Cash-rich Canadian companies are not investing in new plants and equipment to improve productivity or expand output, a recent article in the Report on Business noted. Instead, they are using excess cash to buy back their own shares.
Almost $50-billion has been devoted to buybacks in the 12 months that ended in March, which is 50 per cent higher than the previous peak a decade ago.
Armed with this information, you might be inclined to favour those companies as additions to your portfolio. After all, with fewer shares outstanding as a result of an aggressive buyback program, the earnings-per-share trajectory will be improved. This will surely have a positive impact on the stock price.
In fact, I wrote an article for Report on Business in early 2018 which pointed out that the S&P/TSX Composite Buyback Index enjoyed a return of 19 per cent in 2017 – well ahead of the 9.1-per-cent return for the overall composite. The assumption was that buybacks enhance stock returns and there are academic studies to support this view.
So, it will come as a surprise to discover that the same TSX Buyback Index has lagged the Composite index for the year to date (8.7 per cent vs 17 per cent) and the latest 12 months to June 21 (-5.4 per cent vs +4.4 per cent). Only when we go out five years do we find the buyback index return comfortably ahead of the composite, which indicates that the period of greatest out-performance was some time in the past.
A similar situation has developed in the United States in spite of huge buybacks in that market. The S&P Buyback Index has outpaced the broad S&P 500 Index by more than five percentage points a year over the past 10 years, but all of this occurred during the first five years. For the year to date and the latest one and five years, it has marginally trailed the 500 index.
Does this mean that the original studies were flawed, or has investor attitude toward buybacks changed? As usual in the stock market, there are several moving parts and so the answer is complicated.
First, the industry sector profile of the S&P/TSX Buyback Index is very different from that of the composite index: It tracks the 50 companies in the TSX Composite with the highest buyback ratio over the past 12 months. The index is equally weighted and rebalanced quarterly.
The composite index, in contrast, includes more than 200 companies and is market cap weighted so that the biggest companies and industries dominate the returns.
As a result of these construction differences, the buyback index weighting in financials is currently 25 per cent – a full 10 per cent below that of the composite, while the energy sector is 5 per cent below. To offset this, the industrials and consumer discretionary over-weightings are 8 per cent and 11 per cent respectively. So, a large part of the performance differential between the two indices could easily be a result of sector weightings and not buyback activity.
Second, it appears that the performance is sensitive to small changes in the criteria used to define candidates for a buyback index, at least in Canada.
In addition to the S&P/TSX version, there is another buyback index created by CIBC. This index looks for the 40 companies with the largest percentage of share buybacks over the past 24 months, but also gives equal weight to the consistency of these buybacks measured on a monthly basis. This has a logical appeal; from the viewpoint of an investor, a company which consistently buys back shares on a regular basis is preferable to one which sells off a division and uses the cash proceeds to make a one-time buyback even if the percentage reduction is the same.
The numbers seem to bear this out. The CIBC Buyback index has tracked closer to the S&P/TSX Composite for the latest year and is comfortably ahead over the longer term. The C I First Asset Canadian Buyback Index ETF (TSX:FBE) tracks this index with a generous management fee of 60 basis points. With total assets in the fund of a little more than $11-million, we can dismiss another possible explanation for the recent lagging performance: The buyback return premium in Canada has not been competed away by a flood of money into this strategy.
Finally, it is possible that investors are adopting a more nuanced attitude toward the phenomenon of buybacks. They are desirable when executed in moderation by a company with a strong balance sheet and a stock price trading close to book value per share. Unfortunately, management often becomes addicted to the earnings-per-share boost provided by the shrinkage in outstanding shares and leverages up the balance sheet. Investors correctly see this increased risk profile and place a lower valuation on the stock. In this case, the buyback premium will become much more company-specific and not easily captured by a few simple calculations.
Once again, there is no free lunch in the stock market.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.