Why Share Buybacks Aren’t as Great as They Seem

Buybacks are very popular with investors. But too often they’re done at the wrong time.

| More on:
The Motley Fool

Whenever a company has excess cash sitting around, there are five ways that management can use it: capital expenditures, acquisitions, paying down debt, increasing dividends, or share buybacks.

Capital expenditures and acquisitions may be a wise move at times, but are usually not popular with shareholders. Paying down debt can certainly make a company more secure, but with interest rates so low, reducing the debt load doesn’t come with very much reward. Increasing the dividend is always a popular move, but it’s a decision that’s very difficult to take back; investors are not forgiving towards companies that cut or suspend their dividends.

Share buybacks, on the other hand, can be especially appealing. Management teams love them because they don’t require the same level of ongoing commitment as dividends. Buybacks can also be a way to signal management’s confidence in the company. Shareholders love them, because they boost earnings per share, and almost always result in an increased stock price.

In fact many investors screen for stocks that have a history of buying back shares. But there is a downside.

Like any investment, buybacks are only wise when a company’s share price is depressed. The problem is that most companies don’t follow this pattern, and the reason is simple. When times are good, a company has more cash available for buybacks, but that is also when its share price is likely at lofty levels. Conversely, during the down times, a company is more likely to hoard cash, precisely when its shares are trading at a discount.

A perfect example comes from one of Canada’s oldest companies.

Canadian Pacific: A case study

Consider Canadian Pacific (TSX: CP)(NYSE: CP). Back in 2006 and 2007, when the company was doing well and the stock was flying high, CP repurchased 8.2 million shares at an average price of $63.03. Two years later, in February of 2009, the company was short of cash – the economic crisis and a recent acquisition were both taking their toll.

So CP was forced to issue 12.6 million new shares at $36.75 each. By doing so, the company raised the same amount of money (about $500 million) that it had spent earlier on its buybacks. But the end result was an extra 4.4 million shares outstanding.

Fast forward five years, and CP shares now trade above $160, thanks to numerous improvements from CEO Hunter Harrison. Yet last month, the company announced it would buy back up to 5 million shares. If the company had done this two years earlier, it would have cost less than half as much.

Foolish bottom line

Share buybacks remain extremely popular with shareholders, especially short-term oriented investors who like to see a bump in the stock price. But this isn’t always the wisest use of capital. So before jumping at whatever company is buying back shares, you might want to take a second look.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Benjamin Sinclair holds no positions in any of the stocks mentioned in this article.

More on Investing

funds, money, nest egg

I’d Aim for $1 Million Buying Just These 5 TSX Stocks

Here's a diversified group of TSX stocks that could help investors achieve a $1 million portfolio.

Read more »

Canadian Dollars
Bank Stocks

If You’d Invested $2,500 in Royal Bank Stock in 2012, Here’s How Much You’d Have Today

Royal Bank (TSX:RY) stock has seen some heavy lifting of its stock price in the last decade, but should investors…

Read more »

warning or alert

TFSA Alert: Top Stocks to Safeguard Your Retirement

Are you looking for stocks to hold in a TFSA? Here are three top picks!

Read more »

Bank sign on traditional europe building facade
Bank Stocks

Canada’s Banking Giants: Are These Stocks Worth Your Money Today?

Canadian investors should watch top bank stocks like Royal Bank of Canada (TSX:RY) closely after another interest rate hike.

Read more »

tsx today
Tech Stocks

TSX Today: What to Watch for in Stocks on Thursday, June 8

TSX stocks are likely to remain volatile today, as investors continue to assess the possible impact of higher interest rates…

Read more »

TFSA and coins
Dividend Stocks

Maximize Your Retirement Income: How to Turbocharge Your TFSA Returns

TFSA investors could pick different strategies to boost returns.

Read more »

dividends grow over time

Dividend Aristocrats: Canadian Stocks That Keep Paying Year After Year

Top Canadian stocks like Bank of Nova Scotia (TSX:BNS) also qualify as Dividend Aristocrats that you can trust for the…

Read more »

Golden crown on a red velvet background
Dividend Stocks

Canadian Utilities Is a “Dividend King,” But I Like This Stock Even More

Canadian Utilities (TSX:CU) stock is a solid dividend provider, but there's more to look at then just how much you're…

Read more »