Last Updated on January 11, 2023
To buy back shares is one of five opportunities a company has for allocating the company’s capital and rewarding shareholders. Paying a dividend is far more known, yet companies have since 1997 spent more money on buybacks than dividends. How the company allocates capital is the main determinant of future stock market returns. Are buybacks good for stocks and investors? Are buybacks a good idea?
Yes, empirical evidence points out that stocks that spend the most on buybacks perform better than the S&P 500. Since the year 2000, the S&P 500 BuyBack Index has outperformed the S&P 500 by a wide margin.
In this article, we walk you through some past research and discuss the performance of one of the most referenced buyback index: the S&P 500 Buyback Index.
What are buybacks?
Before we start discussing buybacks we need to explain what buyback actually is:
When a company buys back shares, it buys its own shares. For example, Apple might instruct its treasurer or broker to buy Apple shares in the market. When the treasurer does this, they go out in the marketplace and buy Apple shares on equal terms as all other participants (open market repurchases). This is by far the most common way to buy back shares.
This is not the only method for buying back shares. For example, it can be done via a Dutch auction, something that the “mini-Berkshire” White Mountain Insurance has done several times. A Dutch auction is an auction where multiple bids are considered and used to arrive at the highest price where the total offering can be sold. Nevertheless, the most common form to buy back shares is via regular market trading.
What happens with those shares bought back by Apple? Those shares are either kept on the books of the company or later canceled/written off. But the effect is obvious: There are fewer outstanding shares. When there are fewer shares outstanding, it means more profits are distributed to the remaining shareholders. A company makes the same profits no matter how many shares are outstanding. If you owned 1% of a company that bought back 3% of the shares during a year, your ownership has increased to 1.03%.
Buybacks and capital allocation
Buybacks are just one of five ways how management and the board of directors can spend earnings and retained earnings. The four other methods are:
- Debt reduction
- Merger & acquisitions
- Reinvestment into existing businesses
Additionally, a company can buy back shares.
How the reinvested earnings (in bond terms this is called the interest on the interest) are managed is more important for your compounding than your initial investment. Over at least two decades your pension is more dependent on the reinvested earnings than anything else!
How well (or bad) management is handling the capital allocation process matters a lot. Let’s give you an example:
If the company is trading above intrinsic value, it’s better to pay a dividend than to buy back shares. Opposite, if the company trades below intrinsic value, it’s smarter to buy back shares than to pay a dividend.
Berkshire Hathaway, arguably the best investment company ever, has only paid a dividend once – over 50 years ago. Since then, Berkshire has spent all earnings either reinvesting or buying back shares when Warren Buffett thought Berkshire was trading below intrinsic value. It has not made sense to pay a dividend. Why pay a dividend when you can either reinvest to rates of 15% (or higher) or buy back shares at a discount when Mr. Market is depressed? Why pay a dividend when you can spend the money buying back shares at a discount?
Berkshire has been a great investment because it has not paid a tax-inefficient dividend!
Since the 1980s the share of buybacks has increased. S&P Global publishes a report on how companies spend their capital at regular intervals. The table below shows that more and more is spent on buybacks every year:
Clearly, since 1994 more capital has been spent on buybacks than on dividends! Yet, both the media and investors focus more on dividends.
If so much capital is spent on buybacks it would be pretty interesting to know how companies that buy back shares fare compared to the overall market:
Are buybacks good for stocks or investors?
Let’s look at some research to determine the aggregate returns of companies that buy back shares.
There are at least two ways buybacks can increase the share price: short term when a buyback mandate is being given by the board, or long term via reduction of the outstanding shares.
You can with a reasonable degree of certainty measure cause and effect after a buyback announcement. Much research has been spent on this, and we can conclude that overall there is a positive effect on the share price after a company announces a buyback.
The long-term effect is more difficult to measure because it’s hard to separate cause and effect. Even though a company buys back shares, the share price can increase for a wide range of other reasons. For example, it’s usually quality companies that buy back shares because they have high and consistently positive cash flows. But overall, the empirical research seems to be pretty conclusive that companies that buy back shares fare better than those that don’t, just like companies paying a dividend fare better than those which don’t pay a dividend.
Let’s look at the S&P 500 Buyback Index as evidence of the positive effect of being invested in stocks that buy back shares:
S&P 500 Buyback Index
S&P has constructed a buyback index that tracks the 100 companies in the S&P 500 with the highest buyback ratio in the trailing 12-month period. The buyback ratio is calculated as follows:
The criterium is defined as the monetary amount of cash paid for common share buybacks in the previous four calendar quarters divided by the total market capitalization of common shares at the beginning of the 12-month trailing period.
How has the S&P 500 Buyback Index performed?
From 2000 until 2019 it outperformed by 5.5% annually, according to S&P. It outperformed in 16 of 20 years, albeit with overall higher volatility than the S&P 500. The two charts below show the returns:
Are Buybacks Good For Stocks And Investors?
Overall, the evidence seems to be conclusive: companies that buy back shares perform better than the main indices. Thus, buybacks are good for the share price and investors.