Information Arbitrage: Et Tu, WSJ? Another Mistaken Missive on Stock Buybacks

Not a week goes by these days without some commentary on the "evils" of stock buyback programs, and, on occasion, I just can't take it any more. Well, this is one of those days. Barely two weeks have elapsed since I wrote a somewhat harsh critique of the New York Times coverage of this topic, and today I read a column in the Wall Street Journal that has once again sparked my ire. Come on, folks, is it just me or do mainstream media columnists simply have it in for public companies? One might think so based upon the title of today's Ahead of the Tape column, Self-Serve in the Boardroom. Let me say in advance that most of what's reflected in this column is factually correct, and some of the data actually somewhat interesting, but the shallowness and thrust of the piece is what I object to. And I'll tell you why.

The entire column is provided here:

This year's buyout boom means companies and private-equity funds are gobbling up corporate shares like never before. But the buyback boom is having a huge -- and less noticed -- impact.

Buybacks aren't always what they seem. A company might throw confetti for its share repurchase plan with one hand while issuing shares with the other.

In this case it has led to a substantial reduction in overall number of shares outstanding. Reduce shares outstanding and earnings per share -- the usual way of looking at profits -- goes up. Over the past four quarters, Exxon Mobil took its share count from 6.3 billion to 5.9 billion. While its total after-tax income in the third quarter, at $10.5 billion, was 6% above last year's $9.9 billion, its earnings per share of $1.77 was 13% higher than $1.57 last year.

Exxon isn't alone. The past year's buybacks have boosted year-over-year earnings per share growth by four or more percentage points at nearly a quarter of the companies in the S&P 500, according to Standard & Poor's senior index analyst Howard Silverblatt.

Investors tend to look on buybacks favorably, often seeing them as an efficient way to return value to shareholders. Insofar as earnings per share are higher, and therefore price-to-earnings ratios are lower, there is a lot to like. That is especially true now, when companies have plenty of excess cash to distribute.

At the same time, investors need to be careful to avoid mistaking earnings-per-share growth from buybacks for actual earnings growth. When buybacks slow, as they inevitably will, what's left of earnings per share could be a big disappointment.

Now I am not sure exactly whom the WSJ considers its constituency, but the level of this story presumes little or no sophisticaton as it relates to financial analysis and investment. If this story could be summarized in four words (which, in fact, it can), it would be "Don't rely on EPS." Oh, really? Who that is investing money, either their own or others, relies on EPS as the metric for corporate performance? Anyone who is relying on EPS to make investment decisions certainly isn't reading the WSJ and absolutely shouldn't be investing anyone's money.

And the premise that large corporations like Exxon are implementing share buybacks with the explicit goal of increasing EPS is just a bunch of garbage. It's just not true, especially at a corporation like Exxon. These treasury departments are very smart. I know because I spent many years advising them on corporate finance and risk management policies. They understand the trade-offs among ongoing stock buyback programs, self-tenders, regular dividend policy and special dividends. Further, they internalize two key tenets: first (1) provide the financial resources and the stability necessary for the operating business to thrive; and then (2) work to minimize the cost of providing these resources through intelligent capital structure decisions.

That said, are there dirtbag companies that have EPS-driven executive compensation programs and who undertake stock buybacks because they mathematically know it will increase EPS? Invariably there are. But I don't believe they are in the majority and I don't believe an investor should paint the market with a broad brush and say "buybacks are manipulative." They are a legitimate and appropriate element of corporate finance policy, and arguments to the contrary simply fall flat.

But this is neither here nor there relative to the key question - who really cares about EPS? Isn't what we, investors, really care about After-tax operating cash flow, adjusted by capital expenditures? Doesn't it make more sense to first value the business, and then to take into account capital structure? How can you do this if you are staring at GAAP EPS? Answer: you can't.

Does anyone remember IBM in the early 1990s before Lou Gerstner took over? That company was dead in the water. An emphasis on hardware (which is a war they were losing). A large (but not large enough) services and software business. Warring factions with little cooperation across key verticals. Cash being wasted on stupid projects. It was a mess. So what did Lou do? De-emphasize hardware. Invest in software and services. Streamline the sales organization. Cut unnecessary costs. Buy back stock with excess capital. Anyone remember what happened? Shareholders equity plummeted due to restructuring charges and stock buybacks. Stock price skyrocketed because the business was being run more efficiently on a smaller capital base. This was first and foremost a "fix the business" story followed by an "optimize the capital structure" story. So, at the end of the day was this a good story or a bad story? Answer: a good story.

I appreciate the goal of educating an uneducated body, but a column like this in the WSJ strikes me as sensationalistic and irrelevant. Maybe it is more appropriate for People magazine?