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Are Stock Buy Backs Fictitious Growth?

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Several months back, I wrote about how I was investing in IBM mostly because I think Watson is going to be huge. It was a pretty good investment for awhile. I was up 10% and everything was puppies and rainbows.

Last week, the investment took a dive. IBM earnings were not what Wall Street expected and they sliced the stock 10%. I'm thinking about using this as an opportunity to dollar cost average in, but I'm not looking to rush into anything.

In doing some research, I came across this Seeking Alpha article saying that IBM is an "illusion" that we shouldn't fall for. Before I get into the article, I want to say that there seem to be thousands of articles published there every day and the more outstanding the premise the more eyeballs it is likely to receive.

The author's main point is that, IBM has been deceiving the public with "fictitious growth." My first thought is that sounds like Enron stuff. It turns out to be less interesting.

What has really been happening is that IBM has been buying stock and retiring it. When a company does this they reduce the number of shares and existing shareholders hold a higher percentage of the company. All things equal, you'd rather hold 1 slice of company that has been split 50 ways instead of 1 slice of a company that has been split 100 ways.

So when IBM invests its cash this way, it is very good for shareholders. With fewer shares, the company has a higher earnings per share which causes the stock price to go up. The Seeking Alpha author is pointing out that revenue is declining so IBM is on decline.

While I can understand that view, I would counter with the point that IBM could have used its money to buy businesses that are growing. They could then integrate their financials and show that their revenue is going up, up, up. Suddenly, it wouldn't be fictitious growth, but real growth.

In my opinion, it simply is a question of where IBM wants to invest its money. It seems to think there's more value in buying back shares that they are priced very cheaply. I consider that to be a better sign than simply buying up companies for a short term gain of revenue. So, I'm going to stick with IBM and it's low 10 P/E. It still makes billions and billions of dollars every year...

... and there's nothing fictitious about that.

Last updated on October 29, 2014.

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5 Responses to “Are Stock Buy Backs Fictitious Growth?”

  1. Kevin says:

    Newspapers have very low price to earnings ratios too.

    I think your belief that Watson will be huge is a good reason to invest in the stock, but I wouldn’t get to fixated on the price/earnings ratio

  2. Evan says:

    Having just taken a glace at that article – I don’t think you are actually disagreeing in whole. You seem to be saying you are fine with buybacks with regards to how the company uses its excess cash flow. The SA article seems to be just warning not to believe that the increase in EPS is from growth.

    Where I think you are disagreeing is whether buybacks vs investing in core businesses should or should not worry an investor.

    • Lazy Man says:

      I think that’s it. For the most part I didn’t like the term fictitious growth. It made it seem like they were trying to hide something.

      (Side Thought: Really WordPress? Couldn’t make the title a normal textbox that gets spell-checked by browsers?)

  3. Evan says:

    I am actually in the middle of reading the Intelligent Investor by Ben Graham (was Buffett’s idol/mentor) and multiple chapters are dedicated to trying to read through the bullshit accounting that is legally allowed in financial statements.

    My guess is that the SA Author wanted to make sure that investor’s didn’t just get blinded by the increase in EPS.

    Side note – In the book they use IBM as an example of a growth stock. Kind of funny how time changes all

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