Need Proof That Buybacks Work? Check Out These Stocks

David Sterman's picture

Wednesday, April 16, 2014 - 11:45am

by David Sterman

America's top two automakers, Ford (NYSE: F) and GM (NYSE : GM), are still trying to get their financial house in order.

GM is still faced with operational challenges as it aims to fix a long-broken culture, and Ford continues to invest heavily in new markets (such as China), while launching bold but expensive new vehicle platforms such as the soon-to-arrive all new aluminum F-150 pickup truck. Still, these companies are strong enough to offer up solid dividends that provide yields above 3%.

The companies that do business with Ford and GM -- auto parts suppliers -- have gone a very different route. As I noted a year ago, these companies are leading the market when it comes to share buybacks. And judging by their recent plans, they have no plans to step on the brakes now. Here's a quick snapshot of the falling share counts for these firms. 

Shrinking Share Counts

In theory, these stocks should have outperformed Ford and GM over the past 12 months, as share buybacks can boost per-share profits. Meanwhile, the Big Two's focus on dividends doesn't really have any sort of impact on earnings per share (EPS). It's an interesting litmus test, as both the automakers and their parts suppliers have been subject to the same global industry conditions. 

It's pretty clear that auto parts suppliers have been the better performers (returning an average 58% over the past year, while Ford and GM have risen far more modestly). 

In recent months, these auto parts suppliers have begun to issue more debt, and some of the proceeds will likely go to further share buybacks, if recent history is any guide. That puts these firms in contrast to other stocks we've been recommending as Total Yield plays. Total Yield stocks are characterized by debt reductions in tandem with buybacks and dividends. Still, these firms have correctly concluded that business conditions are so stable that they can boost debt leverage to help support buybacks and dividends. (The average dividend yield for auto parts suppliers is a token 1%.)

But the strong share price gains for these stocks create a conundrum: As I noted last year, "In the context of price-to-earnings (P/E) ratios, massive buybacks make more sense (as) most of these stocks trade for less than 10 times projected 2014 profits." Are these stocks still cheap enough to justify buybacks?

The answer is yes, with the exception of Borg-Warner (NYSE: BWA). (It's worth noting that Ford and GM are now cheaper, as each trades for around 7 to 8 times projected 2015 profits.)

Clearly, the automakers should adopt the robust buyback plans that their suppliers have. GM, which is in the midst of a scandal regarding flawed ignition systems, which has caused its stock to move down 25% from the 52-week high, might benefit from a share buyback plan. At the end of 2013, GM was sitting on $29 billion in (gross) cash, which is more than half of its entire market value.

Risks to Consider: This entire industry is still feeling the effects of a depressed sales environment in Europe, and it's also subject to fierce competition from Asian rivals. As a result, robust growth may be hard to achieve.

Action to Take --> Although investing in the auto parts suppliers proved to be a wise move thanks to those buyback programs, those stocks are no longer the best values in the industry. Instead, it's Ford and GM that should be in focus for investors. Whenever pressed to choose, I am always partial to Ford, regardless of relative valuation, simply because the quality of management's decision-making is so much better.

P.S. We're so excited about the Total Yield strategy that we've devoted an entire newsletter to it. To get an exclusive glimpse at some of the top stocks we've uncovered with this method -- including one that's gained an astonishing 247% over the past year -- view our free research by following this link.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.