Never mind the pundits: use your common sense

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One of the wisest sayings I have heard is that when someone gives you an excuse for not doing something, “there’s always a good reason, and then there’s the real reason”.
If, for example, someone does not want to shovel snow on the sidewalk, he may say, “Let’s wait for the sun to come out and have the snow melt a little. Besides, it might snow again so let’s wait.” That is a sound reason for not shovelling. But the real reason is: “I’m too tired and I’d rather watch TV.”

The same thing happens with “permabear” pundits. For instance, there has been commentary lately about whether or not the increase in share buybacks is good for corporate America. A share buyback occurs when a company decides its stock price is below what it thinks it should be and buys back stock on the open market. In the ideal scenario, shares outstanding go down and the shareholders benefit when earnings per share (and potential dividends per share) go up.

The permabear criticism of this is: “Companies don’t know what to do with their money because there are no longer good uses for it out there.” The real reason they say this is: “I’m a permabear and I need to find some weird way of saying that something that is enormously good for shareholders is bad.”

In Jim Cramer’s book Mad Money, he mentions a metric other than share buybacks that is useful for determining whether a stock is a buy. That is to look at companies that not only are buying back shares but have also in the past bought back significant amounts of stock.

The first company worth looking at is IBM. A big criticism of share buybacks is that they are just used to counterbalance the increase in shares that results from giving employees options. However, IBM significantly decreased shares last year because of its buyback. Shares outstanding at the end of 2006 were 1.6bn, down 4.6 per cent from the period a year before. IBM bought back 97m shares during the year and plans to continue buying back shares. IBM has been slowly buying back its company since 1995. It has bought back 1.2bn shares since then. And it has made an average of 50 per cent on every purchase, since the average price is $62. In other words, IBM seems to be a good investor to piggyback.

What I find intriguing is that among IBM’s large shareholders is Intel Capital, which invests Intel’s money. Certainly Intel has insight into who is buying what in technology. IBM trades at only 13 times 2007 expected earnings. It is buying back its own company hand over fist, and has a 30 per cent return on equity (meaning, every additional dollar it puts to work generates 30 cents in earnings, so it is a smart allocator of capital). I think IBM will hit $130- $140 within the next year.

Next on the list is Disney. The media group has made the news this past year for its multibillion-dollar merger with the animation company Pixar, but the highlight is the domination of television and music over the past year.

Anecdotally, when I was looking at cable TV rankings a month ago, three of the top 10 shows were repeats of the Disney Channel original film Jump In. Top was the original showing, followed by Cory in the House, which came on right before Jump In.

Meanwhile, the album for Jump In was a top seller and the soundtrack based on the Disney Channel hit for 2006, High School Musical, was the number one selling album last year. Disney is on fire with tweens. It has the formula down and this year we will see the numbers for it.

In terms of share repurchases, the company bought back 243m shares of stock in 2006 for about $6.9bn. In 2005 Disney bought back 91m shares for $2.4bn. The company has authorisation to buy back an additional 206m shares. It has also committed to buying back enough shares to keep its float level with where it was before the Pixar takeover (which was purchased for stock). The company trades for 10 times cash flows, has fought off suitors such as Comcast and I think its shares could potentially hit $40 this year.

The healthcare benefits company Cigna is another one that is regularly out there buying back shares. In fact, I would argue it is slowly taking itself private. The company repurchased approximately 8.4m shares for $931m during the third quarter 2006 and about 22.6m shares for $2.4bn (or $106.19 a share) year-to-date through October 2006. Shares outstanding have gone from 140m shares at the end of 2002 to
112m shares at the end of 2006. Consequently, its price-to-equity ratio keeps getting lower as earnings rise and shares shrink. It is trading for just 12 times forward cash flows.

Carl Icahn is a shareholder of Cigna, as is the value investor David Dreman, and my guess is that at some point this will either be a leveraged buyout or an activist investor situation.

My takeaway from this is that no matter how many academic degrees someone has, try not to listen too much to them. Common sense suggests that in any market when you reduce supply, but demand remains the same, the underlying asset goes up. Throw in the fact that more cash is produced to reduce supply further and you have an excellent bullish scenario.

james@formulacapital.com

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