Beware the Corporate Buyback

This Barron's article points out buybacks are at the highest level since late 2007. As the article says:

Many companies effectively are taking themselves private.

Now, given that buybacks have a more than somewhat bewildering history of being executed when stocks aren't necessarily cheap, this activity would seem to be not, in itself, of particular interest.

Unfortunately, there's plenty of evidence poorly judged buybacks.

A recent example of this is that buybacks peaked in 2007 when stocks were hitting highs. From this article:

Stock buybacks: Buy high and sell low

From 2004 to 2008 companies flush with cash and confidence spent $1.8 trillion on their own soaring shares. When the market collapsed, what did they do? Rather than take advantage of discount share prices, as wise investors are supposed to do, they stopped buying.

What seems to make the more recent ramp up in buybacks more interesting is how different the current valuation environment is. For most of the past decade, buybacks made little sense for many companies because stocks were often fully priced (fully priced and then some in more than a few instances even when the market was bottoming in 2002-03).

So prices of marketable securities were frequently near or well above intrinsic value. Buybacks only work effectively when a substantial discount to intrinsic value exists.

A discount to value that should be a plain to see (not a mere five or even fifteen percentage points).

These days, more than a few stocks seem to be selling at comfortable discounts to value (even if the market is well above the more recent 2009 bottom).

Clearly in the short-run prices can go much lower based upon macro factors, but at least there's some buoyancy provided by the fundamentals.

In contrast consider that in 2003, after stocks had fallen roughly 50%, Warren Buffett wrote the following:

We are neither enthusiastic nor negative about the portfolio we hold. We own pieces of excellent businesses – all of which had good gains in intrinsic value last year – but their current prices reflect their excellence. The unpleasant corollary to this conclusion is that I made a big mistake in not selling several of our larger holdings during The Great Bubble. If these stocks are fully priced now, you may wonder what I was thinking four years ago when their intrinsic value was lower and their prices far higher. So do I. - From the 2003 Berkshire Hathaway (BRKa) Shareholder Letter

What seems unique about 2003, as far as stock market bottoms go, is that quite a few stocks bottomed when they were still fully priced to very expensive. What Buffett wrote back then is in fairly stark contrast to what he seems to be thinking now and, these days, it's more than just words. His 3rd quarter buying spree represents one of Berkshire's most active periods in terms of buying stocks in a very long time.

Buffett Invests Over $ 20 Billion in 3Q 2011

Stocks that weren't cheap, for the most part, at the bottom in 2003 went on to rally again over the next several years. The expensive becoming even more expensive. So, naturally, buybacks during that time were not particularly enriching to long-term owners.

Using buyback activity, by itself, as evidence of cheapness for an individual stock or stocks in general doesn't really work*. Instead, investors have to judge whether something is cheap or not by comparing market prices to their own conservative estimate of value. There's no way around that fact.

Still, if valuations in general seem plainly attractive then seeing that the buyback activity being stepped up can't be a bad thing. This is true even if, in a disappointing number of instances, it turns out to be mere coincidence that buybacks are occurring when valuations are low.

Adam

Long position in BRKb

* Though management with a proven track record when it comes to making capital allocation decisions that is buying back stock at some scale would, at least, be noteworthy.
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