Why stock buybacks have become a big yawn

In late July, CBS (CBS) announced that it was increasing the size of its share repurchase program to $6 billion. Yet its shares fell 2% in their first day of trading following that announcement, and today are slightly lower.

This reaction is surprising, since announcements of share repurchases — also known as buybacks — used to cause prices to jump. In the 1980's and 1990's, for example, the average stock outperformed the market for up to three years following a buyback announcement.

To be sure, stock prices are affected by many factors besides share repurchase programs. But in CBS’ case there is no obvious explanation for its disappointing recent performance. On the day the company announced the increased buyback program, for example, it also reported second-quarter revenue and earnings above Wall Street’s expectations and a 20% increase in its dividend.

Regardless of the specific reasons why CBS shares didn’t respond favorably to its recent buyback announcement, however, it’s not particularly surprising, according to research conducted by Neil Pearson, a finance professor at the University of Illinois at Urbana-Champaign. In a study that’s been circulating in academic circles, he and fellow researchers report that, in recent years, fewer than half the companies that are the focus of buyback programs proceeded to beat the market following their announcements.

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Because this recent experience stands in stark contrast to the typical experience in the 1980s and 1990s, he and his co-authors concluded that something must have changed. They are unsure what that something is, however.

Gautam Mukunda, though, a professor of organizational behavior at Harvard Business School, says he is “extremely unsurprised.” He argues that share repurchase programs have become a favored way for executives to engage in short-term financial engineering. Essentially, it's not surprising that the market would “wise up” that such engineering does nothing to promote a company’s long-term value.

This discussion puts in a different light the recent criticism of buybacks from a number of quarters — including by Democratic presidential nominee Hillary Clinton, who has complained that firms pursue buybacks only to please activist hedge funds. Yet firms will have less of an incentive to repurchase their shares as the market wises up to what buybacks really signify. And that in turn would mean the market, on its own, has in large part already fixed the problem.

This may be why buyback activity has fallen to a multi-year low. Buybacks are running at half the year-ago pace and have fallen to the lowest rate since 2012, according to TrimTabs.

Note carefully that, even if buyback stocks in the future don’t significantly outperform the market, there is no reason to expect them to lag either. But, unlike what was the case a couple of decades ago, you will have to be increasingly choosy in selecting buyback candidates that truly represent good long-term value.

David Fried, editor of an investment newsletter called The Buyback Letter, is a source of advice in this regard. His model portfolios of selected buyback stocks have beaten the market over the last two decades, according to my tracking of his service, though by less in recent years than in the late 1990s and early aughts.

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His latest recommendation is a good illustration of his selectivity: It was to purchase Two Harbors Investment Corp.(TWO), a real estate investment trust. It’s been six months since the company announced an increase in its share repurchase program, showing that he doesn’t automatically buy a stock when such a program is announced. His decision instead was the result of applying a number of traditional valuation indicators.

If the trends of recent years persist, then those valuation indicators will take on increasing importance as investors decide which buyback stocks to purchase.

Mark Hulbert, founder of the Hulbert Financial Digest, has been tracking investment advisers' performances for four decades. For more information, email him atmark@hulbertratings.comor go towww.hulbertratings.com.