In the 12 months ended 30 June, companies in the S&P 500 index spent a record $1 trillion to buy back their own shares, according to S&P Dow Jones Indices. But come January, a new 1% tax on buybacks could dampen corporate America’s appetite. S&P Dow Jones estimates the tax would cut corporate profits by half a percentage point at current purchase rates.
Buybacks have recently become controversial, 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 largest buybacks found that their long-term stock returns generally outperformed the S&P 500.
Many smart investors, including Warren Buffett, are big supporters of strategic buybacks. “If a manager wishes to further intensify our ownership by repurchasing the shares, we would appreciate it,” 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 complex to evaluate. For investors trying to navigate this changing market, a few signs can help you find stocks that are likely to benefit from tax-free share repurchases. But first, the basics.
The advantages. Buybacks make a lot of sense when a company can wipe out shares whose prices have been driven irrationally below their true value by market swings. Such purchases indicate insiders’ faith in the company and increase the demand that supports the stock price.
Many investors prefer buybacks over dividends because although you have to pay taxes on the dividends when they are issued, you don’t pay taxes on capital gains until you sell your shares. Additionally, when companies buy back more shares than they issue, each remaining share represents a larger ownership portion of the company.
Some investors want companies to distribute money through buybacks so that managers are not tempted to make worse choices, says Meb Faber, chief investment officer of Cambria Investment Management. “How many companies have spent money to name the stadiums?”
Executives like buybacks because by reducing the number of shares outstanding, a company can report higher earnings per share even when overall profits are flat or down. This can be an especially tempting strategy for any executive whose compensation is tied to increasing earnings per share.
Buybacks also give managers flexibility. A company that raises its dividend risks a stock collapse if later problems force it to cut the payout. A buyout program, however, can usually be suspended without alarming investors. Another advantage: Each share brought home means one less dividend payment for those companies that also pay dividends, reducing future cash obligations.
Finally, economists love buybacks because they take cash from companies that don’t have good internal investment ideas and return it to shareholders—who then typically reinvest it in other publicly traded companies (which, presumably, they have more productive investment plans).
| A year | Share Purchase (billions) | Dividends (billions) |
|---|---|---|
| 2022 (until June 30) | $501 | $278 |
| 2021 | 882 | 511 |
| 2020 | 520 | 483 |
| 2019 | 729 | 485 |
| 2018 | 806 | 456 |
The disadvantages. Politicians as diverse as senators Elizabeth Warren (D-Mass.) and Marco Rubio (R-Fla.) have tried to discourage buybacks. Critics hope to encourage companies to invest more in their operations, and generate 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, on average, firms that have increased earnings per share due to investments in operations they generated twice the stock price earnings of companies that increased per share. shares profits through buybacks. The dividend payment also led to slightly higher income than the buyback did.
And Milano cautions that despite the hype, many buybacks don’t end up 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 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 on airlines, see Why Airline Stocks Are A Bad Deal)
How to make cash. Experts say investors looking to ride the coattails of buyback programs should follow three principles. The stocks mentioned below provide good examples.
Avoid dilution. Don’t jump on every buyback notice. Check if the company’s overall share count is actually going down, thereby increasing your 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 share counts on websites like Yahoo Finance and YCharts. A good example is McKesson (MCK (opens in a new tab)), says Faber, whose investment firm owns the stock. The distributor of drugs and medical supplies has reduced its share count by 7% in the past year, and over the past five years the stock price has doubled.
Look for price discipline. Successful repurchasers, like successful investors, should buy low. Buffett’s Berkshire Hathaway (BRK.B (opens in a new tab)), sitting on 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 worth 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 long-standing cash hoard through a mix of share buybacks and share buybacks.
Bet on strong brands. Fortuna’s Milano says companies likely to have high long-term returns on their buyouts have strong balance sheets and, ideally, are less vulnerable than other firms to economic or commodity cycles . One company high on his list: Apple (AAPL (opens in a new tab)). Since the beginning 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 roughly 6%, excluding dividends, compared to a 3% loss for the S&P 500 index. Says Howard Silverblatt, senior index analyst for S&P Dow Jones Indices , “Apple is the poster child for buybacks.”
