The Dirty-Little Secret Behind Corporate America's 'Buyback Frenzy'

By: Christian Hudspeth of Street Authority

Corporate America's "wealth giveaway" continues.

Ever since America's largest corporations hunkered down and began hoarding unprecedented amounts of cash to protect themselves in the aftermath of the 2008 financial crisis, investors have been hounding companies to put that money to work.

Fortunately for investors, companies have responded. But not in the way you might expect.

You see, rather than putting their cash to work through expanding product lines, opening more stores and investing for growth, many large companies have been rewarding shareholders through record amounts of dividends and share repurchases.

For the most part, this is good news for investors. But there's a hidden element to share about buybacks that you need to be aware of... because behind the scenes some companies are actually using this effective tool to erode shareholder wealth.

Let me explain...

As we've pointed out several times in StreetAuthority Daily, share buybacks are clearly in style. Corporate America uses this technique to boost stock value to reward shareholders, and it is being favored even above dividends.

In fact, since 2009, the largest 500 companies in America have increased buyback spending by 245% -- compared to just 60% growth in dividend payouts since then, as you can see in the chart below.

And this buyback trend isn't slowing down. In the first quarter of 2014, SP 500 companies spent a whopping $159.3 billion buying back shares of their own stock. That's nearly twice what they spent on dividends and just below the $172 billion high set in Q3 2007 before the financial crisis and market crash.

This isn't a bad thing -- share buybacks can be one of the single most effective value-boosting measures a company can take to reward shareholders.

As Nathan Slaughter -- our resident expert when it comes to buybacks and income investing -- explained in an earlier issue of StreetAuthority Daily:

In other words, if you're invested in a company that reduces its total share count through stock buybacks, your shares become more valuable. And more valuable shares typically translate into stock gains. (Nathan shows several examples of this in his latest "Total Yield" research.)

But be warned: Just because many large U.S. companies have been repurchasing shares doesn't mean they all have the best of intentions for their shareholders.

There's a buyback trick that large corporations have been trying to pull on investors simply to make their stock look good in the headlines... with the sole intention to luring money from less-informed investors.

It's a type of "window dressing" on financial statements that could prove to be dangerous for shareholders down the road.

Buybacks boost a company's earnings per share. So, many large companies with stagnant or falling revenues in previous years have been using share buybacks to inflate their profitability image.

Take International Business Machines (NYSE: IBM) for example. The legendary company has been the poster boy of buybacks for years now. Since 2010, IBM has purchased 200 million of its own shares, shrinking its count a whopping 16% from 1.29 billion shares to 1.08 billion shares today.

But at the same time, the company's annual sales have stayed flat over the past four years. In fact, the company's revenue over the past 12-months are actually lower than they were in 2010 -- $98.8 billion now compared to $99.8 billion in 2010.

The value added per share from these buybacks have no doubt made some shareholders happy, at least for now. But it remains to be seen if investors will remain optimistic with large companies like these that aren't actually growing their top lines -- buybacks or not.

Nathan also recently shared another story involving the parent company of job-hunting website Monster.com -- Monster Worldwide (NYSE: MWW). One of his readers was attracted to the stock, noting that the company has bought back 25% of its own shares over the past year.

But as Nathan explained to his readers, it's about far more than just buybacks:

Once upon a time, Monster was a disruptive force. Millions of jobseekers and recruiters relied on the firm's popular website to peruse job openings and fill positions.

But something clearly sidetracked the company's growth plan and sent it careening into a ditch. You'll note that the stock, which peaked during the 2000 dot-com mania, has since lost more than 90% of its value. That drop coincides with a stunning deterioration in traffic, sales and other key business metrics.

Revenues have plummeted to just $800 million last year from $1.3 billion in 2008...

The share repurchases, while commendable, only generate economic value if they are transacted at prices below the firm's intrinsic value. That value, which is linked to Monster's future cash flow generation, is hazy at best right now.

Nathan gives a parting word of advice: "I'm reminded of the words of Warren Buffet that turnarounds seldom turn... stock buybacks could help bail out the sinking stock, but ultimately that won't matter if the craft isn't seaworthy."

Bottom line, always remember that buybacks are great, but only if they come from a company that has a growth plan and is ultimately enhancing shareholder value -- and not simply trying to attract the attention of foolish investors that follow flashy headlines.

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