STOCK BUYBACKS: GOOD, BAD AND THE UGLY

Just as stock options, warrants, and convertible preferred issues can dilute your ownership in a company, share repurchase plans can increase your ownership by reducing the number of shares outstanding. Here are three important truths about these programs - and most importantly, how they make your portfolio grow.

OVERALL GROWTH ISN'T IMPORTANT AS  GROWTH PER SHARE:

Here is an example of ABC Company Inc:

Stock price is  $50 per share. There are 100000 shares outstanding. Market Capitalization is $5.000.000.Profit made this year is 1 million dollars.

So in this example, each share equals .001% of ownership in the company, which is 100% divided by 100000 shares. If the management see that their company (business) will have the same amount of profit this year, like it was last year, that means that their growth rate is 0%. Because the management want to improve the picture and show to shareholders that they are good management, they come up with the idea of stock buybacks. The company use 1 million dollar profit to buy back it's shares on the open market.

After the buyback, as we learned in previous posts, those shares are owned by the ABC Company Inc. and removed form circulation. Now there are only 80000 shares outstanding instead of 100000 that were originally issued.

Average investor (aka shareholder) now no longer have  0.001% of the company, but 0.00125%. In percentage term it is rise of 25% in one year per share!. After the buy back, stock rise will rise in price to 62.50$ from 50.00$! So even though the company made the same amount of profit this year like it did last year, stock price rose 25%!!! Average investors are happy.


WHEN NUMBER OF SHARES OUTSTANDING ARE REDUCED, EACH OF SHARES IS MORE VALUABLE AND MEANS GREATER PERCENTAGE BUSINESS OWNERSHIP:

If a management, like in above example, is in charge, this can lead that amount of shares outstanding goes to 50 or 100. So it good to hold companies like one in the example, buy only if they are fundamentally strong, and hold it in your portfolio as long as they keep doing buybacks. This can increase your profits, but as I said, this destroys companies balance sheet and it's not good long term. One of the best examples is the Washington Post, which was at one time only $5 to $10 a share. It has traded as high as $650 over the past few years.


IF MANAGEMENT BUYBACK SHARES AT HIGH PRICES, BUYBACKS ARE NOT A GOOD THING TO DO!

Even though stock buybacks and share repurchases can be huge sources of long-term profit for investors, they are actually bad if a company pays more for its stock than it is worth or uses money it cannot afford to spend ie. Borrow the money. If the market is overpriced it is bad decision for management to buyback stocks. Instead, the company should put the money into assets that can be easily converted back into cash, to improve liquidity. This way, when the market moves the other way and is trading below its true value, shares of the company can be bought back up at a discount, giving shareholders maximum benefit.

There is a saying: "Even the best investment in the world isn't a good investment if you pay too much for it".

Is Stock Split Beneficial For The Investors?

Do Companies With Splitted Stocks Outperform Similar, Non-Splitted Ones?

On the surface, a stock split is nothing more than accounting transaction, it leaves investors no better or worse off. That is the reason why critics argue that a stock split is a non-event. They're convinced that a split is simply an accounting function with no relationship to stock performance. In fact, they think investors are foolish to believe there is any money to made from something as unimportant as a stock split.

On the other hand, companies argue that by reducing per share prices, stock splits make shares more attractive to individual investors. And splitters often claim that a higher share count allows for more trading liquidity and greater institutional ownership. Finally, some investors argue that stock splits are bullish because of the positive signal they send about a company’s prospects.

Most traders view stock splits as high potential trading opportunities. They consider splits a positive progression in value and goodwill for companies and their investors. Corporate executives use stock splits as marketing and investor relation tools. They know that stock splits make shareholders feel better and engender a sense of greater wealth.

What Academic Researches Tells Us?

One study supports the belief that stock splits help attract new investors and improve liquidity. More important, research suggests that stocks tend to outperform after split announcements.

For many years, academics argued that stock splits should be a poor predictor of stock-market returns. The position was easily defended, because stock splits do not increase a company’s intrinsic value. If you hold 1000 shares of a stock that trades for $100 a share, your position is worth $100,000. After that stock splits 2-for-1, you hold 2000 shares valued at $50 apiece, also worth $100,000.

Some studies using price data from the 1920s through the 1970s,  suggested that stock splits have little effect on future price movements. But a number of studies in the 1980s and 1990s show that stocks tend to outperform after they announce a split, despite the fact that prices had often risen sharply before the announcement.

One study of 2-for-1 stock splits between 1975 and 1990 found companies that split their stock outperformed companies of similar size by an average of 7.9% in the year after the split and 12.2% in the three years after the split.

Another study, between 1988 and 1997,  found that shares of companies that split their stock outperformed stocks of similar size, type such as value or growth and liquidity by an average of nearly 9.0% in the year after the split. Other studies showed that that stock splits increase trading costs because of higher bid-ask spreads, which translate into more profits for market makers on the stock exchange and less money to investor.

While stock prices tend to rise in the days after the split announcement, much of the excess return occurs later. One study found that stock prices outperformed by an average of 3.4% in the five days after the split announcement, then another 4.5% over the next 51 weeks of trading.

The relationship between stock-split announcement and price gains appears to continue today. The Forecasts looked at more than 700 stock-split announcements between August 2000 and July 2004 and determined that, on average, splitters outperformed the S&P 500 Index by 9.7% and 14.7%, respectively, in the six and 12 months after the announcement. More than 64% of the stocks beat the market during those periods. On average, only 3% of the out performance occurred during the five days after the announcement.

A 1996 study by David Ikenberry of Rice University measured the short and long-term performance of stock splits. His research included all the 1,275 companies whose stock split 2-for-1 between 1975 and 1990. Ikenberry compared the split stocks to a control group of stocks for similar-sized companies in similar sectors that had not split. His results were startling. The split stock group performed 8% better than the control group after one year, and 16% better after three years.

In August 2003, Ikenberry updated the stock split study. This time he looked at companies from 1990 to 1997. Using a similar methodology that included 2-for-1, 3-for-1 and 4-for-1 stock splits, he found the results were the same. Shares of split stocks on average outperformed the market by 8% the following year and 12% over the next three years.

 

Reasons Why Stock Splits Increase Profits For Investors:
 
1. The stock split announcement draws attention to a company's success. This results in increased buying and higher prices. 
2. Companies will often report high earnings and raise dividends at the same time they announce a stock split. The synergy of these events can drives the price of the stock up even more. 
3. The reduced price per share after companies split a stock attracts many smaller investors. 
4. With so many news and information services reporting stock splits, the announcements themselves have become a market-moving force. 

Whatever side you take, my advice is not to buy a stock solely based on a split!