The Buyback Fund

Ordinarily, an index fund that charges anything close to an active management fee would not be competitive. Yet, despite its 0.71% expense ratio, PowerShares Buyback Achievers (PKW) has amassed more than $2.5 billion in assets. That is likely due to its impressive performance record. From its inception in December 2006 through February 2014, the fund outpaced the S&P 500 Index by nearly 2.9% annualized, net of fees. Yet, its strategy is simple. The fund targets U.S. stocks that have reduced their shares outstanding by at least 5% in the previous year and weights these holdings by market capitalization, subject to a 5% cap. This results in a portfolio of quality, shareholder-friendly companies that may continue to generate attractive returns.

According to classic finance theory, the mechanics of a share-repurchase program should have no impact on the value of a company's stock--assuming it is fairly valued when it is repurchased. In order to repurchase its shares, a company must either use cash on its balance sheet or issue new debt. Although there are fewer shares outstanding, this reduction in cash or increase in debt reduces the total value of equity by an offsetting amount. For example, consider a company with a market capitalization of $1,000, 100 shares outstanding, with each trading at $10, and net income of $100. The company repurchases 10 shares of stock in the open market at a fair value of $10 a share with cash. This reduces the number of shares outstanding to 90 and the firm's market capitalization to $900. Each share remaining is still worth $10.

Notice that this transaction had no impact on the firm's total net income. While earnings per share increased from $1 to $1.11, the fair value of each share is unchanged. A stock's fair value is the present value of its future cash flows, plus the value of its assets in place, minus debt. With less cash in the business, investors should pay a lower multiple for each dollar of earnings than before the repurchase. This reduction in the fair earnings multiple should offset the increase in earnings per share.

However, if managers can buy their shares at prices below fair value, that changes the game entirely. As Warren Buffett explained in his 2011 letter to Berkshire Hathaway shareholders, "We like making money for continuing shareholders, and there is no surer way to do that than by buying an asset--our own stock--that we know to be worth at least x for less than that--for .9x, .8x or even lower." Managers may have better information about what their stock is worth than does the investing public. They can use this information for their long-term shareholders' benefit by repurchasing their stock when it is trading below fair value. These purchases effectively transfer wealth from shareholders who sell to those who stay. The market may perceive the initiation or increase of a share-repurchase program as a signal that managers believe their stock is undervalued, which can have an immediate positive impact on its price.

While increasing share repurchases when a stock is undervalued is sound justification for instituting these programs, repurchases were procyclical over the past decade. They increased between 2003 and 2007, peaking in the third quarter of 2007, before dropping off precipitously during the subsequent bear market and picking up again with the recovery (1). Companies tend to institute share buyback programs when they are flush with cash, not necessarily in the depths of a bear market when their share prices are most depressed. Consequently, a company's decision to institute a repurchase program does not necessarily mean that its stock is undervalued.

A more cynical view suggests companies use share-repurchase programs to manage earnings per share to meet analyst expectations. While some managers may try to game analyst estimates, intelligent investors should be able to see right through these maneuvers. More-responsible managers use repurchases to return excess cash to shareholders when they do not have more-attractive investment opportunities and to offset the impact of employee stock compensation.

While companies have traditionally relied on cash dividends to distribute excess cash to their shareholders, share repurchases are more tax-efficient. When a dividend is paid out, all taxable shareholders get hit with the dividend tax. In contrast, in a share-repurchase program, only those investors who sell their shares receive a cash distribution and recognize taxes on their capital gains. This option to defer taxes makes share repurchases a more tax-efficient method to distribute cash, even when the capital gains and dividend tax rates are the same. 

However, because they are less binding, share repurchases send a weaker signal to the market about management's confidence in its business prospects than do traditional dividend increases. There is a strong negative stigma associated with cutting a dividend payment. Consequently, managers don't usually commit to them unless they are confident that they will be able to honor them throughout the business cycle. In contrast, failing to fully execute an announced share buyback program is more common and is usually not interpreted as a sign of trouble. This flexibility makes share repurchases an ideal way to distribute residual cash flows that may fluctuate over time.

Similar to a traditional cash dividend, a stock-repurchase program may constrain managers' capacity to engage in value-destructive empire-building. Companies that pursue a disciplined policy of returning capital to shareholders, regardless of the method, may offer better returns over the long term because they will likely make fewer marginal investments than those that amass large cash balances. Firms with healthy repurchase programs also tend to enjoy good profitability. That may explain why a regression analysis of the fund's returns from 2007 through 2012 revealed that it exhibited a quality tilt, using a quality factor that researchers from AQR constructed using profitability, stability, growth, and payout metrics.

Portfolio Construction
The fund tracks the NASDAQ US Buyback Achievers Index, which includes U.S. securities that have reduced their shares outstanding by 5% or more over the trailing 12 months through December. The index is reconstituted annually in January and rebalanced quarterly. Because companies often use share-repurchase programs to distribute residual cash and are not obligated to fully execute these programs, repurchasing activity can be lumpy. Consequently, firms that have reduced their shares outstanding by 5% or more in the previous year may not continue to do so. This can create high turnover. Over the most recent fiscal year, the fund's turnover reached 80%. Mirroring its index, the fund weights its holdings by market capitalization but imposes a 5% cap in order to preserve diversification. The fund climbs much further down the market-cap ladder than most of its large-blend peers. Its average market capitalization is only $24 billion, less than half the corresponding figure for the Russell 1000 Index. Consumer cyclical stocks currently represent the fund's largest sector weighting at nearly 30% of the portfolio.

Alternatives
Funds that track companies with shareholder-friendly payout policies, such as a consistent record of dividend growth, may be good alternatives. Within this category,  Vanguard Dividend Appreciation Index ETF (VIG) (0.10% expense ratio) is one of the best. It targets companies that have increased their dividends in each of the past 10 years. Cambria Shareholder Yield ETF (SYLD) (0.59% expense ratio) measures investor cash flows more holistically. It includes dividend payments, net share repurchases, and net debt reduction in its selection criteria. The fund invests in and equally weights the 100 top-scoring stocks, resulting in a mid-cap value tilt.

Investors looking for a more explicit quality tilt might consider iShares MSCI USA Quality Factor (QUAL) (0.15% expense ratio). It screens for companies with high returns on equity, earnings stability, and low debt/capital ratios. This approach tends to give it a growth tilt.  Schwab U.S. Dividend Equity ETF (SCHD) (0.07% expense ratio) may be a more appropriate quality option for value-oriented investors. While this fund targets stocks with high dividend yields, it also incorporates return on equity, cash flow/total debt, and dividend growth into its screening criteria.

PowerShares recently launched an international version of its buyback achievers fund, PowerShares International Buyback Achievers (IPKW) (0.55% expense ratio), which applies very similar portfolio construction rules as PKW. While this fund charges less than its U.S. counterpart, its expense ratio is still a bit rich. There is no reason why PKW should charge more. 

1) Voss, Jordan. "Why do Firms Repurchase Stock?" http://business.uni.edu/economics/Themes/voss.pdf 

 

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