Don’t Fall Into These 10 Buyback Traps

Submitted by Wall St. Daily as part of our contributors program

This data is hot off the presses…

In the fourth quarter, S&P 500 companies repurchased a staggering $99.1 billion of their own stock. That’s a 13.2% increase over the $87.6 billion spent in the fourth quarter of 2011.

Talk about bullish news, right?

After all, stock buybacks are supposed to imply that management believes the stock is cheap. And the additional buying activity serves as a catalyst for a rally.

At least, that’s what conventional wisdom dictates. And the financial media is certainly buying into that theory…

Take the well-known industry rag, InvestmentNews, for instance. It’s out trumpeting the companies with the biggest buyback programs as “Buyback Kings.”

The implication is that these companies are also compelling “Buys” for investors.

My take? Not so fast!

In fact, treat this news as if it were an April Fools’ prank.

As I revealed in late January, stock buybacks aren’t always bullish.

Before we can make that determination, we need to ensure that management is actually reducing the share count – and, in turn, increasing earnings per share.

So let’s do that today. Because the last thing I want is for you to unknowingly fall into any of the buyback traps lurking in the market.

Not As Bullish As You Think

In the fourth quarter, a total of 317 companies in the S&P 500 repurchased shares on the open market. That works out to more than 60% of the Index, which sounds impressive and extremely bullish.

Until we dig into the data, that is…

As S&P’s Howard Silverblatt reveals, “Most of the companies have shied away from share count reduction.”

Specifically, only 98 of the 317 companies actually reduced the number of shares outstanding. And only 36 did so by a meaningful amount (more than 1%).

Which means a total of 219 companies that repurchased stock during the quarter actually saw their share counts remain the same – or even rise.

Or, more simply, 219 companies flashed false “Buy” signals.

Now do you understand why we can’t blindly treat buybacks as bullish?

In this case, the headlines suggest that a majority of companies reduced their share count, which would be a wildly bullish indicator.

But only a minority actually did (19.6%), which is only a moderately bullish indicator.

Bigger Isn’t Always Better

If we focus simply on the 10 biggest buyers of their own stock, the bullish readings come up short, too.

As you can see, every company spent more than $1.5 billion on repurchases.

Apple (AAPL) surprisingly made the list, too. I say “surprisingly” because it seldom repurchases its own stock. (The last time was in the second quarter of 2006.)

Despite its $1.95 billion in repurchases in the fourth quarter, though, the total number of shares outstanding increased. So if people say you should buy Apple because management is purchasing the stock, tell them to get a clue!

In truth, only one company in the top 10 purchased enough stock to reduce shares outstanding by a percentage that I’d consider extremely bullish. And that’s AT&T (T). It spent over $4 billion on buybacks and reduced its share count by more than 3%.

While that’s bullish, you’ll recall that legitimate buyback activity – accompanied by insider buying – is even more bullish. After all, if management thinks shares are truly undervalued, they should be buying them in their personal accounts, too.

And go figure – such stocks outperform the market by as much as 29 percentage points.

So if we also take insider buying into consideration, AT&T is (once again) the only company that comes close to being a compelling investment.

Add it all up – tacking on an attractive yield, to boot – and it seems like AT&T is currently a strong “Buy” right?

Not so much!

I say that simply because the stock is getting expensive. The current P/E ratio of 30 represents an 85% premium to the average stock in the S&P 500 and a 38% premium to AT&T’s five-year average P/E ratio.

Bottom line: None of the “Buyback Kings” represent irresistible opportunities. Sorry to disappoint. But investing isn’t as easy as looking at a top 10 list and buying blindly. No matter how bullish an indicator is supposed to be.