IBM Corp. became the poster child of questionable buybacks, spending $125-billion to buy its own shares over roughly the past 10 years, which surpassed total capital spending and R&D.Craig Warga/Bloomberg
Although they have helped support the stock market through one of the longest bull runs in history, stock buybacks get a bad rap.
Variably disdained as a feat of financial trickery, as a drain on future growth prospects, and as a manipulation to boost executive compensation, share repurchasing has funnelled trillions in corporate cash back to investors in recent years.
But many of the common criticisms miss the point, said Ian de Verteuil, head of portfolio strategy for CIBC World Markets.
"A lot of the companies that are doing it are highly profitable companies," he said. "It's not that they have no growth opportunities, they're just generating more cash than they need."
As an investment strategy, exposure to buybacks has generally trounced the broader market over the long term. Additionally, buybacks hold potential tax benefits over dividends for higher-income Canadians, Mr. de Verteuil said in a new report titled In Defence of Buybacks.
Whether they are a force for good or ill, buybacks seem to have tremendous influence on equity movements. The past 15 years has seen an "eerie correlation" between share repurchase activity and stock performance, the report said. "When equity markets are at a peak, buybacks are also at high absolute levels."
U.S. companies bought back $725-billion (U.S.) of their own stock in 2015, which was exceeded only once before, in 2007.
While soaring profits have stuffed corporate coffers with cash in recent years, a weaker broader economy has acted as a deterrent to investment.
Plus, executives might be reluctant to boost dividends if they anticipate economic turbulence. While dividend cuts are punished harshly by the market, buyback programs don't represent the same level of commitment.
To a company with excess cash, the buyback is a quick way to deploy funds and appease shareholders while remaining nimble, should economic stresses resurface.
It's a tool that can boost earnings per share simply by reducing the outstanding share count, even if profits themselves are stagnant.
As such, buybacks are often characterized as a sleight of hand. They might create the illusion of improving profitability despite deterioration of the underlying business.
IBM Corp. became the poster child of questionable buybacks, spending $125-billion to buy its own shares over roughly the past 10 years, which surpassed total capital spending and R&D. Between 2007 and 2015, IBM's net income rose by about 25 per cent, but on a per-share basis, profits increased by close to 85 per cent.
But to dismiss buybacks collectively as a manoeuvre of financial engineering is overly simplistic, Mr. de Verteuil said.
"Higher earnings per share and cash flow per share are a positive for a public investor even if achieved in this way," he said.
The recent performance of investing with buybacks in mind emphasizes the potential rewards. Since the market bottomed out in early 2009, the S&P/TSX buyback index has tripled, which amounts to an annualized total return of 16.8 per cent. That compares to 11.7 per cent for the broader index.
The S&P 500 buyback index, meanwhile, has posted an annualized total return of 24.4 per cent over that time, compared with 19.2 per cent for the S&P 500.
Aside from benefits to the individual shareholder, critics of buybacks say that money could be put to better uses.
"It concerns us that, in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies," Laurence Fink, the chairman and CEO of BlackRock, wrote in an open letter last year. "Too many companies have cut capital expenditure and even increased debt to boost dividends and increase share buybacks."
While there are certainly companies that resort to dubious share-repurchase programs, there are many others for which buybacks make sense, Mr. de Verteuil said.
Take a company with 20-per-cent return on equity and a 50-per-cent payout ratio. Half of total profits are distributed as dividends. Investing the rest to grow the business makes sense if the options are lucrative enough, Mr. de Verteuil explained.
"Can I really grow my top line by 10 per cent in this environment?" he asked. "When there's not a lot of top-line growth in any business, [buybacks] make sense."
Canadian tax regulations, meanwhile, might further raise the appeal of buybacks for higher-income Canadian investors.
The recent hike in the tax rate on the highest income bracket in Canada has made the tax treatment of capital gains relatively more attractive compared with dividends. Plus, unlike dividend income, taxes on capital gains can be deferred.
"It's amazing to me how few investors think about after-tax returns," Mr. de Verteuil said.
Investors should look for buybacks that allow profitable companies to manage excess cash, while not foregoing good growth opportunities, the report said. "The most effective buybacks are done consistently, at reasonable rates so as not to distort short-term share prices and trading patterns." Canadian companies fitting the description include Metro Inc., Canadian National Railway Co., Thomson Reuters Corp., Canadian Tire Corp., and Agrium Inc.
With a report from Reuters
Tim Shufelt