In the twelve months ending June 30, Companies in the S&P 500 have spent a record $1 trillion buying back their shares, according to the S&P Dow Jones Indexes. But in January, a new 1% tax on buybacks could dampen corporate US appetite. Standard & Poor’s Dow Jones estimates that the tax will reduce corporate profits by half a percentage point at current repurchase rates.
Buybacks have recently become controversial, with critics arguing that there are better uses for corporate money. But an analysis of the 2020 S&P Dow Jones Indexes of the 100 companies with the largest buybacks found that their long-term stock returns generally outperformed the S&P 500.
Many smart investors, including Warren Buffett, are big proponents of strategic buybacks. “If management wishes to further intensify our ownership by repurchasing shares, we applaud,” he said.
Experts say the new tax is low enough to encourage only the most marginal buybacks, so don’t expect it to go away. But buybacks can be complicated to evaluate. For investors trying to navigate this changing market, a few tips can help you find stocks that are likely to benefit from share buybacks despite taxes. But first, the basics.
Positives. Buybacks make the most sense when a company can sweep up stocks that have been irrationally pushed below their true value by market volatility. These purchases indicate insiders’ confidence in the company and add demand that supports the stock price.
Many investors prefer buybacks over dividends because although you have to pay taxes on dividends when they are issued, you don’t pay capital gains taxes until you sell your shares. In addition, when companies buy back more shares than they issue, each remaining share represents a larger ownership slice of the company
Mab Faber, chief investment officer at Cambria Investment Management, says some investors want companies to funnel cash through buybacks so managers aren’t tempted to make worse choices. “How many companies have wasted money on naming stadiums?”
Executives love buybacks because by reducing the number of shares outstanding, a company can report higher earnings per share even when overall earnings are flat or low. This can be a particularly tempting strategy for any executive whose pay is linked to an increase in earnings per share.
Buybacks also give managers flexibility. A company that raises its dividend risks a stock crash if problems later force it to cut payments. However, the buyback program can usually be suspended without worrying investors. Another plus: Each share brought home means that less dividends are paid to those companies that also pay dividends, reducing future cash obligations.
Finally, economists love buybacks because they take cash from companies that lack good internal investment ideas and return it to shareholders – who usually reinvest it in other publicly traded companies (which are supposed to have more productive investment plans).
|year||Share buybacks (in billions)||Dividends (billions)|
|2022 (until June 30)||$501||$278|
Negatives. Politicians as disparate as Senator Elizabeth Warren (Democrat) and Marco Rubio (R-Florida) have tried to discourage buybacks. Critics hope to induce companies to invest more in their operations, and to create new jobs.
Although some studies highlight the positive aspects of buybacks, others have concluded that shareholders often benefit more from alternative uses of cash. Greg Milano, CEO of Fortuna Advisors, an investment advisory firm, says that over the past 12 years, Fortuna has found, on average, that companies that raised earnings per share due to investments in operations generated twice the stock price gains of companies that collected per dividends. Stocks through buybacks. Dividends also resulted in slightly higher returns than buybacks.
Milano cautions that despite the hype, not many buybacks end up giving investors a bigger stake in the company because companies often issue more shares in stock-based compensation plans than do buybacks. Worst of all, investors have been burned by companies that have spent billions on buybacks rather than clean up their balance sheets or invest in their businesses to guard against an economic downturn — as some airlines have done recently, for example. (For more information on airlines, see Why are airline stocks a bad deal?)
How to invest. Experts say that investors who still want to ride the coat of arms of buyback programs should follow three principles. The stocks listed below provide good examples.
Avoid dilution. Don’t jump at every ad to buy back. Check if the company’s total stakes are actually decreasing, thus raising your ownership stake in the company, Faber advises. You can look up a company’s outstanding shares in stock and exchange filings, or you can find the latest number of shares on websites like Yahoo Finance and YCharts. A good example of that McKesson (MCK (Opens in a new tab)), says Faber, whose investment firm owns the stock. The pharmaceutical and medical supplies distribution company reduced its stake by 7% in the past year, and over the past five years the share price has doubled.
Look for pricing. Successful buybackers, like successful investors, should buy at a low price. Buffett Berkshire Hathaway (BRK.B (Opens in a new tab)), which has more than $100 billion in cash, buys its shares when the price drops below what Buffett calls their “intrinsic value.” Gregory Warren, a Morningstar segment strategist, notes that the company has repurchased $58 billion worth of its common stock since 2019, reducing its stake count by about 10%. Warren, Thor Berkshire, believes that the company is focused on reducing its long-term cash stock through a combination of stock purchases and stock buybacks.
Bet on sound companies. Milano of Fortuna says that companies that are likely to generate high long-term returns on buybacks have strong balance sheets and, ideally, are less exposed than other companies to economic or commodity cycles. One company at the top of his list: apple (AAPL (Opens in a new tab)). Since the beginning of 2021, Apple has repurchased more than $200 billion of its stock, reducing the number of its stake by about 5%. In that time, the stock has gained nearly 6%, not counting the dividend, compared to a 3% loss for the S&P 500. “Apple is the poster child for buybacks,” says Howard Silverblatt, chief index analyst at S&P Dow Jones Indices.