Dividends? Share buybacks work better in a bull market

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Share buybacks don't tend to excite investors the way dividends do, but buybacks deserve a second look: During the current bull market, buybacks have done a better job of driving share prices higher.

This isn't news to high-profile investors such as David Einhorn or Carl Icahn. Last year, they hounded Apple Inc. to spend some of its massive cash hoard on its own shares, arguing that the move would "unlock value" in the stock, driving the price higher.

So far, so good. Since Apple announced a $60-billion (U.S.) share buyback plan in April, 2013, the share price has rallied 32 per cent, outperforming the S&P 500 by a substantial 14 percentage points – and that's without the help of a snazzy new gadget.

Apple isn't an isolated case, though. According to a report by Pavilion Global Markets, companies with the greatest proportion of share buybacks have outperformed companies that have raised their dividends consistently, making buybacks look like a better use of corporate cash.

"In the current market, company managers are getting a bigger bang for their buck with stock buybacks," the strategists said in a note.

They came to this conclusion after comparing two indexes: the S&P 500 Buyback index, which tracks the 100 companies that have the greatest buyback activity over the past 12 months relative to their market capitalization (Apple didn't make the cut); and the S&P 500 Dividend Aristocrats index, which tracks companies that have raised their dividends in each of the past 25 years.

Since the start of the bull market in March, 2009, the buyback index has risen 328 per cent, outperforming the dividend index by 80 percentage points after both indexes factored in dividends.

The buyback index also outperformed during the previous bull market between 2002 and 2007.

While dividends put money into investors' pockets in the form of regular quarterly payments – sometimes making them ideal defensive investments – buybacks reduce the number of outstanding shares, driving up earnings on a per-share basis.

The question now is whether buybacks will continue their winning streak.

Companies certainly have a lot of cash to spend on more buybacks, implying that corporate generosity hasn't been tapped out. They are sitting on nearly $1-trillion (U.S.) in U.S. bank deposits, according to Pavilion.

Nor is the level of buyback activity in record-breaking territory yet. The amount of money spent on buybacks last quarter – $126-billion in the case of companies in the S&P 500 – is still shy of the peak seen prior to the financial crisis.

Buyback activity relative to market capitalization is also well off previous highs. In 2008, the buyback ratio was 4.5 per cent; today it is just 2.8 per cent – meaning that buyback activity would have to rise by 60 per cent to hit a new high.

However, rising buyback activity does have a downside: Companies are notoriously bad at gauging the value of their own stocks. They often become enthusiastic buyers when their share prices are high and they are armed with plenty of cash, which is why buyback activity can coincide with a stock market peak.

Put another way, a frenzy of buybacks could suggest that the bull market is nearing an end.

The effect on companies buying back their own shares can be severe when the market dips: During the bear market of 2007 to 2009, the buyback index fell harder than both the dividend index and the broader S&P 500.

The takeaway, then, is that buybacks are good if you are feeling bullish and want full exposure to the bull market. They're not so good if you want to play it safe.