How a Stock Buyback Strategy Can Deliver Market-Beating Gains

Dividend paying stocks are all the rage, but the other way companies return cash to shareholders-share buybacks-is worth your attention.

The PowerShares Buyback Achievers ETF (PKW) focuses on firms that have repurchased at least 5% of outstanding shares over the prior 12 months. Over the past five years it has outpaced the SPDR S&P 500 ETF (SPY) and a leading dividend ETF.

PKW Chart

PKW data by YCharts

The edge holds up even if we switch over to total return-which includes the reinvestment of dividends.

PKW Total Return Price Chart

PKW Total Return Price data by YCharts

Now if you’re looking for bond-beating income to live off of, then dividends are obviously going to float your boat these days; plenty of blue chips have yields double the yield on the 10-year Treasury, and decent valuations as well.

But if you don’t need the income, focusing on the stock repurchasers could be the better strategy. Especially if you’re trading in a taxable account. Right now the top dividend income tax rate is 15%. The 15% is set to expire at the end of the year. We won’t know diddly squat about what Congress is going to do until after the November election. President Obama has called for returning the dividend tax for anyone making more than $250,000 to where it was before the Bush tax cuts: in line with your marginal tax bracket. Based on current tax rates that could be as much as 39.6%. Mitt Romney has called for the tax being eliminated. And there’s no telling what could emerge after Congress is through with its sausage making.

With stock repurchases you don’t have to worry ‘bout the tax implications.

Stock buybacks work best for shareholders when they are doled out by companies with strong operational fundamentals that happen to be sitting on a bunch of cash. Ideally the buyback is fueled by management’s calculation that the current stock price undervalues the company.

What’s not ideal is a company that is going through a rough patch, but has a bunch of cash on hand; it can use the repurchases to make some of its metrics look better-for example, if you reduce the number of shares outstanding through a repurchase earnings per share will rise, and the PE ratio will fall-regardless of whether the company is actually executing any better.

The PowerShares Buyback Achievers sets its portfolio once a year; the current holdings include companies that reduced their outstanding shares the most in 2011. The five largest holdings currently are IBM (IBM), Intel (INTC), Walt Disney (DIS), Conoco Phillips (COP) and Home Depot (HD).

IBM Chart

IBM data by YCharts

Home Depot’s buyback hasn’t depleted its cash.

HD Cash and ST Investments Chart

HD Cash and ST Investments data by YCharts

But take a look at Hewlett-Packard (HPQ), which is a top-10 holding in the PowerShares Buyback Achievers portfolio, based on a big buyback initiative through most of 2011.

HPQ Cash and ST Investments Chart

HPQ Cash and ST Investments data by YCharts

When Meg Whitman took over as CEO in the fall of 2011 she put the kibosh on continuing to eat into cash to fund aggressive stock buybacks. Using YCharts Pro, the most active recent stock repurchasers-in aggregate dollar amounts-that have an “Attractive” rating are Exxon Mobil (XOM), Chevron (CVX), Conoco Phillips, Intel and Royal Dutch Shell (RDS.B).

XOM Cash and ST Investments Chart

XOM Cash and ST Investments data by YCharts

The energy tilt makes perfect sense; all four have boatloads of cash, but the global economic slowdown has nicked earnings and sent stock prices falling. Unless you think the world has solved its long-term energy consumption challenge, that pullback creates a more compelling entry point for buyers -- clearly that’s what management thinks.

They also deliver on the dividend yield.

XOM Dividend Yield Chart

XOM Dividend Yield data by YCharts

Just in case you’d like some of that cash coming straight into your pocket.

Carla Fried is an editor for the YCharts Pro Investor Service which includes professional stock charts, stock ratings and portfolio strategies.



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