Share buybacks, also known as share repurchases, describe when a public company buys back some of its own shares and therefore reduces the total number of shares outstanding.
This is a topic that I frequently see misunderstood by investors, and there are a lot of reasonable questions like:
- Why would a company buy back its own shares?
- Do buybacks create value, or destroy value?
- How do they help individual investors?
- Do they just create illusionary growth through accounting tricks?
- Is there a right time or wrong time to do it?
- Which is better, dividends or share buybacks?
The short answer is that buybacks can be extremely lucrative, but only in the right context.
In fact, limited data suggests that companies that perform large share buybacks outperform those that don’t:
Source: S&P 500 Buyback Index
Longer-term data going back to the 1970’s shows that companies that return the most cash to shareholders from a combination of dividends and buybacks outperform high dividend stocks, dividend growth stocks, and the broader stock market:
Source: Meb Faber + Alpha Architect
This guide will explain how share repurchases work, what the pros and cons are, what the current market situation is with them, and what names I’m bullish on now.
I’ll also show you the list I use to find the companies that are buying back the most shares, which makes a great starting point for further research.
Share Buybacks 101: Overview
When a company has its initial public offering (IPO), it partners with an investment bank to split itself into millions of shares, and then sells them on a stock exchange. From that point on, investors can buy or sell these individual pieces of the company.
But, the number of shares in existence doesn’t have to stay the same number. It can change over time.
Some companies continue to issue new shares after their IPO. This could be in the form of employee compensation, or as part of large acquisitions of other companies. When they do this, it’s called “share dilution”, and whether it’s good or bad depends on the value they get for issuing new shares.
Real Estate Investment Trusts (REITs) and Master Limited Partnerships (MLPs) usually keep issuing shares, because they are tax-free at the business level and can get tremendous value from using the proceeds of those new shares and units to grow and make acquisitions.
In that case, the business keeps growing, but over time it consists of a larger and larger number of shares, so each share is worth a smaller percentage of the business than it used to be. If management is good and puts the money they brought in by issuing those new shares to work with a high return on investment, it will be worth it. The company will grow more quickly than shares are diluted and therefore the per-share value (cash flow, dividends/distributions, book value, etc.) will continue to increase.
On the other hand, some companies start buying back their own shares some time after their IPO, and this reduces the number of shares in existence, which makes each share worth a larger percentage of the company.
A good analogy for it is buying out business partners. Suppose ten people start a business, and each one owns 1/10th of it, and are entitled to 10% of the profits. After a couple years, one of them wants out. So, the business owners all vote to use some of the company funds to give that one co-founder some cash in exchange for her giving up her ownership stake.
Now, each of the remaining nine owners owns 1/9th of the company, and is therefore entitled to 11.1% of the profits.
But after a couple more years, yet another owner wants out, so once again, the company buys out that person’s stake. Each of the remaining owners now owns 1/8th of the company, and is entitled to 12.5% of the profits.
This could conceivably keep going until one person owns 100% of the company, and gets all the profit.
That’s how share buybacks work, but on a much larger scale involving millions of shares. The company keeps buying back shares and reducing the number of shares in existence, meaning each share is worth a larger percentage of the company.
Travelers Companies: A Powerful Example
I’ve made a lot of money over the last ten years from investing in slow-growing insurance companies trading at low valuations that buy back huge amounts of their own shares, resulting in excellent per-share growth of value, price, and dividends.
Traveler’s Companies is one of the largest publicly traded insurance providers, and is an example of a company that uses an effective buyback strategy to generate excellent returns.
Source: Morningstar (click on the image for a bigger view)
This shows the 2007-2016 performance, but it has been largely the same into 2019.
Insurance companies make money from premiums and pay out money for claims, and along the way they get to keep billions of dollars as “float”. They invest this float mostly in bonds, and the interest that the bonds give them is mostly where their profit comes from.
But, due to the low interest rate environment over the past ten years, insurance companies have had trouble making good money, and Travelers is no exception. Their interest rate on their multi-billion dollar bond portfolio is far lower than it used to be, which means much less income.
As a result, revenue only increased from $26.017B to $28.644B in ten years, which is a growth rate of about 1% per year. Their net income actually decreased over this sample decade, being lower in 2017 than it was in 2007.
However, earnings per share went up, and book value per share and dividends per share more than doubled. This is because the company used most of its profits to reduce its number of existing shares from 669 million to 281 million over the course of a decade, so each share became worth almost 2.4x more of the company by the end. This translates into the company buying back and reducing its share count by about 8% of shares per year while also paying a 2%+ dividend each year.
The result is that the “per-share” values of earnings, dividends, and book value increased far faster than their equivalent company-wide values. The company realized it was in a flat-growth situation and trading at low valuations, and therefore instead used most of the money to buy back shares and reward shareholders that keep holding stock.
Over the past decade, Travelers has outperformed the S&P 500 total return index by a fairly wide margin, and with less volatility. Specifically, Travelers has returned over 385% compared to 287% for the S&P 500. Literally all of Travelers’ returns came from dividends and buybacks.
Part of the reason that the buybacks were so effective was that the price-to-earnings ratio of the company averaged only about 12x during this period, whereas most companies have a price-to-earnings ratio of 15x-20x or more. That means each dollar they spent buying back their own shares went a long way.
Now that the company is slightly more highly valued, it will slow a bit, but most likely not by much.
There are a lot of misconceptions or partial truths about buybacks.
The argument generally follows along the lines that rather than spending money buying back their own shares, companies should spend more money on research and development, or hiring more workers, or paying higher dividends, etc.
While they make some good points, the problem with those types of assessments is that they are cherry-picking. Yes, some companies have misused buybacks. Some executives are desperate to hit earnings-per-share targets to justify their own paychecks and receive performance bonuses, without really setting the company up for long-term success, by throwing money at lazy share repurchases. But not all or even most companies that do buybacks are doing them for the wrong reasons.
This article on the Harvard Business Review by Alex Edmans, professor of finance at London Business School, gives a balanced case for why buybacks are important.
Hewlett-Packard and IBM are two examples of tech behemoths that have lost market share and become less relevant over the past decade because competitors were outperforming their products and services. Rather than try to counter this problem, the management of both of these companies focused heavily on buying back their own shares, which wasn’t exactly a great move when their revenue was declining and proper research and development could have helped them fix that.
Put simply, share repurchases are bad if a company is doing them at a higher priority than other areas of spending, and losing market share because of it. Or if they’re done at bad prices.
Some tech companies have struck a great balance here. Microsoft and Texas Instruments are two examples in my view. Both of them buy back a lot of shares, but they also are gaining and maintaining market share in key areas. Microsoft is outperforming in its cloud services segment, quickly gaining market share. Texas Instruments is holding and gaining market share in analog chips and embedded systems. It’s because they use extra capital for buybacks after they’ve spent the appropriate amount on research and expansion.
And consider boring companies like insurers, banks, and railroads. Should they be spending a ton of money on research and development, or hiring people to grow as fast as possible, or paying 100% of their earnings as dividends only to cut them next time there’s a recession? Of course not. It makes sense for them to use excess cash, after reinvestment and dividends, for buybacks.
“Growth at all costs” without ensuring you have a sustainable market to serve is not good for an economy and it’s not even good for the environment. Companies that can give shareholders great returns with a combination of dividends and buybacks, along with strategic growth in market share of their respective industries with high returns on invested capital, is the right balance.
The key is to be familiar with the companies you invest in, and look for CEOs that have a long tenure with the company and a long-term view of how to strengthen the company’s foundation for continued success.
Be skeptical of no-name CEOs that spend just a few years at a company, hold very little company stock, focus on hitting quarterly targets, and then get traded around by companies like Pokemon cards.
Optimal resource allocation is one of the big differences between great management teams and poor ones. Great management teams know when and where to focus on growth, and when to consolidate and focus on returning money to shareholders with dividends and buybacks.
The Benefits of Share Repurchases
As I described in my article about dividend stocks, a company has five main ways to use incoming capital:
- Reinvest in the company to grow their operations and income
- Make acquisitions- use money to buy other companies
- Reduce corporate debt, especially if they have high debt levels
- Buy back shares to increase the value of each remaining share
- Pay shareholders cash dividends that they can spend or reinvest
The two riskiest and potentially most rewarding uses of capital are to reinvest in organic growth and make acquisitions, the first two on that list. It generally takes years for these investments of capital to pay for themselves, and whether they work or not is highly dependent on business conditions and executive strategy.
Reducing debt is the least risky use of capital, but is obviously context-dependent. If a company is already low or moderate on leverage and has very low interest rates on its bonds, it’s not a relevant use of capital.
That leaves buybacks and dividends. When a company is large and mature enough that it begins to return money to shareholders rather than grow at all costs, these are the two methods they have to give capital back to shareholders. Dividends give shareholders income, while buybacks give shareholders larger ownership stakes in the company.
Buyback Benefit 1) Flexibility
Dividends are the ultimate way to return capital to shareholders, and I emphasize investing in companies that pay them. However, they are also somewhat inflexible.
Buybacks on the other hand are flexible.
When a company starts paying and growing its dividend every year, the management team does whatever they can to never cut that dividend, because the shareholder backlash would be severe and it would be seen as a failure. Therefore, it usually makes sense to only pay out a certain percentage as dividends, so that even during a recession if profits decrease, the dividend will still likely be safe and able to keep growing.
Also, in some years management might want to return more capital to shareholders, while in other years they might find some good organic growth opportunities or acquisitions, and they want to use more capital for those projects. If they pay out most of their profit as dividends, and have a commitment to grow that dividend every year, then they are kind of backed into a corner.
So, blue chip companies usually use a combination of dividends and share repurchases to return capital to shareholders. They pay a regular and growing dividend, and then also buy back a variable amount of shares each year, which helps accelerate earnings per share and dividends per share, because their profits are shared among a smaller and smaller pool of shares outstanding.
Here’s a hypothetical example that looks like many companies I invest in:
This chart shows a company that keeps increasing dividends per share every year for ten years, but has varying amounts spent on buybacks.
A company that pays out less of its money as dividends and more as buybacks will have a lower dividend yield but generally higher dividend growth and capital appreciation. In contrast, a company that pays out more of its money as dividends and less as buybacks will have a higher dividend yield but generally lower dividend growth and capital appreciation.
Some industries are more volatile than others, and need to keep their dividend payout ratios low to ensure they don’t have to cut the dividend during a setback. Oil stocks are a great example, because the price of oil can dramatically affects their profitability. Bank stocks are another example, because they are regulated in how much they can pay in dividends to ensure they have plenty of liquidity on hand for when the next recession comes. Cyclical industrials are another good example- companies whose profits can go up or down sharply based on recession or expansion conditions.
Companies like that do well to keep their dividend payout ratios fairly low and to buy back a lot of shares with the extra capital. When a recession hits and their earnings and cash flow per share drop a lot, they will still likely be able to cover the dividend even if they have to suspend share buybacks.
Buyback Benefit 2) Tax-Efficiency
All else being equal, share repurchases are more tax-efficient than dividends when the shares are held in taxable accounts. In tax-deferred or tax-free accounts, there is no difference.
When you receive a dividend, you have to pay taxes on it when you file your taxes for that year. However, when your investments appreciate in value, you don’t have to pay capital gains tax until you sell your shares, which could be years or decades in the future if you want. Capital gains taxes are therefore slightly better than dividend taxes assuming the same tax rate, because capital gains taxes can be deferred, which lets you compound the money a lot more before you pay them.
Here’s an example using $500k as the starting figure.
In a tax-deferred capital gains scenario, suppose that the value of your investment increases by 10% per year for ten years, reaching $1,296,871.23 on the tenth year. Then you sell the investment, pay a 15% capital gains tax on the $796,871.23 gain, leaving you with $1,177,340.55.
Now in a non-deferred scenario, you also receive a 10% gain each year, but you pay a 15% tax on that gain in the year you receive it. By the end, you only have $1,130,491.72.
Whether your taxes are deferred and able to compound before being paid, or you’re paying them each year, results in almost a $47,000 difference.
This is of course an extreme example- the deferred scenario is a company that pays no dividends and grows its share price at 10% per year, while the other company’s share price does not grow and it pays a 10% dividend every year. But its purpose is to highlight the difference.
Dividends are taxed within about a year of receiving them, and are therefore non-deferred. Share repurchases manifest mainly in the form of capital gains, and are therefore represented by the deferred column.
In other words, when a company buys back its own shares, each share is worth a larger percentage of the company, and therefore should increase in price. Share buybacks help earnings per share (EPS) increase more quickly than net income, which assuming the price-to-earnings ratio stays relatively consistent, results in higher stock prices.
Market volatility of course plays a huge role in the short term, but in the long term it is the company fundamentals that drive stock price, including the the fact that each share is worth more of the company and EPS is growing at a fast rate because of it.
Buyback Benefit 3) Low Share Prices = Better Returns
Consider Travelers as an example again. Suppose that tomorrow, the company profit remains the same, but the share price gets cut in half for some irrational market-driven reason.
Some investors would panic. But true value and contrarian investors would love it.
This is because now each dollar the company spends on share repurchases will be twice as powerful. For the same amount of money, they’ll be able to double the speed at which they reduce the share count and increase the ownership stake of each share. The dividend yield will also double, meaning that reinvested dividends will be able to buy back twice as many shares as well.
Over the short-term, the investment will lose value due to the share price decline.
But over the long-term, the company will actually have faster earnings per share (EPS) growth due to accelerated buyback power, and investors that reinvest dividends will own more shares than they would if the price remained higher.
Dividends and buybacks give great psychological benefits for long-term value investors because market volatility and crashes actually increase your ownership stake and improve the long-term performance of your investment for companies that are able to pay dividends and buy back shares during difficult times.
All else being equal, it’s ideal for the company fundamentals to be great and the stock price to be perpetually undervalued.
Buyback Pros Full List:
- Highly flexible for management
- More tax-efficient than dividends
- Buyback companies outperform on average
- Great for undervalued companies
The Drawbacks of Share Repurchases
While share repurchases are indeed a sensible use of shareholder capital in the right circumstances, all too often they are done for the wrong reasons.
Buyback Drawback 1) Bad Market Timing
The main risk of share repurchases is that companies often buy back the most shares when those shares are expensive or overvalued.
And that is obviously not a good use of capital.
This chart shows how much corporations in the S&P 500 have spent on buybacks over almost two decades:
Source: JP Morgan Guide to the Markets
As you can see, companies tend to spend a ton of money on buybacks at the top of a market cycle, when stocks are expensive and the companies have plenty of cash on hand, like in 2007. As soon as a recession comes, like in 2008 and 2009, the company has less money and starts being more stingy with buybacks, even though due to the low share prices, this would be the best time to buy back their shares.
Some companies just consistently buy back shares year after year, and basically dollar-cost average into their own stock over decades. I tend to like those types of companies, and they statistically outperform as a group.
In addition, share repurchases have become a lot more popular in recent decades. Back in the 80’s, 90’s, and earlier, companies tended to pay bigger dividends and buy back fewer shares, but now they’ve shifted a bit towards buybacks, which I have mixed opinions on.
Buyback Drawback 2) You Can’t Spend Them
One of the highlights I talked about in my dividend article is that dividends give you some degree of protection against volatile markets.
If you are reliant on investment income, dividends matter. Stocks may go up or down in price for irrational reasons, but if the company keeps paying and growing its dividends, your investment income remains unaffected.
And that’s where share repurchases fall short. Over the long-term, share repurchases accelerate earnings per share growth, and accelerate dividends per share growth as well. This eventually results in accelerated share price growth.
But in the short term, all bets are off. A company could be growing all of its per-share metrics and doing great, but in a market correction its share price could decline anyway.
Buyback Drawback 3) Less Shareholder Choice
If you are a dividend investor, you get to decide whether to reinvest your dividends, or spend them.
And if you decide to reinvest, you can reinvest them into buying more shares of the same company that provided them, or you can invest them elsewhere into a different company that you believe is at a more attractive valuation.
But share buybacks? Not so much. The company’s management and board of directors make that decision for you. They decide how much to spend in share buybacks, and when. This goes back to the first drawback; management may reinvest at a time when the share price is already overvalued, which is not a good use of capital.
Buyback Cons Full List:
- Bad for overvalued companies
- You can’t spend buybacks like you can dividends
- Shareholders get less of a choice
The Current Situation
We’ve had extremely low interest rates since 2007, and many companies have used that opportunity to issue very low interest debt and buy back shares with that money.
If they can borrow money by issuing bonds with a 3% interest rate, and use that money to reduce their number of shares, it’s usually a great investment and use of capital. However, there’s a limit to this, and as companies become highly leveraged, they can’t keep borrowing large amounts of money.
And after this lengthy bull market and economic expansion, companies are quite leveraged once again:
Source: Gluskin Sheff
This will reduce the amount of money that corporations can spend on buybacks going forward in 2019. They can still keep doing them, but just not at quite the rate they have been as they were leveraging up on low interest debt from 2011 to 2019.
It’s quite possible that the S&P 500 will see lower EPS growth over the next couple years due to a cooling off in share buybacks due to an economic slowdown, which would make the current high valuations increasingly difficult to justify.
How to Find Buyback Opportunities
The S&P 500 Buyback Index is the best place to start.
It’s an equally weighted index of the top 100 S&P 500 companies in terms of the percentage of market capitalization worth of shares they are repurchasing over the last 12 months. It has considerably lower average valuations than the S&P 500 in terms of price-to-earnings and price-to-book.
If you want to simply invest in this index directly, you can buy the relatively inexpensive SPDR S&P 500 Buyback ETF. It has an expense ratio of 0.35%.
In addition, if you click on that link to the ETF page, and then select “holdings”, you can download a list of all holdings in Excel format. This is an excellent list of buyback stocks to look through for investment ideas if you like to hold individual stocks.
Similarly, looking at the list of holdings for the Cambria Shareholder Yield ETF gives a great list of companies with high overall shareholder yields from a combination of dividends and buybacks.
Here are some names I like that are buying back considerable shares without sacrificing market share:
- Home Depot
- Texas Instruments
- Traveler’s Companies
- Discover Financial Services
- J.P. Morgan Chase
- Dollar General
(Current as of May 2019)
The shareholder yield (dividends plus buybacks as a percentage of market cap) is one of the most important metrics for companies that pay dividends and repurchase shares.
For example, if Discover Financial Services pays a 2% dividend yield and buys back 7% of its shares each year, it has a 9% shareholder yield. And if Home Depot pays a 2% dividend yield and buys back 3% of its shares each year, it has a 5% shareholder yield.
This shareholder yield metric tells you how much money it is returning to shareholders each year as a percentage of market capitalization, and tells you roughly what long-term rate of return you can expect before core company growth is considered.
Higher is not necessarily better here; this metric mainly tells you where returns are expected to come from. For slow-growth companies like Discover Financial Services, I look for an 8% or better shareholder yield, and the majority of returns will come from dividends and buybacks. For a company like Home Depot, 5% is still quite acceptable because it’s also growing revenue and company-wide net income at a fast pace.
In each issue of my free newsletter, I give updates on stocks that I consider good values, usually including some that are buying back shares and paying dividends, since it’s an area of interest for me.