Come down from stock-buyback high: Financial advisor

Let me just start this by saying thank you to all those corporate chieftains for the lovely returns over the last six years. Bravo. You rocked it, and my investors and I greatly appreciate it. We toughed it out through the Great Recession, stuck to our investments, and we are richer for it. You chieftains capitalized on the financial engineering gravy train like no one's business—you became the biggest buyer of your own stock.

In fact, this past April saw U.S. companies announce $141 billion worth of stock buybacks, a new record for a single month. According to Birinyi Associates, the single biggest factor for keeping this bull market alive and well has been stock buybacks, even as investors have been net sellers of U.S. stocks this year.

Spencer Platt | Getty Images

But here's the catch: A great amount of buybacks over the last six years—reaching into the trillions of dollars —have been funded with low-cost debt. Even mighty Apple went from zero to $50 billion of debt in just the last two years to fund its massive stock buyback.

With longer-dated borrowing rates suddenly on the rise, making buybacks more costly, the buyback spigot, I think, will slowly turn counterclockwise and start to turn off. I consider this to be the greatest risk to the stock market. It also leads to the next big buying and selling decision for stock investors.

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You should position yourself to be ahead of the curve on this one.

My real issue is not the buybacks in and of themselves. My concern is that they are stealing value from tomorrow's shareholders because they take away from value created through research and development. Going back to Apple, the company had two near-death experiences many years ago. And as IBM shareholders surely realize, buybacks cannot overcome investor skepticism when there is a perception that a company is behind the times.

"Like most investors, CFOs are lousy market timers."

Companies can never rest on their laurels. They have to keep reinventing themselves in order to stave off competition from both large and smaller upstart competition. Or as Andy Grove, former CEO of Intel, said, "Only the paranoid shall survive." A company's cash is its fuel for research and development, and its R&D is its fuel for future cash flow.

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Another issue is the timing of buybacks. Simply put, as the market has traded higher since the March 2009 bottom, buybacks increased. Sure, that is because corporate bank accounts have grown a lot, but maybe some of that buyback money could be used a little more opportunistically. Like most investors, CFOs are lousy market timers.

One more issue—which will get me some pretty harsh hate email for pointing out—is that I have noticed that CEOs of companies that initiate stock buybacks are baby boomers and older.

I can accept that. After all, if you are a CEO facing retirement in just a few years and you had an opportunity to invest $5 billion into R&D—that may or may not pan out five years from now, or $5 billion for a buyback that provides an instant pop in your stock options—I'm confident saying the buyback will usually win. And of course, I believe in the freedom of the private sector! I also believe in my freedom to invest in companies that I think will have lots of growth coming their way well into the future.

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When considering a stock for the long term from a buyback perspective, though, do you want:

1. A company that will have "buyback" debt that benefited former shareholders and that could become an impediment to its ability to compete due to a lack of spending on R&D?

Or

2. A company that has a strong balance sheet and has the potential to be a great competitor because it spent a lot of money on R&D?

I'll pick No. 2.

To be sure, I think companies still have time and room for more buybacks, and that should help mitigate short-term corrections, but in the long term, I want to invest in companies for their future earnings power, not for their lower share count.

Selling the buyback high

Going forward, I sense that my source of funds for new positions will be from selling buyback winners. So what are a few examples of businesses and/or sectors that are investing in R&D?

Health care, technology and consumer discretionary are the three primary sectors that I want to pick and choose from for my new potential R&D winners. Caveat emptor: Companies that are heavy R&D spenders are also the ones that have high P/E ratios and, by their very nature, are often the more volatile names during turbulent market conditions.

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Many biotech companies reinvest heavily into R&D, although this sector may be a little too binary for many investors. Many high-quality growth companies may be considered too richly valued for many investors. But investing in R&D is ultimately the force that leads to long-term success.

The decision for investors ultimately comes down to the value (using cash flow for buybacks and dividends) vs. growth (reinvesting cash flow back into the business) investing styles. I advocate employing both. But in the long run, I anticipate that today's R&D spenders will potentially become tomorrow's buyback winners. And the happy cycle will go on.

By Mitch Goldberg, president of ClientFirst Strategy, an investing firm

@Mitch_Goldberg

Read more from Mitch Goldberg on the markets and investing.