Despite Harsh Words from Critics, Share Buybacks Remain a Great Way to Boost Earnings and Share Prices

You might know Herb Greenberg, an often quoted columnist for MarketWatch and a frequent guest on CNBC, as someone who focuses on telling the bearish story on the market. Although I'm about to refute one of Herb's recent blog posts entitled "AutoZone: Sustainable Model?" regarding auto parts retailer AutoZone (AZO), I will admit that there are not enough people out there telling people what could go wrong. Wall Street is too often about selling stocks to people, and with that comes a bias toward making the bullish case for an investment, not the bearish one. Although betting against stocks stacks the odds against you, Herb makes it his duty to tell the other side of the story.

In the case of AutoZone, here is what Herb had to say about the company on May 22nd:

"Earnings per share beat estimates, yet again, thanks to buybacks. Who cares about sales missing estimates? Who cares about sales per square foot that are either down or flat year-over-year for 12 consecutive quarters? Or inventory turns at a multi-year lows? Or sliding sales per store? Or continued weak same-store sales? All that matters, in a buyback story, is earnings per share. "The point," says one longtime skeptic, "is whether that's a sustainable business model. Anybody can do this for some finite period of time, but only the 'productivity loop' (as exemplified by Wal-Mart in its heyday and others) has proved sustainable."

Herb does have his facts right, AutoZone has not been greatly improving their sales or inventory turns for a long time. However, when trying to judge the merit of a bearish argument, you have to ask, does any of this stuff matter? From reading Herb's post, it is obvious that he, as well as the long-time skeptic he quotes for the piece, believe that it does matter in terms of the future for AutoZone stock.

Noticeably absent from the piece, however, are any reasons why sales, sales per square foot, inventory turns, sales per store, and same store sales do matter, or why share buybacks are bad. He simply states that a business model that focuses on buybacks, and not sales or inventory, is not sustainable. There is nothing there that explains why it isn't sustainable. Why may that be?

If you do some digging into AutoZone's financials over the last fifteen years, you will see that the model is sustainable. The company has been focusing on stock buybacks since 1999. This year will mark the ninth straight year that choosing buybacks over sales growth has worked for them. The argument that the model isn't sustainable simply does not hold water because the evidence, which I will detail below, points to the contrary.

Now, why has the model worked? Why has it proved wise for AutoZone to reinvest excess cash into its own shares rather than new stores, or other projects focused on traditional retail metrics? Because buying back stock will boost AZO's earnings more than opening a new store, or implementing new inventory management software will. And when it comes to getting your share price higher, earnings are what matters, not sales, or comp store sales, or sales per square foot, or inventory turns.

Herb writes "All that matters, in a buyback story, is earnings per share." That is only partially correct. All that matters, in the stock market, is earnings per share. Stock prices follow earnings over the long term because owning a share of stock entitles you to a piece of the company's earnings. Not sales, but earnings.

Let's take a look at AutoZone in more detail. The company's history since its IPO in 1991 tells two distinctly different stories. From 1991 through 1998, AutoZone focused on traditional retail metrics, the ones Herb and his skeptic friend believe are important when evaluating a stock's investment merit. During that time, sales compounded at a growth rate of 22 percent per year, with same store sales averaging 8 percent growth. Stock buybacks were not used, resulting in total shares outstanding rising each and every year due to option grants.

However, in 1999 AutoZone began to focus on stock buybacks, an effort that was very much an idea from a relatively unknown hedge fund manager by the name of Eddie Lampert, who had begun to amass an investment position in AutoZone stock. Lampert understood the retail sector well, and knew that industry experts loved to focus on same store sales and other metrics like that. But he also knew that such metrics had very little correlation to stock market performance, and as an investor, that is all he really cared about.

As a result of pressure from Eddie and other investors, Autozone began to implement a consistently strong buyback program. Total shares outstanding peaked in 1998, fell year-over-year in 1999, and have fallen every year since. Not surprisingly, with a new focus on share buybacks, there was less cash flow left over to improve store performance in ways that would be reflected in same store sales, sales per share foot, and inventory turn statistics. Not surprisingly, since 1999 sales have only averaged 8 percent growth per year, with same store sales compounding at a 3 percent rate. Both of those are far below the levels achieved before the buyback era began at AutoZone.

So the punch line of course lies in what happened to AutoZone stock during these two distinctly different periods. Herb Greenberg and other long-time skeptics would have you believe, without evidence to support their claims, that sales and inventory matter to Wall Street. I am writing this to prove to you that such arguments are wrong.

AutoZone's stock ended 1991 (the year of its IPO) at $10 per share and reached $26 by the end of 1998, for an increase of about 150 percent. The buyback program reduced share count for the first time in 1999 and today the shares fetch $127 per share, an increase of about 390 percent from 1998. How could this be the case if sales growth and other metrics of retailing health were so much stronger in the earlier period?

The answer lies in the effects of the buyback program. Share count peaked in 1998 at 154 million and now sits below 70 million. So, if you bought 10% of AutoZone at the end of 1998 and held those shares until today, you would now own 22% of the company, without buying a single additional share. And although AutoZone's sales growth has slowed in recent years, the company is still larger now than it was then, so shareholders not only have seen their ownership stake more than double, but the entire company is worth more today than it was in 1998.

Hopefully this explains why retail metrics like sales don't really matter when it comes to share price appreciation. Earnings are all that counts, not just in a buyback story, but in any story involving the stock market. I believe Herb when he characterizes his source as a "long-time skeptic" of AutoZone. He likely has been bearish on the company ever since they decided to put buybacks ahead of sales on their priority list eight years ago. However, the skeptics have been wrong for many years and the reason is pretty simple; the buyback model has proven to be quite sustainable.

Full Disclosure: No position in AutoZone at the time of writing

AutoZone vs S&P 500 Since Market Peak in March 2000

Market Fails to Dismiss Double Top Scenario

About a month ago I mentioned that it was possible the market could find resistance near the old highs on the S&P 500 index and perhaps make a seven-year double top. Interestingly, yesterday marked the third straight day the market could not register a new closing high on the S&P 500 (1,527 and change).

I'm not really into short-term market predictions (You're better off just flipping a coin if you want to know what will happen in coming days), but we are setting up for a near-term top unless we can break through this level. Oddly, the all-time intra-day high is above 1,550. That must have been a wild day back in March 2000.

Here is what the last decade looks like on the SPX:

Tip: When Engaging in Insider Trading, Be Discreet!

Evidently a Hong Kong couple thought the rest of the world was asleep. Listen to what they did before their brokerage accounts were frozen, preventing them from pocketing an estimated $8.2 million. Tell me if you think their broker, Merrill Lynch (MER), might catch on that something was a bit suspicious.

In early April the couple's account was worth $1.2 million, consisting of mostly fixed income and commodity investments, along with a small position in Intel (INTC) stock. All of the sudden, they wire $10 million into their account and borrow $5 million on margin to buy 415,000 shares of Dow Jones (DJ) for an average price of $35.14 per share.

Just days later Dow Jones gets a $60 cash offer from News Corp (NWS) and the couple tries to sell all $23 million worth, netting a profit of $8 million. How on earth do people really think Merrill Lynch isn't going to notice this? Regulators often do investigations after M&A deals are announced to try and uncover illegal activity, but this case was handed to them on a silver platter.

It will be interesting to see what happens to these people. I hope they get the book thrown at them. Perhaps a copy of the insider trading laws would be a good start.

Full Disclosure: Long Intel $10 2009 LEAPs at the time of writing

Dow Winning Streak Longest in 80 Years

It has truly been a breathtaking run, with the Dow Jones Industrial Average rising in 24 of 27 sessions, the longest streak since eight decades ago in 1927. Unfortunately, Tuesday's four point drop snapped the streak. How should investors play this? Many are stuck between two prevailing ideas, either ride the momentum to ensure not missing it, or wait for a pullback and buy on the dip. The problem is, there aren't any dips. We got a 7 percent correction a couple months ago but it was so short-lived that many didn't have time to get back on the train before it left the station again.

I am sitting on an above-average amount of cash right now, due to an overbought market that I am uninterested in chasing, coupled with a seasonal inflow of deposits. Since I'm a value investor, not a momentum trader, I am content with sitting on cash and waiting for an excellent opportunity. With the broad market rallying so strongly, such a dip might only occur in select names, as opposed to a widespread sell-off that makes many stocks compelling.

Why not just get my money in when short term momentum is strong? There are far fewer bargains now than there were six months or a year ago. Although I might miss some upside in the short term, due to above-average cash positions during a long winning streak, I still believe that buying dips and not rallies will prove to be more profitable when we look back a year from now.

The result could be lagging returns in coming days and weeks, but when we get another pullback and I have the ammunition to jump at true bargains, those purchases will more than likely make up the lost ground and plenty more over the intermediate to longer term.

Finding the Next Starbucks - Part 3 - Compound Interest

"Compound interest is the eight wonder of the world." - Albert Einstein

The above quote leads off chapter two of Michael Moe's book, "Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow." Although we learn about compound interest and the Rule of 72 in our high school math class, sometimes it takes some financial related calculations later in life to really drive the point home, enough so that it will have an effect on our saving and investment habits during adulthood.

Moe uses two compound interest examples that are worth repeating here. Although both cases are impossible to be recreated in the real world today, the dramatic numbers should at least intrigue people enough to run the numbers on their own individual financial plans. The results will still most likely be surprising for many of you.

Example #1

Purchase price for Manhattan Island in 1626 by Dutchman Peter Minuit: $24

Value today if invested at 5.0% annual rate of return: $2.7 billion

Value today if invested at 7.5% annual rate of return: $20.7 trillion

Value today if invested at 10.0% annual rate of return: $128.7 quadrillion

Example #2

You have landed a consulting job for the month of January. Your temporary employer has given you the option of earning $10,000 per week or earning $0.01 on the first day and having your daily pay double each day thereafter for the remainder of the month. Which payment plan should you choose?

Earn $10,000 per week for the month = $40,000

Earn $0.01 on first day, double every day = $21.5 million

While these examples are meant to be fantasy, not reality, compound interest is still a very important concept to consider when you are contemplating your saving and investing plans.

This post is the third in a multi-part series discussing the book Finding the Next Starbucks. You may read Parts 1 and 2 in the series below:

Finding the Next Starbucks - Part 1

Finding the Next Starbucks - Part 2

Finding the Next Starbucks - Part 2 - Definition of Risk

Before I delve into some of the specific investment concepts that Michael Moe covers in his book,"Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow," I want to talk about one of the passages that appears in the first 10 pages that sets the stage for finding a great growth stock. Despite Moe's focus on growth, he does an excellent job balancing that objective with a value-oriented, contrarian approach (which is a big reason why I think the book is worthwhile for a value investor as well). Consider the following excerpt from Chapter 1. I want to drill down on one sentence in particular, but these three paragraphs are very important for any investor, regardless of what types of investments they are looking for.

"Ultimately, in sports, gambling, investing, and life, there is little value in knowing what happened yesterday. The largest rewards come from anticipating what will occur in the future. As Warren Buffett once said,˜If history books were the key to riches, the Forbes 400 would consist of librarians.

Fundamental in our pursuit of attractive investment opportunities is my philosophy of risk and reward. I view risk as measuring the potential for permanent capital loss, not short-term quotational loss, and assess the probability of that against what we think the value of the business will be in the future.

It is with this perspective that I fly right in the face of conventional wisdom, which suggests the bigger the return, the more risk one has to assume. From my point of view, large returns will occur when we find an opportunity where the upside potential is substantial, yet the price we pay for it is not. My goal is to find a stock whose price is below what I think the appraised value should be, not what the quotational value is as indicated by the current market price."

Much of that may seem logical and obvious to a value investor. However, to a growth investor it may be a bit off-topic. After all, they focus on growth first, with valuation often trailing in importance. By combining the two, as Moe suggests, you can significantly boost your chances of finding the next great growth stock.

I want to expand on one part of that passage:

"Conventional wisdom, which suggests the bigger the return, the more risk one has to assume."

It amazes me that "risk" is almost always defined as how volatile a stock is. If you open a college level finance textbook , risk is almost always defined as how much a stock moves up and down relative to some other benchmark. In most cases, a stock's beta is used to compare an individual stock's "risk" with that of the overall market, the S&P 500 index. So, a tech stock with a beta of 1.50 is much more "risky" than a utility stock with a beta of 0.50.

I strongly disagree with this assertion, and it appears Michael Moe also objects to this conventional wisdom. Should the words "risk" and "volatility" by synonymous? I don't believe so and let me explain why. Consider two stocks you are evaluating for a one year investment horizon. Both stocks currently trade at $50 per share. After doing a careful analysis you determine that:

*Company A has a 70% chance of rising to $60 in one year, and a 30% chance of falling to $40 in the same time frame. The stock's beta is 1.50.

*Company B has a 50% chance of rising to $55 in one year, and a 50% chance of falling to $45 in the same time frame. The stock's beta is 0.75.

Which stock is more risky?

If you consider risk to be volatility, you are going to say Company B is less risky. If you calculate the expected value of Company B stock in a year, you get $50.00 per share, a zero percent gain.

If you consider risk , as I do, to be the odds of permanent capital loss, you will conclude that Company A is less risky. Not only is your expected value in a year higher ($54.00, a gain of 8 percent), but the odds of losing money are only 30 percent, versus 50 percent for Company B.

I would argue that Company A is less risky despite the fact that the betas of each stock imply that Company A will move twice as much, in percentage terms, during the typical trading day. In my view, risk and volatility are different animals. For me, risk is defined as the probability that I lose money during my desired time horizon for a particular investment.

If I'm investing for one year, I want to minimize the odds that after the year is up, I am underwater on the investment. How volatile the share price is during that year is pretty much irrelevant to me because if my analysis is correct, the stock will be worth more than I paid for it after a year's time.

This post is the second in a multi-part series discussing the book "Finding the Next Starbucks." You may read Part 1 in the series here: Part 1 and be sure to stay tuned for more posts in the series. 

Finding the Next Starbucks - Part 1

I just crossed another book off of my Amazon Wish List and got the idea to feature monthly book reviews on The Peridot Capitalist. It might be a stretch to pin myself down to reading a new book each and every month, so I won't make any promises. But let's just say that I will plan on sharing positive reading experiences with you all in the future. I won't commit to a specific review frequency in order to ensure that I make suggestions because they are worth your time, not just because the calendar flipped to a new month.

Anyway, I just finished "Finding the Next Starbucks: How to Identify and Invest in the Hot Stocks of Tomorrow" by Michael Moe, founder and CEO of ThinkEquity Partners. At first I was leery of the book simply because of the title. In my opinion, many investors obsess over finding the next Microsoft or Google, when in reality, the odds of doing so are close to zero. The end result is people getting caught up in "story stocks" without any regard for the stock's valuation relative to what a reasonable growth assumption would be.

The most recent example of this was Sirius Satellite Radio (SIRI). For months it was the stock I got more questions about than any other. I wrote about it several times back in 2004 and 2005, explaining how the shares were trading at levels that couldn't be justified with any degree of confidence as far as future financial projections were concerned.

Still, you could tell many people really thought Sirius could be the best performing stock of the next decade and they just had to own it. The single digit price tag fueled the urge even more, as they thought the stock was so cheap. Well, today Sirius stock fetches a mere $2.77 a share (down about 70% in less than three years) and is fighting to merge with their only competitor in order to stay afloat. Sirius and XM Satellite (XMSR) were worth more than $20 billion combined back then. Today that figure stands at just a little over $7 billion.

Despite my initial skepticism, Michael Moe really never started to lead readers down the path that usually results in buying Sirius at 9 bucks. As a result, I was pleasantly surprised with the book because it was able to focus on growth investing, but also did not ignore the valuation component. Too often people assume that if a company grows fast enough, they will make a killing regardless of the price they pay. The book outlines some very good lessons to follow when investing in growth companies, and although I didn't agree with everything contained in the 300 plus pages, Finding the Next Starbucks is definitely worth a read.

Since it will take quite a bit of space for me to discuss the major points I think are important in the book, I will spread out my comments over several posts in coming days. Stay tuned for more to come and perhaps we can get a solid discussion going as well.

Could We Get a 7-Year Double Top on the S&P 500?

This really isn't a prediction as much as it is just mere speculation about what could happen to the market in the coming weeks and months. Short term movements don't really concern me as I mostly just focus on undervalued companies regardless of market level, but sometimes it's still interesting to point things out.

A lot is being made about the Dow making new all-time highs lately, but as many of you know, the S&P 500 is still about 3 percent below its peak from the year 2000 at the 1,527 level. Here's a 10-year chart of the S&P 500 index:

One possible scenario would be for a long term double top around that level. A lot of strategists are dissatisfied with the 7 percent correction we got in March and want some kind of retest of that level, or even better, a full 10 percent correction in the S&P 500 so we can get that monkey off our back.

Is a double top around 1,527 the most likely scenario? Of course not, but it's still interesting to think about. I definitely would not rule it out and it would make for some good headlines. The market is clearly overbought, so if we truly need another pullback, as many seem to think we do, what better way for it to play out? It would make for a very intriguing chart pattern, one that technical analysts could cite for years.

Don't Get Caught Up in Optimism from Company Management

Aside from company-specific issues at Yahoo! (YHOO), the main takeaway from the search giant's poorly received first quarter earnings report should be to take what management says with a grain of salt. Yahoo! stock soared from the high 20's to the low 30's after CEO Terry Semel went on the record saying how great its new online advertising system, Panama, was going to be. Obviously, when investors saw poor results and a lackluster outlook from the company, they felt blindsided.

Why would Terry Semel be so optimistic when the numbers didn't reflect that optimism? Because he's the CEO. Management always sees the glass half-full. Many of them believe it is their job to be company cheerleaders. Very few executives refrain from trying to spin anything to be as positive as they can. Investors need to keep that in mind. Don't go out and buy a stock just because you saw the CEO on television and he or she was bullish.

It can be hard to ignore that sometimes. After all, if you watch shows like Jim Cramer's Mad Money, these guys are always brought on camera to defend their company against negative press or to hype their next big thing. A lot of these people are pretty darn good at telling their stories.

Since management will often spin the truth, does that mean that investors should dismiss everything a CEO or CFO ever says? Absolutely not. This is how I would judge these comments. Don't just take what they say as gospel. Managers should earn your trust. Carefully monitor what they say over an extended period of time and compare that to what actually happens.

If you follow this logic, only managers that tell the truth and consistently understand their businesses should earn your trust. Armed with this knowledge, namely a management's track record talking to investors, you know who to listen to and who to dismiss as merely a cheerleader.

Successful investing is not easy. If you could just watch TV and make money like Jim Cramer says, everybody would be rich. However, we know that doesn't work. After all, most professionals can't consistently beat the market. If you want to be in the small group that does, be skeptical when company management teams start telling you how great things are unless you have reason to believe they know what they are talking about.

Full Disclosure: Short shares of YHOO at time of writing

Market Correction Comes and Goes Much Like Last Year

Did you notice the S&P 500 hit a new high today? It seems this market corrects much more fast and furious than in prior periods, but the corresponding snap back is just as quick. If you blink, you might miss it. Just last month we were spooked by a 400-point one-day drop in the Dow after a huge sell-off in the China market. Chinese stocks rebounded to make new highs and now the U.S. market has done the same. The 2006 correction was very similar, short and swift. In fact, compare the two charts:

Bears will undoubtedly be looking for a failed breakout and another leg down. Despite the fact that the market has been pricing in an interest rate cut, and yet no rate cut seems imminent, stock prices keep chugging along. I am in the camp that believes the Fed is on hold and won't cut rates due to a perceived credit crunch. Things would have to get meaningfully worse on that front for Bernanke to move, in my opinion.

Where does that leave stocks? I am still standing by my mid-to-high single digit return prediction for the U.S. market in 2007. Currently the S&P 500 is up 3.5% year-to-date. I just can't get overly bullish with decelerating profits and a Fed that is still concerned with inflation. What would be the catalyst for a big move up? Earnings would have to really be strong. I'm not expecting a huge downward revision to current estimates, but this economy doesn't seem to me to have much upside right now.

With what we know now, the market seems pretty fairly valued overall. I think we'll trade between 14 and 16 times earnings in this environment. The strategists calling for P/E expansion I think are dreaming. Sure employment is high and interest rates and inflation are relatively low, but we still have single digit earnings growth and a slightly above-average valuation on the market. Hardly reason to be overly bullish.

In times like these, I'd suggest investing in cheap companies rather than a fairly valued market.