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Lindley Estes is a business writer for The Free Lance-Star and This blog is on Fredericksburg-area business. Send an e-mail to Lindley Estes.

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Don’t blindly buy into the buybacks bandwagon

WHEN PUBLICLY traded companies announce they’re buying back shares on the open market, investors usually cheer the decision.

It’s easy to understand why. Presumably, management knows better than anyone whether a company’s stock is undervalued. If they decide to repurchase shares, one must assume that means the stock is cheap.

By repurchasing undervalued shares, companies reduce the amount of stock outstanding. That results in higher earnings per share, and in time should lead to a higher stock price.

Many companies have increased buyback programs rather than paying out additional dividends, which have become increasingly rare.

According to a study released this month by Standard & Poor’s Equity Research, 423 companies in the S&P 500 reported share repurchases during the 18 months ending this past June 30. Buybacks among those companies exceeded $700 billion during that period.

The report, titled “How Rewarding Is Corporate Share Repurchase Activity?” challenges the conventional wisdom about buybacks. Todd Rosenbluth and Stewart Glickman of S&P Equity Research co-authored it.

The report shows that just 25 percent of the S&P 500 companies that repurchased stock during the study period outperformed the overall index. The other three-fourths would have done better buying index funds.

Further, more than a third paid more on average for their repurchased shares than their price this Sept. 30. Companies that bought back shares most aggressively often generated the worst market returns.

“We contend that shareholders need to more closely question the buyback activities undertaken by companies rather than blindly applaud such decisions by bidding up share prices,” the report states.

Repurchasers that fared best included, Freeport McMoRan Copper & Gold, Monsanto, Smith International and Schlumberger. Laggards included Circuit City, KB Home, Pulte Homes, Centex and Countrywide Financial.

S&P isn’t the first to criticize buybacks. Others have said they’re ineffective because companies give stock options to management and issue new shares at the same time they buy back old ones, leaving the overall numbers largely unchanged.

Some say dividends are a better use of company cash, especially now that investors are taxed just 15 percent on the payments. And many say buybacks are just a tool management uses to pump up the stock price.

All this is not to say buybacks don’t have their place. It makes sense for legitimately undervalued companies to buy back their own shares.

Also, the S&P study looks at the results of buybacks less than two years after the shares were repurchased. Stocks often stay undervalued for long periods of time. Perhaps in a few years the buybacks will have the intended effect. The report acknowledges that “analysis over a longer time frame may be warranted.”

But at the very least, the study should give investors pause when they consider buying a stock just because management is doing so.