The last time buybacks were sexy was in 2007, and they didn’t make much sense back then.

For example, the PowerShares Buyback Achievers (NYSEArca: PKW), a fund focusing on companies engaged in large-scale corporate buybacks, trailed behind the broader market.

The SPDR S&P 500 ETF (NYSEArca: SPY) was beating PKW by more than 5 percentage points. And, the Nasdaq was beating the PowerShares fund by more than 10 percentage points.

Now, five years later, the tide has turned.

Source: Bloomberg

Buybacks 101

Companies sitting on cash often choose to reinvest in their business or pay out dividends to their shareholders.

But investors tend to forget there’s also a third option a company can take, which is to buy back its stock.

This route is best for firms that are severely undervalued by the market. In such cases, companies buy back for cheap and pay strictly below the stock’s “intrinsic” value.

Firms can use buybacks to signal their confidence about future growth. Repurchases can also reduce the number of outstanding shares, pumping up share price and earnings per share. They also increase the company’s self-ownership, which can give management more leeway.

However, the boost in share price or earnings per share isn’t guaranteed to last. If the company doesn’t do well, then the stock will depreciate. Moreover, shareholders will feel that depreciation more than if the company’s outstanding equity float had remained larger.

Like everything else in the market, it’s a gamble.

Buybacks Then And Now

When consumer confidence is low and stocks are cheap, the market is likely to undervalue many companies. In other words, right now is a good time for firms to buy their own stock.

The problem with buybacks in 2006 and 2007 was that companies disobeyed a pillar of investing. They didn’t buy cheap. In fact, those buybacks happened when markets were at an all-time high.

Worse yet, companies reduced their capital cushions right before they needed it most. When the storm struck in the market crash of 2008–2009, all those firms that had bought back shares were left with stocks that were worth a lot less.

As I said, current conditions are more favorable for buybacks. So much so, Berkshire Hathaway, notorious for reinvesting profits back into its business, is launching its first-ever buyback program. Naturally, investors took notice.

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