According to Wall Street legend, a speculator named Daniel Drew got his start by driving cattle into Manhattan, back when there really were cattle drives there. Just before they got to the market, he'd let his skinny, rangy cattle drink as much water as they wanted after the long, hot drive, giving them a nice, plump appearance — and plenty of water weight, too.
The next day, they'd be skinny, rangy cattle again, and the buyer would exclaim, "I've been sold watered stock!" Over the years, "watering the stock" has come to refer to the practice of companies issuing additional stock, and thereby, diluting its value.
It stands to reason that if watering stock is bad, then decreasing shares outstanding is good. After all, if there are fewer shares, they should be worth more, all other things being equal. But corporate buybacks are rarely the good things that companies promote them as — and they can be a warning sign that management simply has no idea what to do with its money.
Companies in the Standard and Poor's 500 stock index bought back about $160 billion in stock in the first quarter — the number is an estimate because the first-quarter tallies aren't complete, says Howard Silverblatt, senior index analyst for S&P Dow Jones Indices. If that number's accurate, it would be the second-highest amount of stock repurchases in history, trailing only the $172 billion in the third quarter of 2007.
Students of history will recall that the largest bear market since the Great Depression began in October 2007, which is one reason to view stock buybacks skeptically. Companies rarely buy their own stocks because they think the stock is undervalued, as superstar Warren Buffett pointed out in a 1999 investment letter: "Repurchases are all the rage, but are all too often made for an unstated and, in our view, an ignoble reason: to pump or support the stock price."
Reducing the share count is one way that buybacks pump a stock price. But there's a somewhat more subtle way that repurchases kick up a stock's value. Analysts look at a company's earnings per share. If a company's earnings are the same and the number of its shares fall, the stock magically looks a bit less expensive than it really is.
It may not be a shock that the people who benefit most from higher stock prices are executives, because much of their compensation comes in the form of stock grants and options. And yes, those executives have a big say in when a company repurchases its stock. "The people who make those decisions have a big incentive to keep stock prices high," says William Lazonick, professor at the University of Massachusetts at Lowell.
Thus, big surges in share repurchases often happen when stock prices are high, not when they're a bargain. That may have happened in the first quarter of 2014, when earnings were widely expected to slow. "Companies may have decided to spend extra money getting a tailwind going into the first quarter," Silverblatt says.
That's not unusual, Lazonick argues. Looking over four decades of data, Lazonick found that buybacks peak at market peaks, and tail off in bear markets. But he makes other, powerful arguments against corporate stock buybacks:
• Even companies that buy back shares because they think the stock is a bargain don't sell it to lock in a profit. Doing so would be a signal that management thinks the stock is overvalued.
• Companies that depend on research and development for future earnings squander their money by buying back stocks. Pfizer, for example, depends on developing new drugs. Yet, from 2003-2012, the equivalent of 71% of Pfizer's profits went to buybacks, Lazonick says. Similarly, Hewlett-Packard spent $11 billion on buybacks in 2010, $10.1 billion in 2011, then took a $12.7 billion loss in 2012.
• Buybacks are probably the least productive use of a company's money. Companies have any number of things they can do with their cash, borrowings and profits. They can invest in people, plants and equipment. Or they can buy other companies. "It shows a lack of imagination," Lazonick says.
"We use it as an explanation of why earnings are holding up," says Sam Stovall, managing director of U.S. equity strategy at S&P Capital IQ. "Companies buy back stocks because management doesn't feel it has a better use for its funds."
The past five years, the PowerShares Buyback Achievers fund (ticker: PKW), has beaten the SPDR S&P 500 ETF trust by 3.91 percentage points a year, according to Morningstar, the Chicago investment trackers. So far this year, however, the fund has lagged behind the index by 2.28 percentage points — a sign that Wall Street may be getting less impressed by buybacks.
What should investors look for instead of repurchases? Stovall suggests investments in plant and equipment. Factory capacity utilization is at 80% now, about the point where companies start replacing old equipment, Stovall says. Investment in equipment grew 3.1% last year and is expected to grow 5.2% this year. Next year? a sizzling 10.4%.
Buying back stock is more of a sugar high than anything else. But wouldn't you prefer to own a company that has better ideas for using its cash?