Beware of Stock Buybacks

This article originally appeared Jan. 27, 2014, on Real Money. To read more content like this, + see inside Jim Cramer's multi-million dollar portfolio for FREE -- Click Here NOW.

There are few to no truisms when it comes to stock market investing. Some statements sound like they could be true on all occasions, but that is never the case. Not all stocks trading at low price-to-earnings ratio (P/E) multiples are undervalued. Not all dividend paying stocks are safer than non-dividend payers, and not all blue-chip stocks are necessarily safer investments than smaller companies. You can keep going and going. Any time you hear an absolute investment statement, you should immediately be skeptical.

Another statement that many think is always a good is share repurchases. Guess what? Not all share repurchases are good either. But a lot of CEOs try to hide behind  them as good shareholder value creation tools. The purpose of a share buybacks is certainly a noble one; when done correctly, they do add enormous value for shareholders.

First, when a company repurchases its stock, this reduces shares outstanding and thus gives existing equity holders more ownership of that company. If you own 10,000 shares in a company with 1 million shares outstanding, you own 1% of that business. If the share count declines to 900,000 due to buybacks, your 10,000 share block now equals nearly 1.2% of that company.

Second, fewer shares outstanding means profits are divided over a smaller number. This makes earnings per share (EPS) increase. Since Wall Street loves EPS growth, many company's look at share buybacks as a way to keep analysts happy.

Therein lies the problem with share buybacks -- an institutional pressure to do them regardless of whether they create value or not. In this current environment, I would be wary of massive share buybacks. Stocks are trading at elevated levels and companies are flush with cash. Companies remain hesitant to spend on inventory and equipment, so executives take the cash and buy back stock or pay dividends. The preference for stock buybacks results because of taxes -- you don't pay them like you do on dividends.

But when done at overvalued prices, buybacks can be very harmful to value creation. AutoZone (AZO) is an example of how quality buybacks should work. AutoZone doesn't buy back stock based on its cash levels -- management decided years ago that it would leverage their working capital cycle to buyback tons of shares. The result is a stock that is up nearly tenfold in the past decade -- and the company has retired more than 70% of the shares outstanding during that time. And that's why you have guys such as Carl Icahn chomping at the bit to get Apple (AAPL) to buy back a ton of its shares -- he was demanding that when Apple was trading in the $400s.

Other companies, for example, J.C. Penney (JCP), reveal the institutional pressure behind buying back stock. JCP bought back millions of dollars of shares several years ago for nearly $40 a share. Last year, in order to raise capital, the company had to sell shares for $9.

Company buybacks are a form of capital allocation; if it doesn't make sense, companies should be very satisfied with sitting on the cash until they have a better opportunity to buy back stock, make an acquisition or give that money back to investors. Imagine if many of the companies today buying back tons of stocks did the same in 2008 and 2009. The EPS and return-on-equity (ROE) numbers today would be off the charts.

As earnings reports come in, keep an eye on the level of repurchases and consider if they are being done because the shares are a good buy or to appease the institutional imperative.

At the time of publication, Gad had no positions in the stocks mentioned.

Sham Gad is the managing partner of Gad Capital Management, a value-focused investment firm based in Athens, Ga. Gad has written extensively for The Motley Fool and was a securities analyst for UAS Asset Management, a small value investment fund in New York City, in 2007. From 2002-2005, Gad managed assets for the Gad Investment Group.

Additionally, Gad has just released a new book, The Business of Value Investing: Six Essential Elements to Buying Companies Like Warren Buffett. He earned his BBA and MBA at the University of Georgia. Gad appreciates your feedback; click here to send him an email.