Pay Attention to Share Repurchases

Every so often, a company will announce that it is buying back its shares. Management will proudly say that the company's shares are "undervalued" by the market and that buying them is a good investment.

Often, however, the real reason for buying back shares is different. Companies, such as Chrysler, may be the object of a hostile acquisition, and may want to get the shares out of circulation to maintain control. There are other reasons as well. Some companies might want to try to jump start their stock price. Managers at many companies have an incentive to increase the price of the stock because they are given options to buy it at a certain, price, usually higher than on the day the option was issued. When a company buys back it shares, it really wants to say to stock analysts and investors "hey, you're missing the boat on a good deal. We're buying our shares because we know something good is going to happen and you should too."

Another reason may be that the company can't or doesn't want to issue a cash dividend. By buying back the shares, the company increases the earnings per share of the stock, thereby providing some consolation to shareholders.

But buying back shares generally isn't an effective way to boost a company's stock price, according to a recent study by professors at Rice University, the University of Illinois and the University of Limburg in the Netherlands.

They found that the market "underreacts to open market share repurchase announcements." Buying and holding stocks that are being repurchased by the company only increase in value by an extra 12 percent over four years--pretty meager returns indeed.

But you really can make money off of certain share repurchase announcements. The professors found that repurchases made of stocks with high book-to-market ratios do pay off. The book-to-market ratio is a measure of how expensive a company's stock is. If a company has a high book-to-market ratio, that means that its assets per share are far higher than its current price per share.

The researchers found that firms whose book-to-market ratios are in the top 20 percent of all stocks and which announce that they are repurchasing their shares, enjoy an extra return of 45.3 percent over four years, quite a hefty additional return.

Firms with low book-to-market ratios that announce repurchases are blowing smoke into investors' faces; there are no gains associated with stock repurchases for the the 40 percent of stocks with the lowest book-to-market ratios.

Bottom line: when a company announces a stock repurchase plan, go to the library and check out what its book-to-market ratio is in the Value Line Investment Survey. If the ratio is high, check out the company further for possible investment. You might just pick a winner.

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