February 15 2024

Why stock buybacks are suddenly in Vogue

Russell Burns February 15 2024

Buybacks have grown in popularity among companies, in part because of their flexible nature and the tax advantages they have over dividends, And with interest rate cuts likely on the horizon, we could see even more of them.
Even as buybacks rise, dividends are holding their own. The recurring, yearly payouts signal confidence in the outlook for a future company’s earnings, but also that the company may lack high-return investment opportunities.
ETFs that invest in US and global stocks with chunky share buyback programs could be worth a closer look, along with those that invest in dividend aristocrats.

Uber revved up investors this week, announcing its first-ever buyback. And Meta lapped up tons of market affection earlier this month, when it unveiled a huge boost to its buyback (along with its first-ever dividend). In both cases, it was a simple matter of giving shareholders what they want. And it’s something we’re likely to see more of this year. Here’s how you can take advantage of the market’s brand-new obsession.

Why are buybacks all the rage?

Companies have two main levers when it comes to rewarding shareholders: buybacks or dividends. And it used to be that a lot more of them pulled on that second handle: for the past 30 years, the number of firms paying a dividend has held roughly steady, at 66%, according to Goldman Sachs, which did its homework. Buybacks were a mostly forgotten lever three decades ago, with just 3% of firms reaching for them in 1995. But now they’re the more common of the pair: last year, 70% of S&P 1500 companies bought back stock.

Bloomberg reported that $105 billion in share repurchase plans were announced in the first seven days of February alone (the same week Meta dropped its news) – more than the total announced in all of January. And, of course, that won’t be the end of it: S&P 500 companies are expected to repurchase $885 billion in stock this year, up 10% from 2023, but down 4% from the record pace set in 2022.

This trend, like so many things, is driven partly by interest rates. A lot of companies – including ones with bulletproof balance sheets like Apple – took advantage of low interest rates and borrowed money to fund buybacks back when interest rates were near zero. That made sense at the time – but then interest rates surged, and companies hit the brakes on the whole thing. Fast forward to now, and central banks are talking about cutting rates again and that’s got companies feeling confident once again and picking up the pace of buybacks.

Is there an advantage to buybacks over dividends?

Well, both allow companies to return value to shareholders, but these two do work in different ways.

Buybacks increase per-share metrics tracked by investors, such as earnings per share, by shrinking the number of stocks out there. For companies where stock options account for a big share of compensation, buybacks help offset shareholder dilution (the increase in the number of shares issued). That might explain why fewer than half of publicly traded companies in high-growth sectors like healthcare, tech, and communication services pay a dividend. You see, those sectors in particular lean instead toward buybacks, partly to combat the dilutive impact of hefty employee stock option programs.

Buybacks offer more flexibility than dividends. Dividends are a recurring, annual commitment – at least that’s how investors see them. And so, if a company dares to cut its dividend at some time in the future, investors typically sell the shares. Buybacks, on the other hand, happen if and when a company decides the time is right, strategizing the move according to the share price.

Buybacks have certain tax advantages. Dividends are taxed at the ordinary income rate, but buybacks are taxed at a lower capital gains rate, depending on the owner’s overall profit. The Inflation Reduction Act’s 1% tax on share repurchases might’ve made buybacks slightly less advantageous for companies, but it hasn’t slowed their pace.

Dividends have been linked to a drop in future growth potential. Some evidence suggests that big dividend increases are usually followed by a declining return on assets, cash levels, and capital expenditures. In other words, firms tend to increase dividends just before they see a fall in investment and growth opportunities. But that may be because dividends tend to be paid by more mature firms with high profitability but fewer high-return opportunities.

Dividends signal confidence about future earnings. And that can attract a new group of income-oriented investors to the register. Goldman Sachs estimates that there’s around $1.8 trillion in dividend-oriented mutual funds and ETFs worldwide. When Apple initiated a dividend in 2012, it saw the number of dividend funds owning the stock increase from 53 to 124.

Dividends are generally valued higher than buybacks. Since they’re not considered a recurring annual event, buybacks tend to be valued less by investors than dividends.

Bottom line: a combination of the two makes sense for companies with strong balance sheets – maintaining steady dividends and opting for buybacks depending on current cash flows and share prices. In practice, most companies follow this approach: 57% of S&P 1500 companies paid out buybacks and dividends in the past year.

What’s the opportunity here?

Finding a company that might soon announce a first-ever dividend, increase an existing one, or surprise the market with a big share buyback is hard to do. But you could simply follow some of the pros like Warren Buffett or Greenlight Capital’s David Einhorn – they both regularly invest in companies that create a ton of free cash to finance share buybacks.

You could also consider buying into some of the ETFs that go big on buybacks and dividends. The Invesco Buyback Achievers ETF (PKW; 0.61%) tracks the Nasdaq Buyback Achievers index, which houses US companies that have seen at least a 5% net reduction in the number of shares outstanding in the past year. It holds companies across a range of sectors, including Booking Holdings, T-Mobile, Johnson and Johnson, John Deere, and Lockheed Martin. Its total return since December 2022 is 19.9%.

But keep in mind: buybacks aren’t just a US thing. They have become increasingly popular in Europe, the UK, and Japan. The Invesco Global Buyback Achievers UCITS ETF (BUYB; 0.39%) tracks the NASDAQ Global Buyback Achievers index and has posted a respectable 16.2% over the same period.

If you’re more dividend-inclined and prefer to invest in more stable, mature businesses, then the ProShares S&P 500 Dividend Aristocrats ETF (NOBL; 0.35%), with its dividend yield of 2.7%, might be more your speed. It tracks the performance of the S&P Dividends Aristocrats, composed of companies in the S&P 500 that have increased their dividends in the past 25 years. But with a total return of only 7.6% since December 2022, it hasn’t performed well.

For a higher-yielding, UK play, could consider the SPDR S&P UK Dividend Aristocrats UCITS ETF (UKDV; 0.3%), with its dividend payout of 4.6%.

Posh as that might sound, it’s the European aristocrats that are lighting up this corner of the market. The SPDR S&P Euro Dividend Aristocrats UCITS ETF (SPYW; 0.3%) has an impressive yield of 5.9%, and with a punchy 17.2% total return in US dollars, it could be worth a look.