In 2013, Warren Buffett’s holding company, Berkshire Hathaway (NYSE: BRK-B), collected over $4 billion in “tax-free dividends.”
These weren’t distributions from tax-exempt securities like municipal bonds. The dividends I’m talking about came from big, blue-chip companies like International Business Machines (NYSE: IBM) and United Parcels Service (NYSE: UPS).
Now to be fair, these distributions weren’t dividends in the traditional sense. Buffett didn’t see any extra money in his bank account because of them.
But don’t be fooled. Even though he didn’t get any cash, it doesn’t mean those payments weren’t beneficial.
[ad#Google Adsense 336×280-IA]In fact, each time Buffett’s holdings paid one of these tax-free dividends, the value of that stock went up — regardless of whether its share price increased or not…
That’s because these tax-free dividends I’m talking about are actually better known as share buybacks.
We call it a “tax-free dividend” because each time a company buys back shares, your stake in that company becomes more valuable due to the declining number of shares outstanding.
The value you get from that transaction, is tax-free.
Think of it this way. If you own 10% of a company that earned $1,000, your share of earnings would be $100. But if that company bought back half of its stock, your portion of the earnings would double to $200. And that’s without you having invested another dime.
And since you aren’t receiving any physical cash, you don’t owe Uncle Sam a dime for that increase in value.
As I pointed out a few months ago, companies have been increasingly choosing stock repurchases in lieu of dividends to create value for their shareholders for the past two decades.
But that’s good for investors. Buybacks are the gift that keeps on giving.
To show you what I mean, let’s look at companies that repurchased shares in 2011 and 2012.
The table below highlights several standouts that have reduced their share count by 20% or more over the past 3 years.
The companies in this list have aggressively eliminated shares, thereby giving more wealth to shareholders instead.
And as you can see from the table, each of these stocks has handily topped the overall market’s 52.7% return over the past three years, advancing anywhere from 60% to 122%.
So how can you benefit from this? If yesterday’s buybacks have a positive influence on stocks today, then today’s buybacks will carry lasting benefits for stocks tomorrow.
And fortunately, there are plenty of companies to choose from. According to FactSet Research, the total number of outstanding shares among S&P 500 companies has declined for 10 straight quarters. In the most recent quarter, 120 member companies had a net reduction of at least 1% of their outstanding shares. That should help their share prices down the road.
Even better, in the June issue of my premium newsletter, Total Yield, I recommended Discovery Financial (NYSE: DFS). Discovery has reduced its share count to 470 million from 540 million over the past three years, while operating profits have increased from $7 billion to more than $8 billion.
So you’ve got 70 million fewer shares splitting an extra $1 billion in annual profit. What do you do with that cash? Well, if you’re DFS you raise dividends by 20% and authorize a new $3.2 billion buyback program.
Bottom line, the power of share buybacks is irrefutable. Whether you’re the average Joe or Warren Buffett, it’s a tax-free wealth transfer from the company to you. Unlike dividends, the payoff doesn’t come immediately. But if the table above says anything, it’s that buybacks can lead to big gains for those willing to wait.
That’s why buybacks are one of the three criteria I use to find the most stable and profitable companies in the world for my Total Yield newsletter. Since 1982, these stocks have delivered average gains of 15% per year to investors. And last year, this group of stocks more than doubled the S&P 500’s return.