Why I Love Share Buybacks

The Oxford Club’s Chief Income Strategist Marc Lichtenfeld and I share a similar investment philosophy.

We both believe in buying quality, asset-allocating properly, diversifying broadly, cutting investment costs to the bone, keeping a sharp eye on taxes and trying to beat the S&P 500 through security selection, not market timing.

But we do have one difference of opinion. According to an Investment U article he [recently wrote], Marc doesn’t like share buybacks. I do. Here’s why…

[ad#Google Adsense 336×280-IA]Marc states that by purchasing its own stock back, a company can increase its earnings per share without improving the sales or net income of the company.

True. (Although I would prefer to see a company increase its earnings and decrease the shares outstanding.)

However, as he also correctly notes, if the company maintains the same earnings multiple (i.e. price/earnings ratio), it will still increase the value of each shareholder’s holdings.

Buybacks vs. Dividends

Marc says he would rather see the cash returned to shareholders in the form of a dividend.

That can make sense, especially if the alternative is that management uses the cash to buy back shares at an inopportune time. (Before a big drop, in other words.)

But, if the company’s decision to buy back shares is a timely one, there are distinct advantages to foregoing the dividend.

For starters, a dividend distribution is a taxable event. Unless you own your shares in a qualified retirement plan, you’re going to pay Uncle Sam come April 15.

And it’s worth noting that the United States now has one of the highest tax burdens of the 34 countries in the Organization for Economic Cooperation and Development (OECD). The top rate is 23.8% when you include the 3.8% net investment tax to fund Obamacare.

With a share buyback, there is no taxable event. Personally, I prefer that.

What if I need income? I can always sell a few shares – and potentially still avoid any tax liability by taking an offsetting loss elsewhere in my portfolio.

Beating the Market

But there’s another reason I like share buybacks. Academic studies have consistently found that the average stock not only rises immediately after the announcement of a repurchase program but continues to beat the market for several years.

For example, in 1993 IBM had 2.3 billion shares outstanding. However, by regularly buying back shares in the open market, the company has reduced the number of shares outstanding by about 1% per quarter. Today it has only 1.1 billion shares out, less than half as many as it had two decades ago.

And during that time IBM shares have surged 1,365% compared to 337% for the S&P 500.

Someone who clearly approves of this strategy is Warren Buffett. His holding company, Berkshire Hathaway (NYSE: BRK-A), is the single largest IBM shareholder, with 6.7% of the outstanding shares.

Other companies that are currently in the midst of heavy share repurchases include Apple (Nasdaq: AAPL), Sirius XM (Nasdaq: SIRI), Lam Research (Nasdaq: LRCX), Forrester Research (Nasdaq: FORR), Intuitive Surgical (Nasdaq: ISRG), Tesco Corp. (Nasdaq: TESO) and DST Systems (NYSE: DST).

There are funds that target companies with major buybacks, too. One is PowerShares Buyback Achievers (NYSE: PKW). Another is TrimTabs Float Shrink ETF (Nasdaq: TTFS). Both funds have low expenses and have outperformed the market by a wide margin since inception.

So while Marc and I generally agree, we have a difference of opinion here. Of course, with U.S. public companies currently sitting on more than $2 trillion in cash, it’s possible they could make both Marc and me happy.

Why not buy back shares and pay out dividends, too?

Good investing,

Alex

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Source: Investment U