The Only Way You Should Be Investing in Stocks Right Now

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

By David Sterman

NEW YORK ( StreetAuthority) -- What the heck is going on with this market? On two occasions this week, the major indices opened sharply lower and then clawed back higher as the trading session wore on. From hour to hour, the bears -- who fear a spreading European contagion, and the market bulls and who've been digesting solid recent quarterly profits, are wrestling for control of the market.

My take: The risks that could trigger a market pullback remain formidable, and I don't want to touch stocks that don't have some form of downside protection. This protection can come in many forms, from a bulletproof balance sheet to a history of solid, recurring cash flow.

I also like companies that are prepared to defend their stock. The companies I discuss below have recently announced major stock buyback plans, and in a market slump, they'd be active buyers at a time when few friends can be found. Just as important, any market swoon that does affect these stocks will mean more bang for the buyback buck. In some instances, they may have a chance to sharply lower the number of shares outstanding, which would set the stage for solidly higher earnings per share (EPS) in the future.

I've compiled a list of 19 companies that have made buyback announcements since the second quarter began. And their reasons to pursue a buyback now are numerous. Getting to the heart of why they are buying back shares is the key behind seeing whether they represent real value.

Not for Me

As a personal rule of thumb, I never like companies that look to buy back shares unless the forward price-to-earnings ratio is well below the market average. The only exception: if the near-term P/E ratios fail to represent what kind of earnings power a company can eventually have.

Biotech firm Biogen-Idec ( BIIB) and dental supplies distributor Henry Schein ( HSIC) aren't trying to bring attention to a lagging stock -- each trades near its 52-week high. Instead, they simply don't know what to do with their excess cash. I think these companies would be far better off holding tight -- let cash build higher and buy back shares some time down the road when they've fallen sharply from their highs.

A Previous Favorite

Hecla Mining ( HL) is a different story. I've recently written quite a bit about this silver miner. As I noted in this article, if the company can keep its promise that a major shuttered mine will come back online in about eight months, then 2013 results will be far better. The company is using roughly one-third of its $280 million cash balance to buy back stock now, in anticipation of a better outlook, and a higher stock price, in the future.

The Long Slog Back to Relevance

In a similar vein, health care information provider Allscripts ( MDRX) is currently suffering from a botched merger, which I previously discussed in this article.

Allscripts' troubles means earnings per share are constrained, likely staying below $1 this year and next. Yet if management can make the right moves to fix the business and return margins to historical levels, then EPS could move sharply higher. In the interim, the $200 million stock buyback can be used to aggressively reabsorb shares while they remain deeply out of favor. And this isn't a one-time move. In fact, there is already another $200 million buyback plan in place -- and even after that $400 million total is earmarked, Allscripts still has $350 million available for future buybacks.

So why should investors expect profits to eventually move higher? It's because the current numbers are being affected by a series of controllable factors that can be fixed. Allscripts' expenses have spiraled too high as management never made a big cost-cutting push after the company's mishandled merger with hospital information systems provider Eclipsys.

Indeed, the recent moves to bring in fresh management and a new chairman will likely lead to those cost-cutting measures investors had already expected to see. As analysts at Auriga Securities note, "the problems at Allscripts stem from the top, and we wouldn't be surprised to see further leadership turnover." That creates uncertainty right now, and shares may languish until the new team is fully in place and investors hear more about their turnaround strategies.

Yet Auriga's analysts, even as they rate shares a "hold," have a $14 target price, nearly 30% above current levels. And that target is based on very low expectations: By their math, shares are worth more than 15 times the downwardly-revised 2012 EPS of 90 cents (15 x 90 cents = $13.50). That multiple currently stands at 12.

To put that in perspective, rival Cerner ( CERN) trades for around 35 times projected 2012 profits. Both of these companies operate in the same high-growth industry. And Cerner surely deserves a premium for better execution, but should Cerner's P/E be higher by a factor of three? If anything, Cerner is operating at peak levels and has little fat to cut. Allscripts's profit potential is more robust, simply because it is currently too bloated and also has room for improvement in terms of sales force execution.

This isn't an endorsement for Allscripts right now, though. Instead, it's a chance for you to really come to understand this business model while it's deeply out of favor -- and then buy when you think the time is right. Just a few months ago, investors were looking at Allscripts as a decent company in a really attractive business. After a deep fix, that will likely again be the investor sentiment several quarters from now.

Risks to Consider: Buybacks don't prevent stocks from falling -- they just cushion the blow against even deeper falls.

Action to Take: Share count bloat is one of the key factors behind disappointing EPS growth. Conversely, falling share counts can make a tepid growth story look like much better. That's why these stocks are often a fertile area for investment ideas. Aside from Allscripts, any of the stocks in the list above should give you a good head start on your research.

David Sterman does not personally hold positions in any securities mentioned in this article.

StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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