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Corporate Share-Buyback Programs Will Accelerate in 2010, Bringing More Profit Opportunity

The number of companies buying back their own stock has surged since slipping to the lowest level in more than a decade in the second quarter of 2009. That trend is likely to accelerate in 2010, which is a bullish sign for both the economy and stock market.

Stock buybacks among companies in the Standard & Poor's 500 Index totaled $34.8 billion in the third quarter of 2009, according to Standard & Poor's Financial Services LLC. That's a 43.8% increase from $24.2 billion spent on share buybacks in the second quarter, which was the smallest amount spent since early 1998.

In spite of the bounce, however, third-quarter share buyback totals represented a 61.2% decline from $89.7 billion in the same period a year ago, and a 79.7% drop from the record $172.0 billion corporations spent in the third quarter of 2007. But for many analysts the turnaround is a major milestone for the economic recovery.

"The financial crisis put the brakes on most share buybacks. Companies went into survival mode, trying to hold onto every last penny to weather the economic downturn and the lack of credit," said Louis Basenese, editor of The Takeover Trader. "Now, with the economy showing signs of recovery and the credit markets easing somewhat, it's only natural to see a modest up-tick in buyback announcements."

Basenese also said he expects the upward trend in buybacks to continue based on the current economic outlook, a projection validated by S&P, which forecast an additional 10% increase in new share purchase programs in the fourth quarter. S&P also noted a spate of recent actions by corporate boards giving management permission to execute buyback programs in 2010.

However, it cautioned that many of these are just authorizations, not actual buybacks, and that some were replacements for earlier authorizations that were never carried out because of the poor economy.

The size of the programs continues to lag, as well. None of the 195 repurchase plans approved in the third quarter made S&P's historical list of the 20 biggest buybacks. Exxon Mobil Corp.'s (NYSE: XOM) $4.233 billion program was the largest announced in the third quarter, but programs in every industry except for utilities were below year-ago levels.

However, Basenese said investors should still be encouraged by the upturn in activity, despite the smaller program sizes.

"When a corporation buys back its own stock, it's a strong vote of confidence from those who have the clearest view of future prospects for both the company and its industry," he said. "It's also a sign that management feels the company's shares are substantially undervalued."

Essentially, when a corporation decides to initiate a share-buyback program, it is telling investors that it has excess cash available, usually from retained profits, and believes that buying its own stock is the best way to utilize that money – better, for example, than investing in other securities or making capital improvements to plants, equipment, delivery systems, etc. However, several other considerations can also influence a buyback decision.

One of these is a desire to reward shareholders by returning capital to them, but without instituting or increasing dividends. If a cash-rich company declares a dividend, it is making a commitment – a promise to shareholders that it will continue paying that dividend in the future – no matter what. If times then turn bad and the company is forced to reduce or even eliminate that dividend – i.e., breaking its promise – enraged shareholders often dump the stock, driving prices sharply lower.

By contrast, companies have total flexibility with buyback programs. They can buy billions in stock from shareholders one year, then spend nothing the next two or three and no one will complain, or even notice – much less sell the stock in anger.

That is a primary reason share-buyback programs have gained in popularity over the past few decades. Not only did buybacks increase steadily among S&P 500 companies from 1998 (the first year S&P tracked them) until the third quarter of 2007, but another study reported in the Journal of Economic Perspectives found that annual buybacks among all U.S. stocks had risen from just $5 billion in 1980 to $349 billion in 2005.

Buybacks can also help more mature companies with limited opportunities for organic growth improve their financial numbers. When a company buys its own stock, it reduces the number of shares held by the public, – the so-called float – which means the earnings per share (EPS) will increase, even if revenue and profit are unchanged. That apparent improvement in corporate performance will often prompt a rise in share prices, particularly for issues considered undervalued, resulting in an increased return on investment.

Be aware, however, that such "improvement" may also trigger performance bonuses for management – a somewhat cynical view of why the buyback might have been executed in the first place. If that's the case and future financial results don't meet the expectations signaled by the buyback announcement, the related stock gains could evaporate quickly.

Companies also may repurchase shares for internal reasons: to distribute to employees via purchase plans, through stock-option incentives or as employer contributions to retirement plans. Additionally, buybacks can provide ammunition for mergers and acquisitions. The repurchased shares can be accumulated as "treasury stock" that can be exchanged for the shares of a target company in a takeover attempt.

From the individual shareholder's perspective, stock-buyback programs tend to be beneficial regardless of the company's motivation. As already noted, share prices generally rise when a repurchase plan is executed, though returns vary substantially, and a buyback may have no positive impact at all on the price of a "glamour" stock that's already overvalued.

That was the conclusion of a joint study of open-market repurchase plans (the manner in which 95% of U.S. buybacks are conducted) by professors at the University of Illinois, Rice University and the University of Limburg in the Netherlands. It found that the excess return from buying and holding stocks being repurchased by companies was just 12% over four years – and stocks with very low book value relative to their market value showed no gain at all. On the plus side, however, undervalued stocks – those with the highest book-to-market ratios – returned an extra 45.3% over four years.

Buyback programs tend to produce higher yields for shareholders of stocks that already pay a healthy dividend. For example, the dividend yield for the S&P 500 was 2.29% at the end of the third quarter 2009 and had averaged below 3.0% for most of the past two decades. But in its most recent report, S&P said the 10-year average dividend-plus-buyback yield was 4.74%, and the five-year combined yield was an even more robust 5.89%.

In spite of the potential benefits in terms of yield and return, Basenese advises against buying a stock solely on the basis of the announcement of a buyback program.

"The key should always be the underlying fundamentals," he said. "Plenty of companies with less-than-stellar fundamentals announce share buybacks, but that doesn't mean I want to own them. I typically just view share-buyback announcements as a confirmation that the stock of a fundamentally sound company I'm considering or already own is undervalued.

"Besides, it's essential to remember that announcement of a buyback program merely authorizes management to repurchase some of the company's shares; it doesn't obligate them to actually do so."

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