Despite Its Strengths, This Buyback Strategy May Disappoint

On the surface, targeting stocks that have repurchased their shares may seem like a good strategy. Stock buybacks are a sign of strong profitability and shareholder-friendly management teams who understand that their employers may have better investment opportunities than they do. And they are a more tax-efficient means of returning cash to shareholders than dividends, as they create tax bills only for sellers. But share purchases in one period may not continue in the next, and they aren’t necessarily a sign that the shares are undervalued.

Invesco BuyBack Achievers ETF PKW has built a solid record by selecting stocks based on short-term repurchasing activity. Firms that repurchase their shares tend to be highly profitable, but there is little to suggest that past repurchasing activity is predictive of future performance after controlling for profitability. There are cheaper and more direct ways to get exposure to highly profitable stocks. The fund warrants a Morningstar Analyst Rating of Neutral.

The fund targets U.S. stocks that have reduced their shares outstanding by at least 5% in the previous year through repurchases. It weights them by market capitalization, subject to a 5% limit. Like dividends, a disciplined share-repurchase program can constrain managers from making low-return investments. However, share repurchases are less binding than dividend payments, so they may be less effective in constraining managers. Indeed, share repurchases in one year often do not carry forward to the next, so this approach can lead to high turnover.

Share repurchases do not paint a complete picture of a firm’s financial health or its attractiveness as an investment. Repurchases can be financed by debt, rather than by the strength of the underlying business. Such a strategy isn’t always desirable. And repurchases can hurt returns if managers overpay for their shares.

At times the fund can make large sector bets. It currently has greater exposure to the consumer cyclical and technology sectors than the Russell 1000 Index and less exposure to consumer defensive and utilities stocks. These types of sectors are fluid, but they can have a strong impact on performance and dilute the fund's bet on share repurchases.

This strategy has worked well over the long term. It outpaced the Russell 1000 Index by 39 basis points annualized from its inception in December 2006 through January 2019, ranking in the top quintile of the large-blend Morningstar Category. This was partially attributable to its overweighting in the strongly performing consumer cyclical sector.

Fundamental View The mechanics of a share repurchase should have no impact on the value of the stock if it is fairly valued when it is repurchased. Even though this transaction increases earnings per share, its impact on the value of the stock is offset by the reduction in cash or increase in debt the company used to finance the buyback. However, if managers buy their shares below fair value, they effectively transfer wealth from the sellers to the remaining shareholders.

Managers may have better information about what their stock is worth than 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. 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 push its price up.

While increasing share repurchases when a stock is undervalued is sound justification for repurchasing stock, buybacks tend to be procyclical. Companies are more likely to ramp up their 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. Rather, managers typically use repurchases to return excess cash to shareholders when they do not have more-attractive investment opportunities, similar to a dividend.

Buybacks can be more attractive to managers than dividends because they are more tax-efficient, can help offset dilution from employee stock compensation, and allow managers to fine-tune earnings per share. There is also less of a stigma from reducing buybacks than cutting a dividend.

Share repurchases are more tax-efficient than dividends because they create tax liabilities only for investors who sell their shares, whereas dividend payments affect all taxable shareholders. This option to defer taxes makes share repurchases more tax-efficient, even when the capital-gains and dividend tax rates are the same.

Because they are less binding than dividend increases, share repurchases send a weaker signal to the market about management's confidence in its business prospects. Investors often punish firms that cut their dividends, so managers generally don't commit to them unless they are confident 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.

While the fund's market-cap-weighting approach gives larger stocks greater influence in the portfolio, it often has a smaller-cap orientation than most of its peers. It has also tended to favor more-profitable firms than most.

Portfolio Construction This strategy's focus on share buybacks indirectly leads it to profitable stocks with shareholder-friendly management teams. But it uses a short period to measure share repurchases, which may not be indicative of future repurchases. And there is little indication that the screen it uses is predictive of future performance after controlling for profitability. Therefore, it earns a Neutral Process rating.

The fund tracks the Nasdaq U.S. Buyback Achievers Index, which includes U.S. stocks that have reduced their shares outstanding by 5% or more during the trailing 12 months through December. The index is reconstituted annually in January and rebalanced quarterly. Repurchasing activity can be lumpy because firms often use share-repurchase programs to distribute residual cash and are not obligated to fully execute these programs. This can create high turnover, which reached 66% in the most recent fiscal year. Mirroring its index, the fund weights its holdings by market cap but imposes a 5% limit to improve diversification. The fund climbs much further down the market-cap ladder than most of its large-blend peers. Its average market cap is less than half that of the Russell 1000 Index.

Fees It is difficult to justify the fund's 0.63% fee. This fee is not much lower than many actively managed alternatives. The fund has significantly lower operating costs than actively managed strategies because it simply tracks a benchmark and should therefore charge a much lower fee. But because this price is still low relative to the entire large-blend category, the fund earns a Neutral Price rating. Over the trailing three years through January 2019, the fund lagged its benchmark by 71 basis points annually, slightly more than the amount of its expense ratio. The additional drag likely comes from transaction costs.

Alternatives SPDR S&P 500 Buyback ETF SPYB (0.35% expense ratio) is one of the closest alternatives, but it can be expensive to trade, because of its limited trading volume. This fund targets the 100 stocks in the S&P 500 with the largest buyback yields (cash value of buybacks/starting market cap) over the past 12 months. The fund weights its holdings equally and rebalances quarterly.

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. This fund invests in and equally weights the 100 top-scoring stocks, resulting in a mid-cap value tilt.

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 ETF VIG (0.08% expense ratio) is one of the best. It carries a Morningstar Analyst Rating of Gold and targets companies that have increased their dividends in each of the past 10 years.

Silver-rated iShares Edge MSCI USA Quality Factor ETF QUAL (0.15% expense ratio) offers more direct exposure to firms with high profitability. It screens for companies with high returns on equity, earnings stability, and low debt/capital ratios. This fund anchors its sector weightings to the broad market-cap-weighted MSCI USA Index to mitigate unintended sector bets.

Invesco International BuyBack Achievers IPKW (0.55% expense ratio) applies very similar portfolio construction rules as PKW in foreign markets. While this fund charges slightly less than its U.S. counterpart, its expense ratio is still rich.

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