Buybacks are back in play. Looking to boost shareholder value, a number of companies have announced share repurchase agreements to buy back shares on the open market. Betting on one’s own company is usually a safe bet for executives, one which increases the earnings per share for a firm, and allows for a very good return on invested capital.
For stockholders, buybacks also push off a tax liability into the future. Theoretically, a dividend payment is inferior to share repurchases because of the tax liability paid by investors. Share repurchases increase shareholder’s ownership of a firm without taxes.
Buyback Achievers ETF (PKW)
The PowerShares Buyback Achievers ETF seeks to find companies buying back stock in much the same way some investors seek out dividend-paying firms. The rules-based ETF operates very simply on a few basic rules:
- Included companies have to be incorporated in the United States
- Each firm must trade on US exchanges
- Firms must buy back 5% or more of their common stock in the trailing 12-month period
The requirements fuel higher turnover than other funds. Companies that repurchase 5% of their equity each year are quite rare – few can afford such a repurchase strategy for very long. More likely, companies meet criteria only for one or two years before cash outlays for share repurchase are scuttled as cash on hand is diminished.
Investment Methodology & Weighting
Any stocks meeting the three criteria above are put into the Buyback Achievers portfolio. Investments are market cap weighted, and capped at 5% of the portfolio.
The fund holds some 291 different firms, far more than one might expect given the very selective requirements for total share repurchases.
Personally, I like the fund’s inclusion requirements combined with the market cap weighting. Limiting the fund to companies that repurchase more than 5% of their common stock means it avoids firms that buy back shares solely to cover up stock option compensation to insiders. Also, the market cap weighting virtually ensures the fund is never taken by corporate diluters, who would find it very difficult to steal billions of dollars in shares by diluting the stock.
The 5% threshold is a bar set high enough that no stock will “accidentally” find itself as a position in the index. For a company to repurchase 5% of its equity, corporate leaders would have to view their company as a good wager at the current share price.
Major holdings include consumer cyclicals (25.1%), technology (18.54%), health care (15.78%), industrials (11.65%), and consumer defensive stocks (8.33%). The heavy weighting of the fund to cyclical stocks makes this a fund for a turnaround.
Fees and Expenses
The fund carries a .7% annual expense ratio, which is higher than most market-cap weighted funds (Here are the 5 lowest cost ETFs). However, its small size and intriguing strategy make it inherently less cost-effective than large funds. Turnover and research costs undoubtedly add to the costs of managing this particular ETF.
At the end of the day, it all comes down to total return. Here are the 5-year returns for PKW, as well as two other popular exchange-traded funds:
- PowerShares Buyback Achievers ETF (PKW): 23.42%
- SPDR S&P 500 ETF (SPY): 11.77%
- SPDR S&P500 Dividend ETF (SDY): 11.59%
Interestingly, the PKW ETF has bested both the S&P500 index as well as the S&P500 Dividend Index, which currently holds the 62 highest-yielding S&P500 components (more types of High Yield ETFs). As share repurchases are often compared to the alternative, dividends, it is interesting to see a buyback fund perform twice as well over the 5-year period as one of the most popular dividend ETFs. This is especially vexing since dividends provide half the total market return over long periods of time and yet, PKW’s buyback strategy exceeds even the dividend payers in SDY.
See the chart below, which compares the price of the funds over time:
Be sure to note that this performance chart above does not include dividends. We can conclude from the share price performance that total returns from the buyback fund are almost exclusively from appreciation in the fund NAV. This only confirms the view that most companies cannot sustain both a high dividend yield and 5% repurchases of common stock every year.
There are a few reasons why total returns for PKW outpace both the SPY and SDY ETFs:
- Exposure – The PKW fund is unlikely to invest heavily in financial firms. While financial firms were among the largest buyers of their own equity before the financial crisis, few banks ever repurchased more than 5% of their equity in any given year. This fund is unlikely to hold major banks in the future, given that repurchases are now governed by the Federal Reserve’s stress test results. At the time of writing, the PKW fund held only 8.22% of its assets in financial services firms, compared to 13% for the S&P500 index. If seeking a combination of financials and extremely high yield, check out Preferred Stock ETFs.
- Leverage – Companies that repurchase shares increase their operating leverage by decreasing their cash position to buy back stock on the open market. In a recovery, companies that consistently repurchase shares will perform better than average. However, in down markets, companies that repurchase share are unlikely to outperform.
- Timing – The 5-year period is very forgiving to the PKW ETF. In 2009, at the bottom of the market, the fund held companies that were most active in doubling down their bets on their own equity. Anyone who purchased shares in 2009 should have done quite well in the following years. Likewise, the 3 year period from 2006 to 2009 sent the PKW index falling faster than the S&P500 index as fund holdings were purchasing shares at prices in excess of the value on the market – essentially wasting money on falling stock.
This is a fund that I would expect to outperform a broad market index such as the S&P500 index over the longest of investment horizons. The methodology favors firms that are most confident about future earnings power. The exit strategy is also clearly defined, as the fund sells positions once the buyout bank balance runs too thin to sustain purchases. Repurchase agreements often send stock prices soaring as companies repurchase shares on the open market.
Disclosure: The author holds no positions in any of the above funds.