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Why stock buybacks often end up disappointing

Some companies can't seem to get enough of themselves, buying up their own stock even when it isn't a great deal.

Although one of the main justifications for stock repurchase programs is that management thinks its own stock is undervalued, some companies have tended to buy at all the wrong times. Buybacks are a popular method to return excess cash to shareholders because the moves are considered less permanent than dividends and often inflate stock prices and earnings per share by removing shares from circulation.

But about two-thirds of the companies in the Dow Jones industrial average would have been better off simply investing their extra cash in an S&P 500 index fund, which would have grown more than their own stock did in the quarters after they bought and retired shares.

Take Caterpillar, for example: the company has bought almost $15 billion of its own stock over the last decade (excluding the stock it sold again in the same quarter). The biggest buyback round so far was in the last quarter of 2014 for $2.5 billion, when the company's stock was near all-time highs.

Today, that stock would be worth about 30 percent less (a loss of more than $700 million), while the S&P 500 has stayed about even since that quarter. Caterpillar bought itself at market peaks, as research suggests companies often do when pursuing buyback programs. But buying at peaks is, of course, not an investment strategy that most people would recommend.

It turns out that in the 20 quarters in which Caterpillar bought back its own stock in the last 10 years, the return never once beat an investment in the S&P 500 that quarter. All that stock it bought is worth 5 percent less overall today, while buying the S&P at its average price in those quarters would have given almost a 30 percent return.

"Over the long term (10-20 years) our stock has performed well," a spokeswoman for Caterpillar said in an email. "We are a cyclical company and currently in a down cycle."

The company's top priority for cash use is maintaining its strong balance sheet and credit metrics, followed by research and development and other growth initiatives, pension funding and a sustainable dividend, the company official said. Caterpillar increased its dividend by 10 percent in 2015 and 17 percent in 2014.

"Stock repurchase remains the last priority for the use of cash," the official said.

For other companies, buying their stocks seem to have been an excellent move. Home Depot's investments in its own stock would have beaten a similar purchase of S&P 500 stock more than 80 percent of the time. That stock more than doubled in value, more than four times the return from the market during those periods.

Home Depot's biggest buyback was at the end of 2007, when it invested more than $10 billion. That was good timing — the share value rose consistently after that. The company did not respond to requests for comment for this report.

Nike's strong performance over the last decade made its stock buybacks the best investments of all. That didn't seem to be a result of timing the market so much as it was an escalating buyback strategy.

If Nike stock was to tank suddenly in future quarters, it could be that the company is buying its own stock at a market high right now. In quarters with positive net buybacks over the last 10 years, Nike has repurchased a total of almost $13 billion, more than $5 billion of which was in the last two years. Nike did not respond to a request for comment.

Research suggests that buybacks can cause a short-term bump in a company's stock, but the long-term impact is less clear. According to a recent look at the numbers, companies that don't do buybacks seem to have better performance years later.

As Goldman Sachs and others have pointed out, the historical evidence shows that companies as a group tend to buy their own stocks at market highs rather than market lows — the time when they're more likely to actually be undervalued.

"We recognize activist investors often advocate for firms to return excess cash to shareholders via buybacks," Goldman's chief strategist, David J. Kostin, and others said in a June 2015 note to clients. "Tactically, repurchases may lift share prices in the near term, but in our view it is a questionable use of cash at the current time when the P/E multiple of the market is so high."

Goldman itself doesn't seem to have a great track record of following its own advice, according to FactSet data.

To be fair, the banking industry may have its own reasons to find buybacks appealing. Stress test rules and the recent financial crisis may have encouraged banks to seek out the flexibility of buybacks over the "stickiness" of dividends. Goldman Sachs declined to comment for this story.

Whatever the reasons, buybacks are near historical highs and there are concerns that those popular repurchase programs could come at the expense of internal investment. Time will tell which companies are using their resources wisely and which are throwing good money down the drain.