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Buyback Bonanza

Big companies with excess cash have jumped on the buyback bandwagon and are milking it for all it's worth. Should you do the same?

You needn't look far for evidence that stock buybacks are all the rage. Over the past year, many companies, often under pressure from shareholders to return excess cash idling on their balance sheets, have announced large share repurchase programs. According to Standard & Poor's Corp., for the 12 months prior to March 31, 2006, S&P 500 companies bought back a record $367.4 billion in stock. In the first quarter of 2006, buyback activity rose 22.1 percent over the first quarter of 2005. "The result of that share reduction has been that earnings have increased significantly," says Howard Silverblatt, senior index analyst for S&P in New York City.

But should small caps be hopping on the buyback bandwagon? They apparently have the cash, according to stats from Prudential Equity Group, a subsidiary of Prudential Financial in Newark, New Jersey. Cash makes up about 11 percent of small-cap market capitalization, compared to about 8 percent for the S&P 500 and 7.8 percent for the S&P midcap. Among the smallest companies, "buyback activity is up only marginally over the past year or two," says Steven DeSanctis, director of small-cap research at Prudential Equity. "Valuations for the small cap are too [high] right now."

As a result, small-cap CEOs mulling their spending options may be finding better value for the company's money elsewhere. Smaller companies often have, or are expected to have, more reinvestment opportunities, whether it's opening a new store, purchasing new equipment, increasing the advertising budget, or acquisition. And though buybacks can signal a company's good health to investors, you arguably benefit as much from the message that you've found smart ways to reinvest your money, says Dirk van Dijk, director of research at Zacks Investment Research in Chicago. Dijk recommends considering a few options before initiating a buyback. "The first thing I would do is look at my balance sheet and [ask], 'How leveraged am I?'" he suggests. Paying down debt should be first on the list, followed by taking a good look at areas for internal re-investment. Next, you might eye possible acquisition targets. If you've done all that and still have cash to spare, says Dijk, consider a share repurchase or a dividend.

Initiating a dividend program is another way to reward investors, send a positive message to the Street and, in many cases, boost a sagging share price. Dividend-paying stocks have consistently outperformed nondividend-paying stocks, particularly in bear markets, according to Prudential Equity's research. And one advantage to a dividend over a buyback is that, as a small cap with limited liquidity to begin with, you won't further restrict that liquidity by reducing share count, says Michael Taglich, president of Taglich Brothers, a full-service New York City brokerage focused on the microcap segment. Plus, offering a dividend can cut down on the vola-tility of your stock.

On the downside, dividends are more difficult to stop once you've started. "It's considered a bad signal [to end a dividend program], whereas if you have this major share repurchase program, you just stop buying," explains Dijk. "You can do it very quietly."

For those small-cap CEOs who prefer to wait for the right reinvestment opportunity instead of buying back shares or offering dividends with excess cash, you probably won't feel the same heat as the large caps that have been embattled by proxy fights and pressure from hedge funds. Investors in small caps are used to giving management a bit more leeway, says Silverblatt, and they'll reward savvy reinvestment moves for longer-term growth. "The expectations and timeline are very different," he notes.

So if now is a good time, strategically speaking, to buy back your own stock with excess cash, reap the benefits. If not, ignore the peer pressure, and do your spending elsewhere.

C.J. Prince is a New York City writer specializing in business and finance.

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This article was originally published in the October 2006 print edition of Entrepreneur with the headline: Buyback Bonanza.

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