The trouble with stock buybacks as indicators of low stock prices

From the New York Times:

Since the beginning of last year, companies that buy back their shares have generally lagged the overall stock market. That’s the reverse of the long-term pattern, which has shown that buyback companies’ stocks are usually a good bet.

What’s an investor to believe?

…In the early 1990s, researchers noticed that the stocks of such companies significantly outperformed the market for up to four years after the announcement of their repurchase programs. There are [hypothetically] several reasons for this correlation, but a crucial [hypothetical] one is that buyback programs are typically started when managers believe that their shares are significantly undervalued.

…But recent data compiled by Standard & Poor’s doesn’t seem to fit this pattern. S.& P. focused on those companies within the S.& P. 500 index that repurchased shares between the beginning of 2006 and June 30, 2007 — a total of 423 companies. It found that, as of Sept. 30 this year, 320 of them — or 76 percent — would have been better off had they not repurchased their shares and instead invested in an index fund benchmarked to the S.& P. 500.

The article then describes a new academic study that attempts to link stock buyback announcements, actual buyback activity, and managerial intent to mislead. But that analysis seems strained to me, and perhaps unnecessary.

Based on my experience watching company behavior up close, I believe there are two other big factors involving company managers and buybacks that I think are often overlooked.

First, it’s not clear to me that a company manager typically really knows whether or not her stock is undervalued — or accurately valued, or overvalued. Academic researchers and reporters tend to assume that a company manager must have inside information that gives a better indication of accurate company valuation than the information already known to the public professional investor. I think it is equally likely that the company manager would simply have more detailed information about operations — information that might not be all that useful in determining valuation of a large, complex public company — and less information about other companies and other outside factors — because, after all, the manager is busy running her own company; she doesn’t have that much time to think about outside factors that might be really important.

Add this to the level of positive bias you would typically expect a company manager to have about her own company, and I think it’s pretty clear why it’s not atypical for company managers to buy back their own stock at inappropriate times in the real world: they don’t really know whether their stock is undervalued or not.

Second, consider that company managers are often strong-willed, high-ego individuals who hate to lose and hate to be told that they are wrong — and hate to see their stock price fall, and hate for investors to pressure them to fix problems in the business.

A typical scenario goes like this: there’s some problem in your business. Your investors perceive this and your stock falls, and you start to get phone calls from investors asking when you’re going to fix things. You either don’t yet agree that there is a problem, or you remember the last time that investor thought there was a problem and there wasn’t, or you just don’t like being pushed around by Hermes-tie-wearing dilettantes. So you say, to hell with them, they’re wrong, everything’s just fine, and so I’ll publicly signal my faith in my company and in my own management skills — I’ll initiate a buyback.

Of course, when there’s smoke there’s sometimes fire, and so time passes and it turns out that there really is a problem in your business, and more investors realize it and realize you’re not dealing with it, so your stock drops further despite your buyback. At a certain point you may even realize that your buyback doesn’t make sense until you fix the actual problem, and so you quietly suspend the buyback and go back to work. Or, in an extreme case, you never acknowledge the problem, the stock keeps dropping because now the market doesn’t have any faith in you, you keep fighting the perception of the problem but not doing anything about it, and you ultimately get fired.

For these reasons, I think that all you as an investor can conclude about a stock buyback announcement — best case, assuming no intent to mislead — is that the company’s management believes that the company is undervalued. But this belief may not be based on any relevant information you don’t have, may be uninformed by other information about other companies or external factors that you do have, may be the product of wishful thinking, or may be a serious case of denial on the part of the company’s management. None of that adds up to a situation in which you want to invest.

Or, as the man said: opinions are like you-know-what’s, everyone’s got one…