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Stocks & Bonds

Be Skeptical of Stock Buybacks

They don’t necessarily guarantee higher share prices for investors.

Berkshire Hathaway recently made headlines when it began buying shares of its own stock for the first time in company history. Berkshire is far from alone. Stock-repurchase programs have hit near-record highs, with buyback authorizations on track to reach $540 billion this year, according to Birinyi Associates. That would make 2011 the third-best year for buybacks.

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The argument in favor of share repurchases goes like this: When a company buys and then retires outstanding shares, it drives up earnings per share and, in theory, should boost the share price. A buyback gives existing shareholders a larger cut of the profits, and hints to those thinking of purchasing new shares that company executives—the classic insiders—think their stock is undervalued.

But buybacks don’t always follow that mutually beneficial course. Some businesses stretch programs out for years, reducing the chances they’ll reach completion. Companies may wind up overpaying for their own stock. A buyback could have more to do with countering the dilution that accompanies issuing stock options to executives than with rewarding shareholders. Finally, critics argue that businesses should be reinvesting in the company or giving cash directly to shareholders by paying or raising dividends.

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These days, companies have to answer for cash hoards earning next to nothing. And companies don’t want to have to cut a dividend they can’t sustain, or lay off workers in a ramped-up business that stalls later on. Still, when corporate press releases gush about a buyback, savvy investors should approach the announcement with a healthy dose of skepticism.