Companies are snapping up their own shares – be afraid

As a rule, we don't like share buybacks.

Buybacks where companies buy their own shares back from current shareholders - might be good news for big institutions, and bonus-grabbing managements.

But speaking for private investors, if companies have spare cash that they can't put to better use, we'd much rather see it paid out in the form of dividends.

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However, there's another reason to be wary of buybacks. And it's this: companies are generally terrible market-timers.

Why is this a worry just now?

Because buybacks are at record levels

Why we don't like buybacks

There are many reasons as a private investor to dislike share buybacks. The main one is that companies should really have better things to do with the money.

Either invest in growing the business, or increase the dividend payout. Those both offer shareholders genuine rewards.

Instead, a buyback is largely all about (legal) accounting fiddles, keeping institutions happy, and making sure board members get paid their bonuses regardless of how the underlying company is doing.

We've written about them on many occasions in the past my colleague Bengt Saelensminde details the main objections here.

Now just because an individual company is doing a share buyback, doesn't mean we would sell it. Many big companies do them. Indeed, my colleague Tim Bennett looks at a way to potentially profit from them in the latest issue of MoneyWeek magazine, out on Friday. If you're not already a subscriber, subscribe to MoneyWeek magazine.

But when buyback fever grips the market as a whole, it's worth raising a warning flag. In theory, if there's any justification for buybacks at all, it's that a company deems its shares to be cheap and under-appreciated by the market.

In other words, it buys its own shares for the reason that you or I might buy them. Because they're a great bargain, and they can't see anything else out there that represents better value.

And in theory, this makes sense. After all, a share buyback is almost the ultimate insider trade. Who knows a company's prospects better than its own directors?

Trouble is, companies as a whole seem to be no better than individual investors at market timing. They don't buy their shares when they are cheap. They buy when they are expensive.

The record year for share buybacks in the US was 2007. And we all know what happened next.

Companies are woeful market timers

The bad news is that US share buybacks today are now back at record levels.

Last month, nearly $118bn-worth of buybacks were authorised, according to Birinyi Associates. That's the largest level of buybacks on record for a single month. At this rate, it looks as though 2013 will be the biggest year for buybacks since 2007.

Not only that, but companies have been issuing debt (borrowing money) to buy back their own shares. In effect, companies are altering how they are funded.

Again on some level that might make sense. You can borrow money very cheaply just now, whereas shareholders expect things like regularly increasing dividends. Debt also carries tax advantages. So you can see why companies might favour debt where they can get it.

Trouble is, loading up on debt makes a company more risky overall just as it's risky for an individual investor to borrow money to buy shares. So while it might seem like a good idea for the company, it's not great for existing investors.

Perhaps more to the point, just as borrowing money to buy shares is often a sign of irrational exuberance among small investors, this may well apply to companies as well.

As Matt Levine points out on the Dealbreaker blog, animal spirits' and the herding instinct "probably [apply] to corporate treasurers as much as to other humans. So my guess is they're mostly buying back stock because prices are up," rather than for any more rational reason.

I received an interesting piece of research from Lombard Odier last night which backs this up. Since 1964, there have been only two occasions where companies were issuing debt to buy back shares at this sort of level. The first was in 2000. The second was in 2007. Both were of course followed by major crashes.

"Our best case scenario would be for the equity rally to lose some steam, and the worst case scenario for it to experience a significant sell-off," say Lombard Odier.

There's no doubt that markets have had a superb run. And it's also clear that sentiment is very bullish, which is always a warning sign. At the same time, you don't want to have to be pulling your money in and out of the market every five minutes. So what can you do?

We've said it before, and we'll say it again: stick with what's cheap, and avoid what's priced to perfection. I wrote about some of the most promising destinations for your money last week.

Our Roundtable experts will also be looking at where they think you should put your individual savings account allowance this year in the next issue of MoneyWeek, out on Friday.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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