Time to get out of bank stocks

Commentary: If your bank is buying, sell. Buybacks are usually ill-timed, ineffective and costly. With video on 3 reasons to dislike buybacks.

By MSN Money Partner Mar 23, 2011 9:19AM

By David Weidner, MarketWatch

 

For the first time in years, investors are cheering the big banks. The latest round of stress tests are over, and dividends are back.

 

Forgive me if I don't share the excitement.

 

Sure, it's about time that BB&T (BBT)JPMorgan Chase (JPM) and U.S. Bancorp (USB) are allowed to reward shareholders for their patience and support. Those banks are well run and can afford the cost.

 

But banks can never let a good thing just be a good thing. Enter the return of stock buybacks.

 

Post continues after video on stock buybacks:

 

 

Buybacks allow companies to use their cash stockpiles to purchase their shares on the open market. The theory is that buybacks shrink the float and make each share worth more.

 

It is, however, just a theory. In reality, most buybacks don't work. In fact, if your bank is buying, maybe you should sell.

"Most companies have been too enthusiastic with their stock-buyback programs," Standard & Poor's concluded in 2007. They "have not increased shareholder value."

 

Before we get into why buybacks are a waste of money, let's consider when they do work. Let's say Company X is trading at less than book value. There's worry about X's industry, but X has ample cash. It buys back 2% of its stock. Voila, the price-to-earnings multiple is higher, the momentum shifts, and the shares rise. It's a great story if it's true.

 

Here's what really happens. Company X's stock is stuck in the doldrums -- mostly because X can't show any meaningful profit growth. So, X announces and spends money on a buyback. The announcement sends shares up briefly, but then they continue to bump along. Any increase in the stock price is offset by cash used to buy shares or shares issued for compensation. If the stock goes down suddenly, Company X has made its situation worse.

 

OK, you say, that's your opinion. Yes, but consider someone who knows the game pretty well. His name is Warren Buffett. In an interview with PBS's Nightly Business Report in 2009, the head of Berkshire Hathaway (BRK.B) gave his opinion on buybacks:

 

"If your stock is undervalued, significantly undervalued, management should look at (buybacks) as an alternative to every other activity," Buffett said. "That used to be the way people bought back stocks, but in recent years, companies have bought back stocks at high prices. They've done it because they like supporting the stock."

It's nice to see that Buffett and I are on the same page. But, you say, those are just opinions. Where's the evidence?

Chris Wood, an analyst at Casey Research, took a look at some of the biggest buybacks in recent years: IBM's (IBM) $18.8 billion buyback, General Electric's (GE) $12.4 billion buyback and Home Depot's (HD) 10.8 billion buyback. In all, they represent $42 billion in cash spent on stock.

In every case, the earnings multiples dropped.

 

So what happened? Wood said the problem with CEOs launching buybacks is the same problem shared by most investors: They try to time the market. He pointed out that there were more than $600 billion in buybacks in 2007 -- the top of the market. When the market tanked, buybacks fell to $180 billion for the full year, even though most companies had cash, Wood said.

After a two-year bull run, the Dow Jones Industrial Average ($INDU) is at roughly 12,000. Does this sound like a good time for a buyback?

 

"More importantly, when a company repurchases its own shares," Wood said, "it's saying that it has nothing better to do with its cash than employ a strategy that may or may not benefit shareholders and will do absolutely nothing to improve the firm's long-term prospects."

 

Here's another often-overlooked part of buybacks: They're almost always offset by new shares offered to employees as options. Intel (INTC) was one company that learned the hard way. It spent $1.3 billion on buybacks in the early 1990s, but its shares outstanding actually grew by 4 million because of options. Moreover, it bought stock at an average of $77 but received only $15 for stock options granted to its employees.

 

For the banks, which have been handing out more stock compensation after the financial crisis, the equation is likely to be even more skewed.

So, while the dividend hikes by big banks are overdue, banks are pushing their luck by using their precious cash for buybacks. Many bankers would argue that their stock meets the criteria laid out by Buffett ("significantly undervalued"), but that's more myth than reality.

 

Their stocks are valued fairly — at exactly what investors are willing to pay for them.

 

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