During the 12 months ending June 30, S&P 500 companies have spent a record $1 trillion buying back their own stocks, according to the S&P Dow Jones Indices. But in January, a new 1% tax on buyouts could dampen the appetite of American businesses. S&P Dow Jones estimates the tax would cut corporate profits by half a percentage point at current buyout rates.
The takeovers have recently become controversial, with critics saying there are better uses for corporate money. But an analysis of the 2020 S&P Dow Jones indices of the 100 companies with the biggest buybacks found that their long-term stock returns generally outperformed the S&P 500.
Many smart investors, including Warren Buffett, are big proponents of strategic buyouts. “If any management wishes to further intensify our ownership by buying back shares, we applaud it,” he said.
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The new tax is low enough to discourage only the most marginal redemptions, experts say, so don’t expect them to go away. But buyouts can be complex to assess. For investors trying to navigate this changing market, a few signals can help you find stocks that may benefit from share buybacks despite the tax. But first, the basics.
Benefits. Buybacks make a lot of sense when a company can sweep stocks whose prices have been driven irrationally below true value by market fluctuations. Such purchases demonstrate insider confidence in the company and add demand that supports the stock price.
Many investors prefer redemptions to dividends because although you have to pay tax on the dividends when they are issued, you don’t pay any capital gains tax until you sell your shares. Also, when companies buy back more shares than they issue, each remaining share represents a greater share of ownership of the company.
Some investors want companies to distribute cash through buyouts so managers aren’t tempted to make worse choices, says Meb Faber, chief investment officer of Cambria Investment Management. “How many companies have wasted money naming stadiums?”
Executives like buybacks because by reducing the number of shares outstanding, a company can post higher earnings per share even when overall earnings are flat or falling. This can be a particularly attractive strategy for any executive whose compensation is tied to rising earnings per share.
Redemptions also give managers flexibility. A company that increases its dividend risks a stock crash if problems later force it to cut the payout. A buyback program, however, can usually be suspended without alarming investors. Another benefit: Every share brought home means one less dividend payment for 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 more productive investment plans).
| Year | Share buybacks (billions) | Dividends (billions) |
|---|---|---|
| 2022 (until June 30) | $501 | $278 |
| 2021 | 882 | 511 |
| 2020 | 520 | 483 |
| 2019 | 729 | 485 |
| 2018 | 806 | 456 |
The inconvenients. Politicians as disparate as Sen. Elizabeth Warren (D-Mass.) and Marco Rubio (R-Fla.) have tried to discourage buyouts. Critics hope to spur companies to invest more in their operations, thereby generating new jobs.
While some studies highlight the positive aspects of buyouts, others conclude that shareholders often benefit more from alternative uses of cash. Greg Milano, CEO of Fortuna Advisors, an investment advisory firm, explains that Fortuna has discovered over the past 12 years that, on average, companies that have increased their earnings per share through investment in operations have generated two times the stock price gain of companies that rose by-share earnings through buybacks. Dividend payouts also resulted in slightly higher returns than redemptions.
And Milano warns that despite the hype, many buyouts don’t end up giving investors a bigger stake in a company because companies often issue more stock in stock-based compensation plans than they do. don’t buy it back. Worse still, investors have been burned by companies that have spent billions on buyouts instead of cleaning up their balance sheets or investing in their businesses to protect against downturns, as some airlines have done recently, per example. (For more on airlines, see Why airline stocks are bad business)
How to cash out. Investors who still want to take advantage of buyback programs should follow three principles, experts say. The stocks mentioned below provide good examples.
Avoid dilution. Don’t jump at every takeover announcement. Check to see if the total number of shares in the company is actually decreasing, thereby increasing your stake in the company, advises Faber. You can look up a company’s outstanding shares in its Securities and Exchange records, or you can find its most recent share count on websites such as Yahoo Finance and YCharts. A good example is McKesson (MCK (opens in a new tab)), says Faber, whose investment company owns the shares. The drug and medical supplies distributor has cut its stock count by 7% in the past year, and over the past five years the stock price has doubled.
Look for price discipline. Successful buyers, like successful investors, should buy low. Buffetts Berkshire Hathaway (BRK.B (opens in a 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 industry strategist Greggory Warren notes that the company has repurchased $58 billion of its common stock since 2019, cutting its stock count by about 10%. Warren, a Berkshire bull, thinks the company is focused on shrinking its long-standing cash hoard through a combination of stock purchases and share buybacks.
Bet on healthy companies. Fortuna’s Milano says the companies most likely to have high long-term returns on their takeovers have strong balance sheets and, ideally, are less vulnerable than other companies to economic or commodity cycles. A company at the top of his list: Apple (AAPL (opens in a new tab)). Since the start of 2021, Apple has repurchased more than $200 billion of its stock, reducing its stock count by about 5%. During this period, the stock gained about 6%, excluding dividends, compared to a loss of 3% for the S&P 500 index. According to Howard Silverblatt, principal index analyst for S&P Dow Jones Indices, “Apple is the headliner of takeovers”.
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