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Dividends Or Buybacks?

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.

PKW vs. SPY

Source:Bloomberg

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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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In a climate that perhaps isn’t conducive to tactical acquisitions, Warren Buffett chose buybacks over dividends.

If Mr. Buffett approves, what could be so wrong?

What Is The Right Price?

The crux of the problem is that determining the “intrinsic” value of a company is a bit like voodoo. It’s hard to know for sure.

Some get it right, others wrong. Hewlett-Packard may have overestimated its growth potential or paid too much for the stock it bought back. Either way, its share price has plunged since 2004. According to the Wall Street Journal, HP has spent $57.6 billion repurchasing its own stock, while the current value of outstanding shares is $47 billion.

On the other hand, AutoZone has had a very profitable buyback program. The company paid about $10.5 billion over the past decade to take 150 million shares off the market. In the past two years alone, the company’s share price has tripled.

And here’s an ETF reality check:PKW is currently holding a greater share of HP than AutoZone.

Buyback ETFs

The takeaway is that until there’s a good enough index screening to distinguish the good investments from the duds, I’d be cautious about buyback ETFs.

One recent addition to the ETF market, the AdvisorShares TrimTabs Float Shrink ETF (NYSEArca:TTFS), is trying to tackle this problem.

According to its prospectus, the fund’s subadvisor ranks buyback-company stocks every four months based on the following criteria:decreases in outstanding shares; increases in free cash flow; and declines in leverage. Time will tell if its methodology picks winners.

Unfortunately, TTFS and PKW aren’t cheap. In addition, both have expiring fee waivers and may raise their expense ratios next year, from 0.99 percent to 1.29 percent in the case of TTFS, and from 0.70 percent to 1.00 percent for PKW.

As buybacks are beginning to look a lot more appealing, creating more efficient and less costly funds to track them could be a worthwhile endeavor for fund sponsors.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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