.5 turned up companies like defense contractor L-3 Communications Holdings (LLL) Inc.
There is another way for investors to tell which corporate managers view their stocks as bargains: Look for the ones who are spending their personal cash on shares, too.
"Valuation ratios are useful, but company insiders are in a particularly good position to know when their shares are cheap," says Shrikant Jategaonkar, who teaches finance at Southern Illinois University at Edwardsville. "Their actions matter more than their words."
Prof. Jategaonkar studied the relationship between share repurchases, insider buying (net of selling) and stock performance between 1991 and 2006 and reported the findings in a working paper that is now under review for publication.
In the study, stocks that were subject to repurchases but not insider buying beat other stocks in the study sample by nearly nine percentage points over four years. That makes sense, because the period was one of healthy stock gains, which boosted the returns to share repurchases in general. But stocks that were the subject of both repurchases and insider buying beat others by a whopping 29 percentage points over four years.
Recent insider data paint a bullish picture for the stock market, says Jonathan Moreland, director of research for InsiderInsights.com, who judges by the number of companies with net buying and the quality of those purchases.
But only a handful of companies that have bought back stock of late also have been the subject of recent insider buying that Mr. Moreland views as significant.
Three of them attracted insider purchases in December. Boston Scientific (BSX) Corp.,
Of course, neither repurchases nor insider buying makes a complete case for purchasing a stock. Investors, Wedgewood's Mr. Rolfe says, should focus most of their research on whether they are getting a quality company at a reasonable price, no matter who else is buying.—Jack Hough is a columnist at SmartMoney.com. Email: email@example.com