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Buyback Now, Payoff Later? : Critics Scoff, but Many Analysts Think There Can Be Big Gains in Tagging Along When a Firm Repurchases Its Stock

November 19, 1996|Jon D. Markman

There is one investor in every public company that ought to have perfect knowledge of the firm's real value and its ability to grow.

That investor does not work for the Psychic Friends Network or read growth lines in the chief executive's palm.

No, that shareholder is the company itself--and an increasing number of market analysts believe that private investors who tag along with companies that are buying back their own stock can reap substantial gains.

Corporate stock buybacks, say proponents of the strategy, can be symptoms of greatness: They show that a company is healthy enough to fund its domestic and overseas expansion, pay for research and development and dividends and still have plenty of cash left over. They show that a company is investor-friendly enough to put that cash to work reducing the number of shares in the public market, making each one left more valuable. And they may show that the company, relying on insider knowledge, considers its shares undervalued.

Critics of the strategy don't doubt the value of these portents. But they believe it is nearly impossible to determine whether a company has followed through on its announcement to buy back shares, and harder yet to figure out if buybacks truly affect the value of the remaining public stock. For example, buybacks have become popular as a kind of tax dodge, paying investors with a higher stock price instead of by dividends, which are taxed immediately as ordinary income. In addition, critics say, many firms repurchase their shares without making any announcement.

David R. Fried, a money manager in Malibu, believes that solid research on stock buybacks can tip the scales in private investors' favor. And two years ago, he launched a monthly publication called the Buyback Letter ($149 a year, [888] 289-2225) to help investors track the approach.

The letter lists all major buyback announcements each month (there were 140 in July), spotlights a few companies' programs and follows a rather short portfolio of stocks. According to Fried, the buyback portfolio has been led this year by soaring shares of semiconductor maker Intel Corp., to a 24% gain through Nov. 9. The value of the S&P 500 grew 18% in the same period.

Fried divides the buyback universe into three groups:

* Companies that never follow through on their announced repurchase plans and only use the declarations to signal Wall Street that they consider their shares undervalued. Ignore these whiners, he says.

* Companies that only repurchase stock when their shares are bargain-priced. An example, Fried says, is SkyWest, which regularly buys back its shares when they fall close to the airline company's book value. These companies, he says, offer opportunities to profit over two to three years only if one can purchase shares near the price the company pays.

* Companies that are committed to long-term buyback programs to build shareholder value. This group, he says, is made up of companies such as Coca-Cola and General Electric and holds the most appeal for investors.

To illustrate the value of a buyback program, Fried says Coca-Cola repurchased 483 million of its shares from 1984 to 1995. As one result, he says, the company has turned 14% annual gains in earnings into 18% annual growth in earnings per share.

Critics of the approach, such as the Connecticut-based market research firm Birinyi Associates, mostly cast doubt on the reliability of public data on buybacks as well as on companies' earnestness. According to a Birinyi white paper published in August, from 1985 to 1995, only 44% of the 1,155 companies that announced share repurchases completed them. During the same time, Birinyi reports, an additional 343 buybacks were not announced. Even of the successful repurchase programs, the firm concludes: "We are not persuaded that buybacks are indicative of future prices."

Further muddying the picture are companies that issue new stock even as they're repurchasing old shares. In 1993, according to Birinyi, Merck announced a $1-billion buyback, then followed up with a $2-billion buyback announcement in 1994. But corporate reports show an increase of 103 million Merck shares from 1993 to 1994, Birinyi says, largely because the company issued stock to purchase Medco Container.

How can a private investor profit on buybacks?

Fried advises that investors wait after an announcement to ensure that the company is truly buying back its stock. Evidence of a decreasing number of shares can be found in the quarterly reports that companies file with the Securities and Exchange Commission.

He advises that investors follow up with phone calls to the firm's shareholder relations department to ask at least two key questions:

* Does the firm have a history of issuing new shares to raise money whenever its stock price rises? (That would dilute the advantages of its share repurchase program. Sell when the firm issues new shares.)

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