Buyback Champions

What's the big deal about stock buybacks? In a nutshell, they're one of the most direct actions a company's management team can implement for the benefit of shareholders. All else being equal, when a company buys back shares, investors own a bigger piece of the pie. To take a simplified example, let's say a company has 1,000,000 shares outstanding and you own 20,000 of those shares. That translates into 2% of the outstanding shares. If the company buys back 100,000 shares, reducing shares outstanding to 900,000, you now own 2.2% of the company, and that stake should be worth more.

Stock buybacks can also indicate that a company's management team is allocating capital wisely. It makes sense for management to use a company's extra free cash flow to fund new investments if there's a strong reason to believe the new ventures will generate above-average returns. But if the company's growth has slowed, allocating excess cash to share buybacks is a more prudent tack.  

Stock buybacks stand in direct contrast to the rampant dilution that has plagued the hardware and software sectors in recent years. This is particularly true for companies that have handed out generous piles of options to employees, such as  Cisco Systems (CSCO). Cisco's shares outstanding have steadily increased over the past 10 years, and the total number of shares outstanding is now 54% higher than it was 10 years ago.  Microsoft (MSFT)--which just announced that it plans to stop granting employee stock options--also has faced some dilution over the years, though the impact hasn't been nearly as severe.

Of course, buying back stock isn't a no-brainer. It's not a good idea for a company to buy back shares at an inflated price, because the returns on that investment are likely to be low (or even negative). It's also worth watching out for share buybacks if they're used to manipulate earnings. Reducing the number of shares means higher earnings per share, so it's worth making sure that the company isn't trying to engage in manufactured growth. And now that dividends and long-term capital gains are taxed at the same rate, some companies will probably use their excess cash to pay dividends instead of buying back shares. 

On balance, though, share buybacks are beneficial more often than not. For this week's Five-Star Investor, we started by using Morningstar's Premium Stock Screener to find companies that have reduced the number of shares outstanding in each of the past five years. By consistently buying back shares, these firms have shown that they're committed to using capital to benefit shareholders. But we also wanted to make sure that companies that made the final cut would have the resources to continue buybacks in the future, so we also required them to have free cash flow on hand equal to at least 5% of their market capitalizations. 

Here are some of the highlights.

 Altria Group (MO)
Business Risk: Average
Economic Moat: Wide
Morningstar Rating: 4 Stars
From the  Analyst Report: "Altria is a cash machine. It generated $7 billion in free cash flow in 2001 and $10.6 billion in 2002, despite the problems plaguing its Philip Morris USA unit. In 2002 it sold struggling Miller Brewing to South African Breweries, creating a $1.7 billion windfall that it used to accelerate its share-repurchase program. Yet its stock price does not reflect those positive fundamentals because of the competitive and legal challenges the company faces."

 First Data 
Business Risk: Below Average
Economic Moat: Wide
Morningstar Rating: 4 Stars
From the  Analyst Report: "First Data boasts dominant market share, defensible competitive advantages, and large, recurring cash flow. Given these characteristics and the firm's below-average business risk, we'd pick up the shares at a 20% discount to our fair value estimate."

 Gillette 
Business Risk: Average
Economic Moat: Wide
Morningstar Rating: 3 Stars
From the  Analyst Report: "We continue to believe that the razor-and-blade business is the true gem of Gillette's operations. However, a lot of the company's financial excellence is masked by underperforming business units. We'd pick up shares in the mid-$20s."

 UnitedHealth Group (UNH)
Business Risk: Below Average
Economic Moat: Wide
Morningstar Rating: 3 Stars
From the  Analyst Report: "UnitedHealth's financial statements reflect its strength. During the past four years, the company increased operating margins from 3.7% to 7.9%, while increasing returns on invested capital from 10.1% to 18.5%. During that same period, operating cash flow was almost 2 times net income, and the company's modest reinvestment needs allowed it to return more than $3.7 billion to shareholders through share repurchases. Now that the company's technology infrastructure is largely built, we expect even lower reinvestment during the next few years."

To run this screen yourself and see all the stocks that passed, click  here. (Note: You will need to be a Premium Member to view and save the complete screen.) After clicking, you can save the search by using the "Save Criteria" button in the bottom right-hand corner of the screen.