Buybacks Destroy Blue Chip Stocks, GE Is A Prime Example

October 26, 2017

Buybacks Destroy Blue Chip Stocks, GE Is A Prime Example

  • GE spent more than $21 billion on buybacks in 2016. The stock price is now down more than 30%, thus that $21 billion was thrown away.
  • Other S&P 500 companies aren’t much better and their time to reckon with financial engineering will come too.
  • The more buybacks a company does, the lower the market cap will be in 5-years, which is something managers don’t want to know.



Introduction

In December 2016, I wrote an article titled Is Your Value Being Destroyed? where I discussed how buybacks are destroying long term shareholder value.

My favorite example from that article was General Electric (NYSE: GE) because it seemed completely illogical to me that a company would sell valuable assets in order to increase buyback activity because this isn’t how you operate a business, this is pure short term financial engineering.

Unfortunately for GE shareholders, it didn’t take long for the bubble to burst. Since last December, the stock has lost more than 30%.

Figure 1: GE year-to-date stock performance. Source: CNN.

The problem is that by doing buybacks at a price that’s higher than book value, you are just temporarily pushing the stock price higher while spending valuable capital that should be used for business growth. This leads to inevitable declines in earnings that can’t be covered by the lower number of shares because due to aggressive buyback activity, the stock price gets more expensive while earnings suffer.

The sad thing is that GE continues with their divestments in order limit the potential the business has.

Figure 2: GE targets another $20 billion in divestitures. Source: GE.



The problem is that if that money is used to do expensive buybacks at a price to book value of 2.61, which was above 3 back when the stock price was above $30, it’s only adding value to those who are selling the stock to GE. However, most GE shareholders are long term investors like pension funds or retirees who will not see any benefit from the costly buybacks. On the contrary, their value will continue to get destroyed.

So the $21 billion GE spent to push up the stock price in 2016 is now gone with the wind as the stock price is below where it was at the beginning of 2016, 2015, and 2014.

Figure 3: GE’s buybacks didn’t create long term value. Source: CNN.

Therefore, be very careful when investing in a company that boosts its buyback program at a price that is above its book value. This is pure short term financial engineering and has no long term value creation because businesses are cyclical. Sooner or later, earnings will falter and consequently, the stock will drop significantly and sharply as there is no tangible value to protect the stock price or to give hope for higher future earnings.

A General View Of Buybacks & Dividends: Corporate Suicide

The sad thing is that GE isn’t the only company that focuses on financial engineering instead of on business growth. Most S&P 500 companies are so focused on their stock prices and buybacks that researchers Robert Ayres and Michael Olenick from INSEAD call the current buyback activities “corporate suicide.” They found that the more a company spends on buybacks, the less likely it is to grow in the future. The table below shows how much buybacks impacted certain companies, their market cap, and how that affected their share prices.

Figure 4: Top companies with buyback activities have destroyed shareholder value. Source: Ayres-Olenik.

Consequently, companies that don’t focus on buybacks but rather on growth achieve much better long-term stock price performance.

Figure 5: Top companies that don’t focus on buybacks. Source: Ayres-Olenik.



The next chart is one that must be shown to corporate managers, but the fact is that they don’t want to see it because buybacks cover their incompetence. Managements buy stock when they have run out of ideas for better uses of the money.

Figure 6: The higher the buybacks, the lower the returns. Source: Ayres-Olenik.

Conclusion

The conclusion is pretty simple. If you are a long-term investor, stay away from companies that are forcing buybacks.

If you are a trader, try to take advantage of buybacks in the short term as the company itself will push stock prices temporarily higher, but run or go short as soon as those buybacks start impacting earnings and the business. Because sooner or later, they will, it’s impossible to avoid.

By Sven Carlin Buybacks General Electric Investiv Daily Share: