In the 12 months ending June 30, 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 from current buyback rates.
Recently buybacks have become controversial, with critics arguing that there are better uses for corporate cash. But an S&P Dow Jones Indices 2020 analysis of the 100 companies with the largest buybacks found that long-term stock returns have outperformed the S&P 500.
Many smart investors, like Warren Buffett, are big supporters of strategic buybacks. “If a management wants to further intensify our ownership by buying back shares, we applaud,” he said.
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The new tax is low enough that it will discourage only the most marginal purchases, experts say, so don’t expect them to disappear. But buybacks can be complex to evaluate. For investors trying to navigate this changing market, some signals can help you find stocks that are likely to benefit from stock buybacks despite the tax. But first, the basics.
The advantages. Buybacks make a lot of sense when a company can sweep up shares whose prices have been irrationally driven below true value by market swings. These purchases signal insiders’ confidence in the company and add demand that supports the stock price.
Many investors prefer dividend buybacks because although you must pay taxes on dividends when they are issued, you do not pay capital gains taxes until you sell your shares. Additionally, when companies buy back more shares than they issue, each remaining share represents a larger piece of ownership in the company.
Some investors want companies to distribute cash through buybacks so managers aren’t tempted to make worse choices, said Meb Faber, chief investment officer of Cambria Investment Management. “How many companies waste money on stadium names?”
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 attractive strategy for any executive whose compensation is tied to increased earnings per share.
Repurchases also give managers flexibility. A company that raises its dividend risks a stock meltdown if problems later force it to cut the payout. A buyback program, however, can usually be stopped without alarming investors. Another advantage: Each share taken home means a smaller dividend payment for those companies that also pay dividends, reducing future cash obligations.
Finally, economists like buyouts 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 investment plans most productive).
|Year||Redeem shares (billion)||Dividends (billion dollars)|
|2022 (until June 30)||$501||$278|
Disadvantages. Politicians like Sens. Elizabeth Warren (D-Mass.) and Marco Rubio (R-Fla.) have tried to discourage buybacks. Critics hope to push companies to invest more in operations, generating 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 consulting firm, says Fortuna has found over the past 12 years that, on average, companies that increase earnings per share due to investments in operations have generated twice the gains in stock prices. companies that have increased per share. profit sharing through buybacks. Dividend payments also led to slightly higher returns than repurchases.
And Milano warns 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 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 make money. Investors who still want to ride the coattails of buyback programs should follow three principles, experts say. The actions mentioned below provide good examples.
Avoid dilution. Don’t jump at every buyout ad. Check to see if the company’s overall stock count is actually decreasing, 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 find its most recent stock numbers on websites like Yahoo Finance and YCharts. A good example is McKesson (MCK (opens in 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 in the past five years the stock price has doubled.
Look for price discipline. Successful buyouts, like successful investors, should buy low. The Buffett Berkshire Hathaway (BRK.B (opens in 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 number of shares by about 10%. Warren, a Berkshire bull, believes the company is focused on reducing its cash hoard through a mix of stock purchases and stock buybacks.
Bet on healthy companies. Fortuna’s Milano says the companies most likely to have high long-term returns on buybacks have strong balance sheets and, ideally, are less vulnerable than other companies to economic or commodity cycles. A company listed above: Apple (AAPL (opens in new tab)). Since the beginning of 2021, Apple has bought back more than $ 200 billion of its stock, reducing the number of its shares by about 5%. In that time, the stock has gained about 6%, not including dividends, compared to a 3% loss for the S&P 500 index. “Apple is the poster child for buyouts,” said Howard Silverblatt, senior index analyst for S&P Dow Jones Indices.