In the 12 months ending 30 June, companies in the S&P 500 index spent a record $1 trillion to buy back their own stock, according to S&P Dow Jones Indices. But in January, a new 1% tax on buybacks may dampen corporate America’s appetite. S&P Dow Jones estimates the tax would cut corporate profits by half a percentage point at current buyback rates.
Buybacks have become controversial of late, with critics arguing that there are better uses for corporate cash. But a 2020 S&P Dow Jones Indices analysis of the 100 companies with the biggest buybacks found that their long-term stock returns generally exceeded the S&P 500.
Many smart investors, including Warren Buffett, are big supporters of strategic buybacks. “If a management wants to further strengthen our ownership by buying back shares, we welcome that,” he said.
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The new tax is low enough that it will discourage only the most marginal buybacks, experts say, so don’t expect them to disappear. But buybacks can be complicated to evaluate. For investors trying to navigate this changing market, a few signals can help you find stocks that are likely to benefit from share buybacks despite the tax. But first the basics.
The benefits. Buybacks make a lot of sense when a company can scoop up shares whose prices have been driven irrationally below their real value by market swings. Such purchases indicate insiders’ faith in the company and add demand that supports the stock’s price.
Many investors prefer buybacks to dividends because while you have to pay tax on dividends when they are issued, you don’t pay capital gains tax until you sell your shares. Additionally, when companies buy back more shares than they issue, each remaining share represents a larger ownership stake in the company
Some investors want companies to distribute cash through buybacks so managers aren’t tempted to make worse choices, says Meb Faber, chief investment officer at Cambria Investment Management. “How many companies have wasted money naming stadiums?”
Managers like buybacks because by reducing the number of shares outstanding, a company can report higher earnings per share, even if overall profits are flat or lower. This can be a particularly attractive strategy for any manager whose compensation is tied to rising earnings per share.
Buybacks also give managers flexibility. A company that increases its dividend runs the risk of a stock crash if problems later force it to reduce the payout. However, a buyback program can usually be suspended without alarming investors. Another benefit: Each share brought home means one less dividend payment for those companies that also pay dividends, reducing future cash obligations.
Finally, economists like buybacks because they take cash from companies that lack good internal investment ideas and return it to shareholders—who then typically reinvest it in other publicly traded companies (which, presumably, have more productive investment plans).
|Year||Share buybacks (billions)||Dividends (billions)|
|2022 (until June 30)||$501||$278|
The cons. Politicians as diverse as Sens. Elizabeth Warren (D-Mass.) and Marco Rubio (R-Fla.) have tried to discourage buybacks. The critics hope to encourage companies to invest more in their operations and create new jobs.
Although some studies emphasize the positive aspects of buybacks, others conclude that shareholders often benefit more from alternative uses of cash. Greg Milano, CEO of Fortuna Advisors, an investment advisory firm, says Fortuna has found over the past 12 years that companies that increased earnings per share due to investments in operations generated twice the share price gains of companies that raised per share. share profits through buybacks. Dividend payouts also led to slightly higher returns than buybacks.
And Milano cautions that, despite the hype, many buybacks end up not giving investors a bigger stake in a company, because companies often issue more shares in stock-based compensation plans than they buy back. Worst of all, investors have been burned by companies that have spent billions on buybacks instead of cleaning up their balance sheets or investing in their businesses to protect against downturns — as some airlines have done recently, for example. (For more information on airlines, see Why airline stocks are a bad deal)
How to pay in. Investors who want to ride out the downsides of buyback programs should follow three principles, experts say. The stocks mentioned below provide good examples.
Avoid dilution. Don’t jump on every buyback announcement. See if the company’s overall share count is actually going down, thereby increasing your ownership stake in the company, advises Faber. You can look up a company’s outstanding shares in its Securities and Exchange filings, or you can find its most recent stock count on sites like Yahoo Finance and YCharts. A good example is McKesson (MCK (opens in new tab)), says Faber, whose investment firm owns the stock. The drug and medical supplies distributor has reduced its stock count by 7% in the past year, and over the past five years, the stock price has doubled.
Look for price discipline. Successful buybacks, like successful investors, should buy low. Buffett’s Berkshire Hathaway (BRK.B (opens in new tab)), with more than $100 billion in cash, buys back its own shares when the price falls below what Buffett calls its “intrinsic value.” Morningstar sector strategist Greggory Warren notes that the company has repurchased $58 billion of its common stock since 2019, reducing its share count by about 10%. Warren, a Berkshire bull, believes the company is focused on reducing its longstanding cash hoard through a mix of share buybacks and share buybacks.
Bet on healthy businesses. Fortuna’s Milano says the companies likely to have high long-term returns on their buybacks have strong balance sheets and are ideally less vulnerable than other companies to economic or commodity cycles. One company high on his list: appeal (AAPL (opens in new tab)). Since the start of 2021, Apple has bought back more than $200 billion of its stock, reducing its share count by about 5%. In that time, the stock has gained about 6%, not including dividends, compared with a 3% loss for the S&P 500 index. Howard Silverblatt, senior index analyst for S&P Dow Jones Indices, says: “Apple is the poster child for buybacks.”