Insights From ETFs: Share Buyback: A Long-Term Outperformance Factor
1. What is share buyback?
Share buyback or share repurchase is one of the key options in capital allocation that a company can choose to allocate cash flow in addition to paying dividends, implementing acquisitions, or paying down debt.
In a share buyback, the issuing company repurchases its shares on the open market from any investor interested in selling, which reduces the amount of shares available, and increases the value of remaining shares.
The purpose of a share buyback is to provide investors who want to sell shares necessary liquidity and a fair exit price. It also rewards investors who choose to stay invested in the company by allowing them to own more stake in the company and increasing earnings per share (EPS), as there are fewer shares outstanding to be divided for net income.
Two seemingly similar companies in comparable industries and operating results can show vastly different shareholder outcomes over the long term, depending on each company’s chosen capital allocation policy.
2. Why investors should pay attention to it?
According to PGM Global, from 2011 to 2023, the annualized return for the S&P 500 during that period was around 13.9%, of which Earnings growth and Buyback contributed 57.3% and 27%, respectively. Dividends accounted for 9.1% of the total return, while the remaining 6.6% contribution came from Multiple Expansions.
In addition, Earnings Growth and Multiple Expansion would be dependent on macro factors like interest rates and the health of the economy.
Capital returns in terms of buyback and dividends are at the discretion of management teams of public companies. Historically, share buyback has contributed a key part to the total returns of shareholders and is expected to continue to do so in the future.
3. The benefits of repurchasing shares
We think there are a few critical benefits that make share buyback attractive:
- In contrast to dividends, where investors expect it to be recurring and growing over time, share buyback is discretionary. Share buyback is best done opportunistically, especially during market dislocations. A well-timed buyback could create tremendous shareholder value over time. As a result, investors need to have some insights into management’s thinking related to value creation through share repurchases, so that shareholders will trust management to do the right things at the right time.
- Buyback is more tax-efficient than dividends, as investors pay income taxes when they receive dividends, no matter if they need the money or not. On the other hand, share buyback provides investors with the flexibility to defer capital gain into the future and only realize the gain when investors choose to do so. This allows investors to do tax planning more efficiently.
- Lastly, share repurchase is taxed as capital gain, as a result, being taxed at a lower rate than dividend income, which is considered as investment income.
Share buyback, if done sensibly, can create tremendous shareholder value over time. Some of the companies have become so successful with share buybacks that they fuelled double-digit EPS growth lasting for decades. A few prominent case studies of such practices include companies like AutoZone (AZO), and NVR Inc. (NVR).
On the other hand, not all share buyback is created equal. Sometimes the management of the company just blindly follows the practice that peers are doing, or just buys back their shares for the sake of doing it without considering the valuation that their shares are trading at.
With dividend payments that require no imagination or timing, management needs to be disciplined on the valuation to buy back their shares. Like acquisition, when management overpays for its shares, it destroys shareholder value as money could be better spent on other value-creating activities.
Lastly, companies that have share repurchase authorization in place also provide skilled investors with a few positive signals, including:
Management believes shares are undervalued, as insiders tend to have a better picture of the true worth of their company than outsiders.
The company management team value shareholder-friendly policies.
We think share buyback could be a key factor for long-term outperformance relative to indices. As a group, companies that consistently buy back their shares tend to do better in terms of total returns than a basket of companies that do not.
Investors can also get exposure to the theme through diversified, low-cost Exchange-Traded Funds (ETFs):
Invesco Buyback AchieversTM ETF (PKW)
The Invesco Buyback AchieversTM ETF (PKW) provides investors with exposure to the NASDAQ U.S. Buyback Achievers Index, which consists of companies that have a net reduction in shares outstanding of at least 5% on the trailing 12-month basis. PKW is a well-established ETF which currently has $1.3 billion in Assets Under Management (AUM) and a Management Expense Ratio (MER) of 0.61%. The fund is rebalanced quarterly in January, April, July and October.
Piwi’s portfolio is broadly diversified across sectors, strategy (growth, value) and market caps (large-cap, small-cap). Some of the largest positions include Booking Holdings (BKNG)at 5.2%, T-Mobile US (TMUS) at 5.1%, Johnson & Johnson (JNJ) at 4.4%, Comcast Corp (CMCSA) at 4.2%, and Deere & Co (DE) at 4.2%. The common theme among these companies is that they are solid businesses that have been in operation for decades, generating tremendous amounts of free cash flow that are ready to be returned to shareholders.
The overall portfolio is trading at a very attractive valuation, on average, Piwi’s portfolio is trading at 15.2 times Forward Price/Earning and earns an impressive Return on Equity of around 57%. The ETF also offers a decent twelve-month trailing yield of 0.82%.
Pacer U.S. Cash Cows 100 ETF (COWZ)
The Pacer U.S. Cash Cows 100 ETF (COWZ) is a U.S.-focused ETF that invests in companies that provide the most attractive free cash flow yield by screening the Russell 1000. These companies are flush with cash in general and are expected to return the majority of it to shareholders, either through buyback or dividends.
COWZ currently has 103 holdings, and the portfolio offers an attractive free cash flow yield of around 7.6%. The portfolio is diversified across sectors consisting of Energy (23.4%), Information Technology (17.0%), Consumer Discretionary (16.6%), Health Care (15.7%) and Consumer Staples (9.8%).
Some of its largest positions consist of QUALCOMM (QCOM) at 2.19%, EOG Resources (EOG) at 2.15%, Valero Energy VLO) at 2.11%, Hewlett Packard Enterprise (HPE) at 2.09%, and Schlumberger NV (SLB) at 2.09%.
COWZ currently has around $25.6 billion in AUM, charges an MER of 0.49% and a twelve-month trailing yield of 1.82%.