Schafer: Buying back stock can be a company's best option

The management of IBM had very few friends last week, with the company's stock falling sharply and writers from the New York Times, Reuters and Bloomberg piling on with criticism.

IBM, it seems, is being led by people so intent on "financial engineering" that they've neglected to actually run the business as a business. They've used way too much capital to buy back IBM stock — nearly $80 billion since 2008.

IBM certainly has its problems, but buying back stock isn't necessarily one of them. What the critics are pounding IBM for doing is allocating capital to the best opportunities for returns — and that's job No. 1 when running the business.

And while IBM may have turned down promising opportunities to invest to instead keep buying stock — no outsider could say for sure — at least IBM's executives can't be accused of wasting the capital. That $80 billion went to the shareholders, not up in smoke.

And after all, it's the shareholders who own the company.

IBM is the latest company in the headlines, but company after company has been criticized of late for buying back stock.

The Harvard Business Review, hardly known for its anti-corporate views, just carried an article that harshly denounced the practice, arguing that returning capital to shareholders starves innovation and stunts economic growth.

And I hate to pull the curtain back on a corporate secret, but there is no clever "financial engineering" involved in buying back stock, either.

All that's needed is an Excel spreadsheet and some business common sense.

Executives every day face choices in how to spend money. They invest when the best research shows that the company can earn a return.

All sorts of things companies buy can be analyzed this way, from a new piece of equipment in an assembly plant to upgraded desktop computers in accounting.

Again, this is pretty basic stuff. Ben Franklin did a version of this exercise before he bought a new printing press.

Buying another business can also be an investment option.

But to make sense, these investments have to pay a better return than the shareholders could make by taking the money back and putting it to work somewhere else. Corporate cash, even if it came from last year's profits and hasn't been borrowed from a bank, isn't free.

If there are more good projects than the company has money to spend, then they have to be sorted and ranked. If there aren't enough good projects, meaning enough that they will generate a return that exceeds the cost of capital, then returning money to the owners is a no-brainer.

It's not a good idea to drain the checking account at the end of every month, and leave no flexibility to jump on unforeseen opportunities or help the company weather downturns. But if management looks at the checking balance and doesn't know how to profitably invest most of it, then it has excess capital.

And IBM, as it turned out, has generated a lot of excess capital.

IBM could have spent that $80 billion buying other big companies, a strategy that's been tried at another iconic American technology company, Hewlett-Packard Co.

Maybe the best that could be said for HP is that at least it was consistent. Its three biggest acquisitions since 2000 all turned into smoking craters.

HP's own stock would have been a far better place for its cash. So would have a mattress.

Companies that are profitable will keep generating cash and face this choice, said Fred Martin, the founder and chief investment officer of Disciplined Growth Investors in Minneapolis.

Earlier in his career companies invested relatively more in physical assets like plant and equipment, or maybe carried higher inventories. All these things took money, particularly as companies grow.

But while Martin expects growth companies to generate cash, he's not a fan of stock buybacks.

It's an uncomfortable situation, he says, for the chief financial officer to be buying back her own company's stock armed with every internal projection, report and e-mail from large customers, when Martin has to decide whether to sell based on what's been reported publicly.

Martin is an enthusiastic fan, however, of good, old-fashioned dividends. A generation ago paying a dividend seemed to suggest to investors that a company had hit middle age and wasn't going to be an exciting growth company anymore, but Martin argues that's no longer the case.

Executives hear from him on this topic, too.

If managers don't have any good ideas for the money piling up in the checking account, he said, he and his clients will be happy to take it. He has plenty of good ideas for how to invest it.