Hudarios (< 20)

Hudarios's CAPS Blog

The Buyback Bubble Motherload

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January 26, 2008 – Comments (7) | RELATED TICKERS: PKW , MSFT , XOM

From my blog, the Hodar Report:

Excessive share buybacks have reduced dividends and caused U.S. stocks to become over-priced relative to their payoffs, and I'm convinced that the current crash represents the recognition of this problem by investors. A good medium-term play would be to sell short the companies with the largest buybacks in order to get the maximum payoff from this decline.

The Power Shares Buyback Achievers fund (ticker PKW) is an ETF which has collected all of the worst buyback offenders into one basket, allowing investors to buy them (or short them) as a group with one click. Companies have to buy back at least 5% of their shares per year in order to be included in the fund's lineup. Not surprisingly, the dividend yield of the group is anemic - less than 0.5% - and that makes it particularly attractive for selling short.

This ETF includes some well-known powerhouses. Microsoft, Exxon, Time Warner, Goldman Sachs and Prudential together comprise nearly one-quarter of the holdings. At first glance it might seem crazy to bet against this group of titans, but it makes sense when you consider what's been happening over the past few years. These companies have been generating enough cash to buy back 5% of their own market capitalization every year. In the best case scenario, without any options dilution, these buybacks have been increasing shareholder stakes in the companies by 5% per year. Thus, after 4 years of buyback activity, long-term investors now own 22% more of these companies, and have been collecting (best case) a 0.5% dividend yield in the meantime.

Had these corporations paid dividends with that money instead, investors would have been pocketing at least 5% per year in cold, hard cash. The question is: would investors rather own $1000 of a company that pays a 5.0% yield ($50 per year), or $1,220 of the exact same company paying a 0.5% yield ($6 per year)? That 8-to-1 difference exemplifies the dividend bubble, and I think it is the reason why investors are finally heading for the exits. If I'm right, then PKW should be hit harder than most in the coming months.

7 Comments – Post Your Own

#1) On January 26, 2008 at 11:14 PM, abitare (99.70) wrote:

Interesting overview. 290,000 points? You are Top Points fool!

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#2) On January 27, 2008 at 12:25 AM, dwot (99.88) wrote:

I am agreeing that buy backs are bad, but I have differing reasons. A lot of these companies have not been buying back with cash, but by borrowing money. I don't know specifically about the companies in this ETF, but this is what I notice when I look at buy back programs. Also, the companies tend to issue so many new options for executive there tends to be marginal reduction in the number of shares by comparison.

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#3) On January 27, 2008 at 12:58 AM, Hudarios (< 20) wrote:

dwot: Yes, I've already discussed the buyback->options cycle in my previous post. I was assuming the absolute best case here to make a point. But the truth is that exercised options are nullifying any advantage buybacks have for investors.

If it's true that companies are borrowing money for the buy-backs, then they're in even more trouble than I thought - particularly if they have any trouble paying off the debt.

abitarecatania: Obviously I didn't earn 290,000 points - there have been some major scoring errors in CAPS over the last several days. I got 290,000 from GUR and -500 from RXD. I suspect these errors will be even more common in the coming weeks when the market really starts to crash and the data streams become strained from the volume.

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#4) On January 27, 2008 at 1:08 AM, Hezakiah (94.66) wrote:

I don't really agree with your conclusion that buybacks in general are bad. I think they are good if the company's stock is cheap enough that it outperforms the market over the foreseeable future.

I looked at your example in which the company forgoes paying a 5% dividend in order to reduce its # of shares by 5%...

Assuming the market prices the company at a constant P/E, then your $1000 stake in the company would be expected to grow just like you said to about $1,220 (not accounting for any earnings growth in this case). Although it would actually be about $1,228 since a 5% buyback corresponds to an increase in shareholder equity of slightly more than 5% (100/95=1.0526). If the company instead paid dividends of 5%, then its share price without earnings growth would stay constant and thus you would still have $1000 in stock plus the $200 in dividends.

So if you didn't invest the dividends at all, then you could sell off some of your stock and be left with $228 as opposed to $200. Obviously you would invest your dividends, but the point here is that after buybacks, a company's stock can be expected to increase accordingly (and then some) even without a change in earnings. Thus you could pay yourself a dividend merely by selling off some of your appreciated stock.

Now, the problem essentially boils down to whether you are better of investing the 5% dividend on your own or by having it automatically reinvested in more of that company's stock. Let's say you are only good enough to match the market with your dividend. If you expect that company's stock to outperform the market, then you would be better off with the share buyback. If you expect it to underperform the market, then there is no reason you should own any of that stock it in the first place.

I agree with you that there are some potential downfalls to share buybacks, and maybe this ETF will fall as a result. But share buybacks are only fundamentally bad for companies that are expected to underperform the market.

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#5) On January 27, 2008 at 1:14 AM, Hezakiah (94.66) wrote:

I don't really agree with your conclusion that buybacks in general are bad. I think they are good if the company's stock is cheap enough that it outperforms the market over the foreseeable future.

I looked at your example in which the company forgoes paying a 5% dividend in order to reduce its # of shares by 5%...

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#6) On January 27, 2008 at 8:36 AM, Hudarios (< 20) wrote:

"... you could sell off some of your stock and be left with $228 as opposed to $200 ... Thus you could pay yourself a dividend merely by selling off some of your appreciated stock."

That's exactly my point. You have to sell the stock in order to benefit from the buybacks, and you had better be sure you don't sell at the wrong time, like during a big market correction. If lots of people decide all at once to cash in for some "self-paid dividends," (Maybe they're all a little cash-strapped at the onset of a recession?) then a big market correction is precisely what you get.

Let me further focus my original question. Which stock would retirees prefer to hold for the long haul: the 5% yield or the 0.5% yield that (hopefully) will keep going up in price? I'll bet you that 9 out of 10 retirees would take the $200 per year, and sacrifice the extra $28, so that they wouldn't have to call their broker every month to sell some shares and get some cash to live off of. They also wouldn't have to nervously watch the market every day with the 5% yield - the price matters little as long as the dividend is preserved. Time and peace-of-mind are priceless for many people.

No matter how you slice it, I think the current decline is a result of buybacks replacing dividends.

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#7) On January 27, 2008 at 9:23 AM, dwotBuyback (< 20) wrote: