Buybacks and Abnormal Returns
How to beat the index
Hi Everyone,
Happy New Year to all of you!
Let’s start with today’s topic.
Share buybacks are happening more and more often, both in the U.S. and around the world. Since 1998, about 10% of all U.S. companies with shares on the stock market have announced a buyback program every year. Even though this percentage is higher than in many other countries, rules have changed since the late 1990s, making share repurchases much more common in the rest of the world.
This "buyback wave" has gotten a lot of attention from the financial press and has been criticized by the general media and politicians for hurting economic growth and causing companies to cut back on long-term investments in order to focus on short-term goals like earnings per share. The underlying assumption of these arguments is that companies don't invest enough and may use buybacks to boost their stock price in the short term, even if it hurts shareholder value in the long run.
This worry is behind calls for stricter rules. Critics say that buybacks hurt long-term shareholder value, but the research on U.S. buybacks shows that they are linked not only to a rise in the stock price when the buyback is approved but also to positive long-term excess returns.
As an investor, it is my job to determine which elements have historically increased returns and incorporate them into my investment strategy. I ignore the political discussion.
Share repurchases are a powerful tool, and their announcement should not be overlooked. For some obscure reason, too many investors focus on hypothetical future possibilities (profit predictions, possible market growth, innovative technologies, etc.) while disregarding repurchase announcements that reveal precisely what will occur in the future: The business will reduce the number of outstanding shares, thereby increasing the value of the remaining shares.
For the following example, we will use the S&P 500 SPY 0.00%↑ as the stock universe we select from. How would an equal-weighted index perform, which consists of 100 stocks with the highest buyback ratio and is rebalanced every quarter? (The buyback ratio is defined as the ratio of cash used in the repurchase of common shares in the trailing four quarters divided by the total market capitalization of outstanding common shares at the beginning of the buyback period). Let’s take a look at the past 10 years:
The Buyback Index (white line) had an annualized price return of +11.87% vs. the S&P 500 which had an annualized price return of +10.41% (total return incl. dividends would have been +13.6% vs. +12.26%). That’s impressive, considering we have a simple single-factor methodology. We see that the Buyback Index was ahead of its benchmark most of the time, except at the beginning of 2020 when it had a much more significant drawdown.
I ignore this simply because an event (shutting down the world economy) that occurs probably once in 100 years is not helpful to determine if an investing strategy works or not. I focus on the rule and not on the extremely rare exception of the rule.
Examining last year's performance will help us determine how well this strategy protects our capital during a bear market:
A -12.66% return vs. a -19.44% return looks good considering that our index was ahead of its benchmark during the whole year. A back-tested performance using a particular approach (in this case, the buyback ratio) demonstrates if and to what extent a factor may have positively affected its performance. I use it to determine if I'm on the correct path and if I should focus on a particular strategy.
Over a 25-year timeframe, the results of such a portfolio are even more impressive:
An excess return of more than +4% per year is incredible (Note: in this example it’s the total return with dividends included, not the price return)
Insightful is also the composition of this index. We see that the biggest sectors are the ones that are shunned by many (financials in this case mean banks and insurance companies):
Food producers, banks, insurance, and healthcare companies are considered “boring”. Yet, stocks that can be found in those sectors produce outstanding returns over time.
How to utilize this information?
Here are two ways we can profit:
Share repurchases have historically been pro-cyclical, rising in strong markets and falling in down markets. We can use buybacks as a better source of information about the current phase of the market cycle we’re in. Media pundits love to talk about “the market” and give their opinion. I, on the other side, prefer to look at facts. When I read that more and more companies are buying back their shares and share buybacks are at an all-time high, I can deduce from it that we’re coming closer to the end of the business cycle.
Before even thinking about single stocks, I want to make sure that I’m fishing in the right pond. While the S&P 500 Buyback Index is not investable anymore (the former ticker was SPYB), I found a similar Index: The Invesco BuyBack Achievers ETF PKW 0.00%↑. It replicates a different benchmark - the NASDAQ Buyback Achievers Index - which consists of companies that have repurchased at least 5% or more of shares in the trailing 12 months. Here are its TOP 10 Holdings:
Despite the fact that I’m not a big fan of ETFs, I still find them helpful for backtesting if a certain strategy has worked or not. If it has, I use the stocks it includes for further research because I’m already fishing in a pond that has produced outsized returns.
The next possible steps would be a combination of another factor that outperforms, value for example (cheaper stocks outperform expensive stocks over time), narrowing down the selection by sorting out the stocks that trade at high multiples. Or to check the Piotroski F-Score that I introduced in this previous article:
Those are just two of many options that illustrate how you can construct a portfolio strategically.
(The following tickers are simply for the search function so that readers can find my article if they look for any of those stocks ORCL 0.00%↑ CI 0.00%↑ BAC 0.00%↑ LOW 0.00%↑ HCA 0.00%↑ MET 0.00%↑ MPC 0.00%↑ DG 0.00%↑ CHTR 0.00%↑ ORLY 0.00%↑)
Final thoughts
To be a successful investor, I take a holistic approach to the game. Too often, I observe investors seeking absolute solutions:
“Is this the best stock?”
“Should I buy now?”
“What’s the price target?”
…and so on.
In the previous example, we utilized a single-factor solution that was already effective. Nonetheless, we can increase our profits by including other historically outperforming characteristics. Instead of obsessing over single stocks (that will hopefully rise), we should focus on building a portfolio with factors/ratios that have historically outperformed. Then we won’t worry that much about single events because we have a team that does its job over time, even if a few players get injured.
As you see, buyback announcements are another piece of the puzzle that deserve more attention.
I hope you learned something today, until the next issue. 👋
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