The Incredible Shrinking Stock Buyback

"Buy low, sell high" is a stock market mantra, but too often investors end up buying at the top of the market and selling at the bottom.

And new data on stock buybacks show U.S. companies have fallen into the same trap. According to Standard & Poor's, companies in the S&P 500 index bought back just $30.8 billion in stock in the first quarter of 2009, down 73% from a year before, even though stocks were arguably unbeatable bargains at the time. In March, the S&P 500 hit its lowest level in more than a decade.

By contrast, in the third quarter of 2007, when stocks were near their all-time peak, S&P 500 firms bought back a record $172 billion in shares.

Buybacks had become a wildly popular way for firms to reward shareholders. By buying shares and taking them off the market, firms can bolster their earnings per share.

But the recession and financial crisis forced companies to save cash even as their stock prices plunged. "The need to conserve capital in the current recession, combined with the uncertainty of future cash flow, has made buybacks too high-risk for most corporations," S&P senior index analyst Howard Silverblatt said in a statement accompanying the data's June 18 release. (Silverblatt is a contributor to BusinessWeek's Investing Insights blog.

ExxonMobil, Wal-Mart Buck the Trend

In the S&P 500, 83 firms stopped buying back stock entirely from the fourth quarter of 2008 to the first quarter of 2009, Silverblatt notes. And more than a quarter of all buybacks in the first quarter came from one company, ExxonMobil (XOM), which bought back $7.85 billion in shares. "The fourth quarter of 2008 and the first quarter of 2009 were in theory the perfect time to do buybacks because prices were depressed," said Scott Armiger, portfolio manager at Christiana Bank & Trust. "In practice, companies aren't buying back stock because they literally can't afford to."

Along with ExxonMobil, another exception to the trend of shrinking buybacks is Wal-Mart (WMT). On June 5, the retailer announced a plan to buy back $15 billion in shares. Wal-Mart also hiked its dividend 15%. "We remain committed to returning value to our shareholders through share repurchase and dividends," Wal-Mart Chief Executive Mike Duke said in a statement.

Stocks in the health-care and energy sectors cut their share buybacks the least last quarter, down 45% and 53% respectively in the last 12 months. By contrast, telecommunication stocks and utilities slashed buybacks to the bone, down 99.5% and 98% respectively year over year.

What's causing companies to end buybacks is, first, a drop in corporate profits that leaves companies less money to pay out, says Michael Sheldon, chief market strategist at RDM Financial Group. But even profitable firms are trying to save cash at a time when it's become difficult to borrow from banks or credit markets. "Many companies have suspended share buybacks to conserve cash in case it might be needed down the road," he says.

Many troubled firms are no doubt wishing they had saved cash from the previous years when they spent heavily on buybacks. With the subsequent plunge in stock prices, many of those buybacks now look like colossal wastes of money.General Electric (GE), for example, was forced to cut its dividend by two-thirds this year to cover losses at its financial division. The conglomerate bought back no stock in the first quarter of 2009.

Dividends Could Regain Favor

In the fourth quarter of 2007, however, GE spent $7.7 billion on stock buybacks. Since the beginning of 2008, those repurchased shares have lost 68% of their value, as GE shares dropped from above 37 to below 12. "You want to buy low and sell high," Armiger says. "On buybacks, [companies] were buying high."

"History will show that many of these large stock buybacks…reflected poor judgment and a bad use of cash," Sheldon says.

A key question is how much companies learn from the experience. Will they reward shareholders differently in the future? Sheldon believes companies may reemphasize dividends, because, he says, in uncertain times skittish investors prefer actual cash in their pockets to the indirect benefits of buybacks.

In 2004, before buybacks boomed in popularity, S&P 500 firms paid out roughly the same amount of buybacks and dividends. But buybacks jumped 228% from 2004 to 2007, to $589 billion. Dividends, meanwhile, rose only 36% in that time period. Buybacks were favored over dividends despite the fact that, in 2003, Congress and the Bush Administration lowered the tax rate on dividends to 15%, more competitive with capital-gains rates.

In the first quarter of 2009, the $30.8 billion in S&P 500 buybacks was exceeded by the $51.7 billion in dividends paid.

Vicious Circle?

Companies cautious about buybacks may be doing the right thing. The economic recovery, whenever it arrives, could be uneven. Firms may appreciate having an extra cash cushion.

However, companies' caution now raises the chances that when the economy does recover and buybacks resume, they could be buying back shares at the top of the market all over again.