By WallStreetDaily.com

• Avoid companies that disavow ethics.
• Volkswagen is buying its own cars back.
• Are all buybacks created equal?
• Also recommended: Gold mine lurking beneath the sea.

You’ll recall that Volkswagen admitted to rigging 11 million vehicles with software designed to trick emissions tests.

Well, it’s time for the company to make amends.

A federal judge just approved an order for Volkswagen to buy back $1.2 billion worth of “cheating” vehicles.

All told, Volkswagen will buy back 20,000 polluting diesel-engine cars.

The company will offer free repairs on another 63,000 cars.

Volkswagen’s buyback plan got me thinking…

What’s the difference between Volkswagen buying back its own cars and a public company buying back its own shares?

Warren Buffett believes that stock buybacks destroy shareholder value.

Others think it’s a bullish sign when a company is hoarding its own shares.

Bloomberg:

Repurchase activity slowed last year and is down drastically in 2017 to the slowest pace in five years… Bank of America, based on its own proprietary survey, says buyback activity could be down as much as 30%.

I asked my senior analyst, Martin Hutchinson, to give us the final word on buybacks.

Bullish or bearish?

Hutch’s full report is below.

Ahead of the tape,

Louis Basenese
Chief Investment Strategist, Wall Street Daily

Question: Martin, you agreed to help us compile a library of the most important investment catalysts. These are baseline concepts that every investor should know. Today we’ll be discussing stock buybacks.

Let’s jump right in, Martin. Let’s start right at the beginning. What’s a stock buyback?

Martin Hutchinson: In a stock buyback, a company announces a program of buying stock from the market generally over a time period rather than through a single tender offer. By doing this, it reduces the number of shares outstanding and increases earnings per share.

There are two reasons for doing this. Firstly, buying back shares returns cash to shareholders like dividends but in a way that tends to boost the stock price. Because there are fewer shares outstanding, it pushes the price up.

This benefits management, which has stock options, more than dividends, which they don’t receive until they exercise the options into shares. If you hold stock options, dividends are a bad thing. They represent a leakage of cash and value from the company from which they don’t benefit.

The second reason for doing buybacks is if the buyback does increase the share price by reducing the number of shares outstanding, shareholders don’t have to pay tax on the gain immediately. If you pay a dividend to them, they pay tax on it immediately.

Question: Interesting, Martin. Now, I know coming out of the financial crisis, we were seeing a ton of stock buybacks. In fact, some experts were thinking that the bull market was being facilitated by these tons and tons of stock buybacks. Might that have been true?

Martin Hutchinson: Yes, it was. I think companies have a lot of cash, and they use it on stock buybacks because those are more beneficial to management. There are, however, some dangers to stock buybacks.

Question: Would you walk us through those dangers?

Martin Hutchinson: Absolutely.

Firstly, management has more money for buybacks in good years, obviously enough. But then the stock tends to be high. If management buys back stock at the top and then runs out of money at the bottom, which they quite often do, they may have to do an emergency share issue at a much lower price. Obviously, a company that buys stock high and sells low is bad news for its other stockholders.

Secondly, companies often do buybacks and pay dividends together that are more than company earnings. For example, they might pay dividends of 40% of earnings and buybacks of another 80% of earnings — for a total of 120%. They finance these by piling on leverage, which of course, in today’s market, is at attractive rates. Apple, for example, is doing this. Naturally, in a downturn, those companies have a risk of failure because they’ve used all their cash during buybacks.

Question: Interesting. At the end of the day, Martin, if I’m ordinary Joe investor and I’ve got my eye on a stock and the company has recently done some stock buybacks, do you think I should view that as bullish, or neutral or bearish?

Martin Hutchinson: I think you should be slightly bearish on companies that do buybacks. They’re bad for individual shareholders because the individual shareholders get no direct benefit from buyback offers, which are generally made directly to institutions.

Question: What about the theory or the feeling that management is so bullish on its own company and prospects that it’s eating up its own shares? What about that idea?

Martin Hutchinson: That’s fine, but the management benefits more from the buybacks than the individual shareholders do, because they’re the ones with stock options. They’re extremely beneficial for company management.

Personally, I much prefer steady dividends. I think in general, individual shareholders should prefer companies to pay the money out in dividends rather than in buybacks.

Question: Before we break, Martin, I’ll give you the final word on stock buybacks. Give it to me. Boil it down for me.

Martin Hutchinson: I think there a great tool for management. Obviously, companies have to return cash to stockholders somehow sometimes. But I’d much rather they did so in dividends as a stockholder.

Question: There you have it: Martin Hutchinson. He believes that stock buybacks are overrated. Thanks for your time, Martin.

Martin Hutchinson: Great to be with you.

Question: This is Wall Street Daily, signing off.

Good investing,

Martin Hutchinson
Senior Analyst, Wall Street Daily

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