Investing

Not All BuyBacks Are Created Equal

By John Del Vecchio  |  August 1, 2019

The key driver of this bull market isn’t revenue. It’s not earnings. It’s not profit-margin expansion.

The key driver of the bull market is share buybacks.

According to a study in the Financial Analysts Journal, nearly all of the market’s gains in this historic bull market can be linked to stock buybacks.

The problem is, not all buybacks are created equal.

You see, when companies buy back stock, management removes shares from the share count. Fewer shares means more earnings per share. The earnings per share, which Wall Street focuses on, went up. But nothing necessarily changed with the business itself.

Aggressive management teams can use buybacks to boost the earnings per share while wasting cash flow in the process. Meanwhile, the business itself remains in the dumps.

A Sinking Ship

IBM (NYSE: IBM) has been my poster child of wasting tens of billions of dollars to buyback stock in the face of a business in decline. The company is equivalent to the Titanic.

After the ship hit the iceberg.

After the orchestra started playing the music.

IBM’s stock price has bounced back a bit in 2019. But it’s still well under it’s highs, even as the broader market sets new records almost every day. And it’s well below where the huge buy backs — and billions of wasted dollars — started.

In a market that is richly valued by every traditional measure stick, you got to be a little skeptical about whether companies buying back a lot of stock are actually paying a good price for it. Is it a good investment or just accounting hocus pocus?

The accounting hocus pocus usually ends pretty badly…

So, I took a look at my Forensic Accounting Stock Tracker (FAST) software and ranked big companies based on shareholder yield. Historically, the best scoring FAST companies out-perform the market by several percent a year. Over time, that results in a big performance difference.

The Top Three Stocks

Focus on those companies that are buying back stock but that also have solid earnings quality, and your portfolio will thank you for it.

Aspen Technology, Inc. (Nasdaq: AZPN) — Aspen is a process manufacturing software firm. The company is a buy back machine. In just the last few years, management has bought back about 20% of the stock. The business gushes cash flow and capital expenditures are low. So, free cash flow is massive. Earnings quality are consistently high.

The risk of hocus pocus from management is low.

Of course, everyone else knows this too. The stock has been on fire in 2019. Even before this year, Aspen has been a major winning stock.

That said, it’s not all straight up. In the bloodbath last Christmas, the stock fell from $117 to $75. That was the time to back up the truck. Now the stock is trading around $137.

Aspen is a stock to keep an eye on during the next pull back.

Next is Target (NYSE: TGT). Like Aspen, management at the retailer has reduced the share count by nearly 20% in recent years. The company has stellar earnings quality. While Target has increased its investments dramatically, the business still produces loads of free cash flow.

A combination of successful store remodels and powerful online performance has rocketed the stock higher.

Target is a former recommendation in Hidden Profits. We made a tidy 30% profit in less than eight months.

Last is Emerson Electric (NYSE: EMR). The company is a 129-year-old industrial manufacturer. Clearly, not as sexy as Match Group (Nasdaq: MTCH), but you may not want to swipe left on this stock. It’s probably not going out of business anytime soon.

While revenues have slid, earnings quality is stellar period after period. The business is also overflowing with cash flow.

Meanwhile, management has bought back 15% of the stock in recent years.

Has that been a good trade?

While the stock is up year-to-date, it trades well off it’s highs. In this bull market, shares of Emerson are in the dog house.

Lots of companies are buying back their stock. And it’s not always a positive sign.

Focus on those companies that are buying back stock but that also have solid earnings quality, and your portfolio will thank you for it.

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John Del Vecchio

John Del Vecchio is the author of the bestselling book, Rule of 72: Compound Your Money and Uncover Hidden Stock Profits and What’s Behind The Numbers: A Guide To Exposing Financial Chicanery And Avoiding Huge Losses In Your Portfolio.

As the in-house stock market guru and forensic accountant for Dent Research, John stood on the shoulders of the great David Tice, James O’Shaughnessy and Dr. Howard Schilit, and built a framework of algorithms and a multi-factor grading system that has made him one of the more successful short-sellers around.

John is also the executive editor of our Hidden Profits newsletter and our trading service Small Cap All-Stars.

He graduated Summa Cum Laude from Bryant College with a B.S. in Finance and was awarded Beta Gamma Sigma honors. He earned the right to use the Chartered Financial Analyst designation in September 2001.MORE FROM AUTHOR