Investors in individual stocks are familiar with notices of corporate buybacks — when a company goes to the open market to repurchases shares it had once sold to the public.
Reducing shares in circulation raises earnings per share, which should push share prices up, and buybacks are usually touted as a signal executives are confident and think their shares are a bargain.
But critics say otherwise, arguing that since money spent on buybacks is drained from company coffers, each remaining share is worth less, offsetting the benefit of higher per-share earnings. Some say buybacks show management has run out of better strategies, such as investing in research and plant expansion.
And some suspect nefarious motives, like using shareholders’ money to inflate executive compensation keyed to share prices or earnings per share.
Many experts say buybacks are a legitimate use for excess cash, a use often preferable to alternatives such as sitting on money that earns virtually nothing. “When a company’s stock price is lower than what it’s worth, stock buybacks can be a smart use of money,” says Christian Ryther, portfolio manager at Curreen Capital in Denver.
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“Great businesses — think Google’s (ticker: GOOG, GOOGL) AdSense — make much more money than can be profitably reinvested in expanding the business,” he says.
One thing is for sure: buybacks are hot: Since 1997 cash spent on buybacks has exceeded that paid out in dividends, according to Standard & Poor’s. In the year ended March 31, companies in the Standard & Poor’s 500 index spent a record $589.4 billion on buybacks, up 9.5 percent from the previous 12-month period, S&P says.
Buyback spending jumped 10.6 percent from the fourth quarter of 2015 to the first quarter of 2016, with 28.2 percent of the 500 firms reducing their shares outstanding over the previous 12 months by at least 4 percent, a pace that continued into the second quarter.
The buyback binge is possible because those 500 firms held enormous cash reserves of $1.35 trillion at the start of the year, S&P said, noting that firms used buybacks to prop up share prices when the market was sinking early in the year. Companies have not been turning as often to dividend increases, the chief alternative, because raising dividends entails a commitment that’s harder to reverse if conditions worsen.
For the investors companies serve, buybacks are also kind at tax time. Dividends are taxed the year they are received. But if a buyback succeeds in raising the share price, there’s no tax until the shares are sold.
“Share buybacks are a tax-efficient method of returning cash to shareholders,” says Kirk Chisholm, wealth manager at Innovative Advisory Group in Lexington, Massachusetts. “While this is not always the reason companies repurchase shares, it is the reason that great capital allocators do it.”
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Research shows the strategy often works. S&P says buyback announcements typically give share prices a bump in the next few days. To measure long-term effects, S&P has created a buyback index, composed of the 100 S&P 500 firms with the largest percentage of market capitalization spent on buybacks in the previous four quarters.
Over the 20-year period ending Dec. 31, 2015, the S&P 500 buyback index outperformed the S&P 500 in 16 of 20 years, the firm says, reporting the buyback index’s average annual return beat the broader 500-stock index by 5 percentage points a year.
S&P says the buyback index, and others for mid-and small-cap stocks, tend to be more volatile than the broader indexes and typically perform best in down markets.
Of course, there’s no guarantee investing in buyback-heavy stocks will pay off, as many factors drive an individual stock’s price. But investors who want to play the broad trends can use an exchange-traded fund launched last year by State Street Global Advisors, the SPDR S&P 500 Buyback ETF (SPYB), which tracks S&P’s buyback index. It has lost 2.65 percent over the past 12 months, while the S&P 500 has gained 4.87 percent, according to Morningstar.
Some academics have argued that the growth of buybacks has undermined the economy, since that cash could otherwise be used to build plants and hire more workers. But investors tend to focus on returns. Since buybacks are mainly a concern for those who buy individual stocks, investors should ask several questions:
Is the timing right? Critics point to cases where companies buy back shares that are selling near the high end of their trading range, and then raise money by issuing new shares when prices are low. To avoid this upside-down strategy of buying high and selling low, the investor can ask: “Would I pay that much for the stock at this time?”
Is executive compensation a factor? It’s often tough for shareholders to find the details of executive compensation plans, but if you can dig them up, look for benefits triggered by things like earnings-per-share and stock-price targets that can be met with repurchases. Then look deeper at the company’s reasons for repurchasing.
“If a company repurchases shares and the capital is pulled from a project that could generate huge growth for the company, then that would be a concern,” Chisholm says. “But I don’t think any executives would be so bold as to do that when they would be compensated better for growing their company’s revenues.”
Investors should also be wary if a company is using buybacks simply to offset the dilution caused by new shares released into the market by executive and employee compensation plans. It’s a red flag if the firm isn’t actually reducing shares outstanding.
Is the company borrowing to fund the buyback? “If the firm is incurring a large amount of leverage to buy back the shares, I might question if the buyback is in my best interest,” says Robert R. Johnson, president of the American College of Financial Services in Bryn Mawr, Pennsylvania. “Having said that, if a company with little debt were to take out some debt in this low interest-rate environment and buy back stock, that would seem to be prudent.”
Is there a better use for that cash? “We hope that companies that pay dividends and buy back stock use only the cash that is not required to run and properly grow the business” says Jim Wright, chief investment officer at Harvest Financial Partners in Paoli, Pensylvania. “Make sure you fund the business first.”
Would I prefer a dividend? A shareholder who needs cash for living expenses or other investments might prefer a bigger dividend over the somewhat unpredictable benefits of a buyback. But an investor with a long-term view might prefer the share price gain from a buyback, especially if annual tax bills are a concern.
“I would much rather invest in a stock that never pays a dividend, makes capital investments when good opportunities arise, and also repurchases stock when the stock falls below its intrinsic value,” Johnson says, noting this strategy is employed by Warren Buffett’s successful Berkshire Hathaway (BRK.A, BRK.B).
[See: Warren Buffett’s 10 Biggest Deals.]
In the end, buybacks present a problem most investors would like to have. Whether a company chooses a buyback, dividend increase or other reinvestment, the debate usually means the firm has made lots of money.
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What to Do When a Company Buys Back Stock originally appeared on usnews.com
