Are You Missing the Boat on Share Buybacks?

Investors have been focused on dividends in recent years, but are buybacks the better bet?

   

What represents a better allocation of capital: dividends or buybacks?

This has been an age-old debate for stock investors, with neither side able to claim definitive victory. And while dividends have received the most attention in recent years, investors could be barking up the wrong tree.

Since its inception on Dec. 20, 2006, the PowerShares Buyback Achievers ETF (PKW) — which invests in companies that have repurchased at least 5% of their outstanding shares in the prior 12 months — has provided an average annual return of 6.8%, outpacing the 4.5% annual return of the SPDR S&P 500 ETF (SPY). Perhaps more surprisingly, PKW has outperformed both high-dividend stocks — based on the 2.1% average annual return of iShares Dow Jones Select Dividend Index Fund (DVY) — and dividend growers — as measured by the 5.9% average return of Vanguard Dividend Appreciation ETF (VIG).

Despite this return gap, PKW has only $348 million in assets and is dwarfed by the combined $41 billion held by DVY, VIG, and the SPDR S&P Dividend ETF (SDY) — a possible reflection of investors’ preference for receiving cash rather than achieving the indirect benefit of buybacks. Still, share repurchases represent a powerful longer-term performance driver that should receive more attention.

A Closer Look at Buybacks

Buybacks might be best known for the pop in the stock price that occurs after a company announces a repurchase, such as the rally of more than 5% in EMC (EMC) on Wednesday. But a closer look shows that share repurchases represent a powerful long-term catalyst far beyond the initial move. In a May 3 Wall Street Journal article titled, “How Investors Should Play Stock Buybacks,” Mark Hulbert reported that David Ikenberry, Dean of the Leeds School of Business at the University of Colorado – Boulder, found that “…the average buyback stock outperforms the market in each of the four years following the company’s announcement of its share-repurchase program.”

It’s worth noting that the two sectors that have the heaviest weighting in the PKW portfolio — consumer discretionary and financials, due to their abundance of buybacks — have each outpaced the broader market in the past year. The Consumer Discretionary SPDR (XLY) and Financials SPDR (XLF) have delivered a one-year return of 31.5% and 42.8%, respectively, versus 26.3% for SPY. Also, nine of PKW’s current top 10 holdings have outpaced the S&P 500 in the past 12 months, with ConocoPhillips (COP) — up 23.7% — being the only laggard.

There are several reasons why this type of outperformance would occur. While most investors focus on the (sometimes illusory) impact on EPS, a more direct benefit is that buybacks help create a more favorable supply-and-demand profile for the shares of companies that are reducing their float. For instance, Amgen (AMGN) has reduced its share count from about 1.3 billion 10 years ago to 750 million today.

Buybacks also act as a signal to investors that companies are confident in their outlook — and have enough cash on hand to act on that view. And let’s not forget that buybacks enable shareholders to defer taxes into the future rather than pay a tax on dividends each year.

Another reason share repurchases deserve greater notice is that, in many cases they reflect an intelligent capital allocation decision on the part of the company. In his 2012 white paper for Legg Mason titled “Share Repurchases from All Angles,” Michael J. Mauboussin makes this point:

“Here’s a very basic question: If you own the shares of a company because you believe the stock is undervalued, why would you ever want the company to pay a dividend instead of buying back shares? If you believe the shares are undervalued then you should always favor a buyback because buybacks add value for continuing shareholders at the expense of selling shareholders. As Warren Buffett wrote in Berkshire Hathaway’s 1984 annual report, ‘When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.’”

Given all of that, investors should consider putting buybacks at least on an equal footing with dividends when making investment decisions, and perhaps even elevate funds such as PKW to the role of a core portfolio holding.

And you can always use the PKW portfolio — available here — as a quick reference guide to see which companies are leading the way in share buybacks.

As of this writing, Daniel Putnam did not hold a position in any of the aforementioned securities.

 


Article printed from InvestorPlace Media, http://investorplace.com/2013/05/are-you-missing-the-boat-on-share-buybacks/.

©2014 InvestorPlace Media, LLC

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