Share buybacks dominate 2024: here's why not all buybacks are worth it

Wall Street often celebrates when companies announce stock buybacks, seeing them as a vote of confidence in a firm’s future.

However, veteran stock researcher Bradley Safalow is sounding a cautionary note.

A report by Barron's has put out Safalow's argument that while buybacks can give a short-term boost to stock prices, their long-term impact is often less favorable, particularly for companies with financial or operational weaknesses.

The buyback paradox: big spenders, underwhelming results

Safalow’s research reveals a striking trend: companies with the largest buyback programs in the S&P 500 have underperformed the broader index over the past decade.

In his note to subscribers of PAA Research, he likened stock buybacks to a “sugar rush”—a fleeting spike in share prices that often leaves companies weaker in the long run.

From 2019 to 2023, S&P 500 companies repurchased a staggering $3.5 trillion worth of shares.

However, much of that spending failed to significantly reduce outstanding share counts due to the offsetting effect of rising stock-based compensation.

Only a small percentage of companies achieved a net share reduction of more than 4%.

For companies with high debt or structural challenges, buybacks can be a poor use of capital.

Safalow highlights examples such as ITT Educational Services and Big Lots, which spent over $1 billion on buybacks before eventually filing for bankruptcy.

Poor timing: the pitfalls of buyback strategies

Safalow’s critique aligns with academic research and insights from seasoned investors like Leon Cooperman, who have long observed that corporate managers often mistime buybacks.

Companies frequently buy their stock when prices are high, only to pull back during downturns when shares are undervalued.

“Most management teams lack a clear understanding of their businesses’ intrinsic value,” Cooperman has noted.

Safalow echoes this sentiment, emphasizing that buybacks should ideally occur only when a company’s stock is significantly undervalued.

Buyback outliers: companies that get it right

Despite the overall criticism, some companies have managed to use buybacks effectively, generating substantial shareholder value.

Safalow identifies firms like AutoZone, Dillard’s, and Build-A-Bear Workshop as prudent buyers of their shares.

These companies have consistently repurchased stock at opportune times, contributing to strong performance relative to the S&P 500 and the Russell 2000 over the past five years.

In December, Safalow published a list of “Buyback Outliers”—companies that demonstrate disciplined buyback strategies, even during periods of market weakness.

To qualify, these firms consistently generate free cash flow, achieve high returns on capital, and maintain low levels of share-based compensation.
Some of the notable names on Safalow’s list include:

Charter Communications: The cable operator has shown strategic timing in its buybacks, bolstered by strong cash flow.

Williams-Sonoma: The retailer has outperformed thanks to disciplined capital allocation and prudent buyback activity.

Etsy and Polaris: Among smaller firms, both companies have effectively used buybacks to enhance shareholder value.

Stock-based compensation: an overlooked cost

One of Safalow’s primary concerns is the role of stock-based compensation in distorting the true impact of buybacks.

Many companies have successfully convinced Wall Street to exclude stock-based compensation when calculating adjusted earnings, despite it being a real cost to shareholders.

At some tech and consumer discretionary firms, stock-based compensation exceeds 15% of operating cash flow, diluting the benefits of buybacks.

Safalow argues that companies often use buybacks to mask these costs, creating a misleading picture of financial health.

Lessons for investors

Safalow’s findings offer important insights for investors navigating the buyback landscape:

Be skeptical of large buyback programs: High buyback spending doesn’t necessarily equate to strong long-term returns.

Evaluate management’s timing and strategy: Look for companies that repurchase shares when prices are low, rather than chasing high valuations.

Prioritize cash flow and capital efficiency: Firms with disciplined capital allocation and limited stock-based compensation are more likely to deliver sustainable returns.

For investors seeking opportunities, Safalow’s “Nice List” of Buyback Outliers could serve as a starting point.

These companies demonstrate that, when executed thoughtfully, buybacks can still be a valuable tool for enhancing shareholder value.