Investing on Corporate Generosity
By some accounts, thanks to the Trump tax incentives, corporate America finds itself with over $2T (Trillion) on its books, and the best thing they can think of doing with that stash of cash is: M&A, dividend hikes, and you guessed it – Share buybacks!
In Q1 of 2018, companies announced nearly $242.1B (Billion) in share buybacks. That number jumped nearly 80% in Q2, with a record amount of $433.6B announced in buybacks. Some analysts estimate that stock buybacks are on track to hit the $800B mark in 2018.
Portfolio View of Buybacks
So, are buybacks good, bad or indifferent to a portfolio containing shares of companies engaged in buying back their shares? Well, it depends who you ask! There are proponents as well as detractors of this corporate action. Detractors (such as money-managing giant BlackRock’s CEO Larry Fink, and ex-Vice President of the USA, Joe Biden) suggest that buybacks absorb much-needed capital away from the company, resulting in less outlays on innovation, hiring, pay increases and long-term growth projects.
However, supporters of buyback action, including senior executives from industry leaders like Boeing and Amazon, beg to differ. In their view, corporate America has more than sufficient cash on the books to hire workers when needed, to innovate and to compete globally for a long time to come. In their view, rewarding shareholders by returning some of their own cash back to them isn’t such a bad thing.
But how would a portfolio of buyback-indulging companies benefit you – the investor? Well, lets take a look at the numbers.
Firstly, when corporations buy back shares, the total “float” of stock available in the open market is reduced by the number of shares bought back. The result? This helps lower a denominator in key performance metrics used by investors and company analysts alike, the most important of which are Dividend Per Share, Dividend Yield and Earnings Per Share (EPS).
Notice how, in the above table, all three metrics improve with each successive buyback. With each successive tranche of shares bought back by the company, your portfolio becomes more attractive and more efficient, in terms of the returns that it generates.
For instance, assuming that this was the only company you held in your portfolio, while you started the year with a portfolio yielding 2.22% return, you end the year holding a portfolio returning 3.33%. Where, at the beginning of the year, you earned $0.75 per share held, you end the year earning $1.25 per share held. Since there are fewer shares to claim the company’s earnings, each share is now entitled to a bigger piece of the earnings pie. All of this happens despite no improvement in either share price or quarterly earnings. And that’s the power of share buybacks!
Building the Portfolio
Buying a stock (or avoiding it) purely on the basis of your belief that buybacks are good (or bad) is not a great investment strategy. It matters not which side of the buybacks debate you are on; the fact is that you need to assess each investment that you make on its own merit.
So, when building a buyback-portfolio, your primary considerations should be whether the company:
- is in the right industry
- has strong earnings and growth potential
- offers an opportunity for diversification to the portfolio
- has a track record of “survival” through multiple market cycles
- can serve as a source of stability and income for your portfolio in the long-term
Above is a (partial) list of companies that have announced share buy backs over the past several months. In some instance (for example NUE, NKE and AAPL) the announcement represents a new offer as of the date noted, while in all other cases these are additional buybacks announced in continuation to previous such announcements.
Notice that in every case, the names being proposed are all dividend payers. Some, like ORCL, have a decade or more history of consistent dividend pay-outs. Others, like AAPL and BAC, have track records of paying, interrupting or freezing, and then resuming/increasing their dividends over the years. However, in every case these are names that currently have a policy of paying dividends.
If you believe that buybacks are yet another plus point in your overall buy thesis for a stock, here are two additional factors that should consider before adding the name to your portfolio:
- The annual dividend yield of the proposed investment: Stay away from companies that have too high a dividend yield. Dividend payers that offer more than six or eight percent yields are signalling that their yields are in jeopardy of either being cut or suspended altogether in the future
- The pay-out ratio: Companies that pay out a significant portion of their free cash (95% or even 100% plus!) signal that the dividends are being sustained either through reserves or through debt. And that’s not a good stock to invest in! All of the proposed names above (except for ORCL) have reasonably low pay out ratios which can be sustained and even increased over the years.
A portfolio built from the 12 names discussed in this post would have delivered a handsome 23.90% average return over the past 1-year period – despite the recent massive correction in some of these names. And that only reflects price appreciation. When you include dividends and other pay outs, your total portfolio return would likely be higher.
While 23.90% isn’t a bad one-year return, the share buy-backs announced by these companies over the next few quarters is likely to super charge your portfolio even further.
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Author does not have investment in stock discussed in this article.