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What’s the buzz on share buybacks?

By Dr. Don Taylor ·
Monday, March 31, 2014
Posted: 10 am ET

What got me interested in share buybacks was Ben Johnson's review in February of an ETF that invests in companies making a substantial commitment to buying back shares of their common stock. Johnson is director of passive fund research at Morningstar.

The ETF in question is PowerShares Buyback Achievers (PKW). That's not an investment recommendation from either Johnson or me -- just a starting point for a discussion of share buybacks. (The ETF is, in fact, a bit pricey with a 0.71 percent expense ratio.)

How share buybacks can help investors

When a company buys back its shares, it reduces the number of shares outstanding. All else being equal, that increases the earnings per share of the company's stock because the share buyback means there are fewer shares outstanding to receive the earnings allocation. Share buybacks also put a bid in the market for the company's shares. That demand should drive prices higher, at least during the buyback program.

Companies sometimes do share repurchases to offset the options or shares they grant their employees. That offsets the dilution of earnings to shareholders of executive compensation. Another reason to buy back shares is when companies feel that the market is undervaluing their shares. When investors perceive this as the reason, the management team is sending a signal to the market about the undervalued shares.

How share buybacks can hurt

Unfortunately, it can also signal to the market that the management team doesn't see growth opportunities for the firm, or that the company can't find productive investments in which to use the cash generated from its current operations.

The share buyback can sop up excess liquidity in the firm without explicitly paying a cash dividend to shareholders. Academicians like this approach because shareholders that need income can sell shares, but shareholders that want to stay invested can do so without the tax hit of reinvesting a dividend payment. Even borrowing to buy back shares can make sense for tax reasons, especially in today's low interest rate environment. Multinational firms may be reluctant to repatriate foreign earnings, triggering a corporate tax obligation, so they borrow against it instead.

What I keep coming back to are Jim Cramer's comments after the 2008 stock market decline. He talked about how silly corporations should feel for buying back shares in 2007 at market highs, only to see those share prices decline -- in many cases, dramatically. The market, as measured by the Standard & Poor's 500 index, was up 32.39 percent last year, and that index, as I write this, is near its all-time high.

Would you invest in companies with stock buyback programs?

Think you can beat the stock market? Read about the efficient market hypothesis.

Follow me on Twitter: @drdonsays.

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