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What Buffett's buyback says to investors

Warren Buffett launched a share buyback program at Berkshire Hathaway Inc for the first time in 40 years that poses the question of how best to deploy the cash a profitable company generates and how investors might respond.

September 28, 2011 / 02:37 PM IST

The Issue: Warren Buffett launched a share buyback program at Berkshire Hathaway Inc for the first time in 40 years that poses the question of how best to deploy the cash a profitable company generates and how investors might respond.

Investors and corporate management often are at odds over what to do with a company's free cash flow -- the money left over after all the bills are paid.

Management can do four things with free cash flow: acquire another business, reinvest in their company through capital expenditures, raise the dividend or buy back shares.

Companies that make up the benchmark Standard & Poor's 500 Index will end the third quarter this week with close to USD 1 trillion of cash on hand. About 350 of the 500 companies in the index typically conduct buybacks every quarter.

Investors and their advisers have similar choices on what to do with their money. Here are ideas from investing experts:

Pinpoint companies, not buybacks

Buybacks garner a lot of attention because they often involve billions of dollars and can spark a good bump in a stock price. Shares of Berkshire Hathaway jumped 8 percent on Monday when the stock repurchase was disclose.

Anyone looking to invest in potential buybacks might consider Berkshire's story. They could have waited four decades for that one-day pop. Or they could have bought USD 10,000 worth of Berkshire stock in 1962 that would be worth USD 80 million now.

"It's not a viable investment strategy just to go for companies that could buy back stock, that's a trading strategy," said Paul Atkinson, head of North American equities at Aberdeen Asset Management Inc.

"What you're looking to do is look for companies with a strong balance sheet and excess capital and ask the question 'How do they intend to use it?'" he said.

Investors should not just look for cash bundles in corporate coffers, said Jim O'Shaughnessy, a well-known investor who runs O'Shaughnessy Asset Management in Stamford, Connecticut.

O'Shaughnessy favors large-cap stocks with a solid balance sheets, robust earnings and attractive valuations. "This combination of factors has historically outperformed the market," said O'Shaughnessy, author of the best-seller "What Works on Wall Street."

Stocks that meet this criteria and in which his firm has positions include Gap Inc, DirecTV Group and Travelers Companies Inc, O'Shaughnessy said.

Dividends preferred

To be sure, investors like dividends, Atkinson said, although many companies believe their shareholders prefer stock buybacks. Ultimately, he would like a company that puts their cash to the best use.

"We do not screen for stocks to identify potential buyback candidates," O'Shaughnessy said. "Our research shows that cash-rich companies are not necessarily attractive investments historically."

How to analyze and decide what to do with companies that hold large amounts of cash is widely discussed on Wall Street.

A prime example is Apple Inc, whose spare USD 75 billion has led to calls for a buyback or dividend.

"It's hard to conceive how (it) could possibly spend that much cash in reinvesting in their own business," said Robert McConnaughey, who helps oversee about USD 100 billion as head of equity at Columbia Management in Boston.

"You look back over history because bad decisions with capital or good decisions with capital make all the difference in the world," McConnaughey said. Indeed, studies suggest, "corporations are terrible timers of buying back their stock."

Dividends are longer-term commitments, he said. "The nature of a repeatable program, the reliability of that and what that says about management's confidence in their own business is different than a one-time purchase."

Management holds the key

It's a mistake to think of a company as an automated teller to tap for cash needs. Instead, investors should buying a company's ideas and products -- in short, its management.

"You have to be confident they will do the right things with that cash," said Todd Bassion, a portfolio manager at Delaware Investments in Boston.

"Companies like Cisco are sitting on huge cash piles. But they've been criticized in the past for doing M&A and over-spending on the deals," he said. Moreover, the cash is held abroad and returning it to U.S. holders would generate tax.

Dell Inc meets the strong balance sheet criteria and has a history of returning earnings to shareholders, Bassion said.

"If you get that formula, you have a pretty good recipe for success," he said.

Dell has USD 16 billion in cash, only has USD 8 billion in debt and over the past 12 months has generated USD 5 billion in free cash flow, the size of a buyback program it announced two weeks ago. The stock also trades at just 8 times earnings, he said, so the can prudently carry out the buybacks.

Bassion cites CGI Group, the largest technology outsourcing and consulting company in Canada, as good model.

"Almost every deal they've done historically has been a good M&A deal. When they don't find the M&A they give the cash back to you," Bassion said.

first published: Sep 28, 2011 03:45 am

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