Stock buyback / repurchase strategy update

The ETF Expert blog put out an interesting post about the buyback ETF I like, PKW (PowerShares Buyback Achievers Portfolio). The title of their post is “Do “Buyback” ETFs Deliver On The Performance Promise?” and they make several interesting observations. First they note that “the market does tend to see stock repurchasing/buyback as a positive” which I don’t think is much of a surprise.

Companies are sitting on a lot of cash these days (in comparison to historical average levels) and repurchasing shares might make a great deal of sense, depending on the situation. Even if management does not necessarily believe that its shares are currently undervalued, but does believe that its earnings will increase meaningfully coming out of the recession, then a meaningful buyback at current levels can significantly boost EPS throughout the cycle.

Given that M&A has historically not benefited shareholders of the acquiring firm, on average, I prefer to see the majority of firms repurchase their shares or pay out dividends instead of making acquisitions. Unless the deal is a no-brainer from a synergy standpoint, investors are unlikely to view M&A announcements as a positive, and if the synergies are very compelling then  you can bet that the takeover price premium will probably eat up the vast majority of the savings.

Their blog post also notes that over the last 3 years the PKW buyback ETF has outperformed the S&P 500 and the Russell 3000 (which includes a heck of a down-market). More significant to me is the prospect that, should the market be relatively flat or uncertain over the next couple years, the buyback strategy offers the prospect of two ways shareholders can benefit from buybacks: 1) better EPS used in P/E multiples, and 2) technical support in the form of company open market repurchase activity (which is the most common type, as opposed to privately negotiated buybacks or tenders).

The link to their blog post is here: http://www.etfexpert.com/etf_expert/2009/12/do-buyback-etfs-deliver-on-the-performance-promise.html

The ECONOMPIC DATA blog addressed buyback question as well in a recent post, thought it raises more questions than it answers. When comparing the relationship between market levels and buyback activity they note that companies tend to spend the largest $ amounts when markets are at their highs and less around their lows.

Here is the link to their post: http://econompicdata.blogspot.com/2009/12/on-timing-importance-of-stock-buybacks.html

I’ve got a few comments on that:

1) It raises the ‘chicken or the egg’ question of what the cause and effect are and the correlation, which means we have to dig a bit deeper before making any bold or definitive statements.

2) I believe that companies are more likely to not-spend money on a buyback when the macroeconomic and credit liquidity picture is unclear, which implies that you would expect companies to hold onto their cash during uncertain times instead of returning it to shareholders via buybacks. Assuming that the markets and the economy move in relative lock-step (and I think that while the market clearly leads the economy, they do move in tandem) then it is reasonable to conclude that the fact that buybacks shrink when the markets decline is not due to the fact that companies are poor at timing their buybacks and are instead merely reacting to uncertainty that faces their operations as well as investors.

3) The data only examines a 10 year period, which really is not enough to form conclusions about corporate decision making processes. Given that the two recessions occurred within a reasonably small times span suggests to me that, before forming conclusions about what “always must be the case” regarding managements’ capital allocation decisions, there is a solid possibility that recency bias could explain that management merely did what they did the last time, which would account for the similarity in a two-period sample.

4) The fact that the total payout yield (dividends paid plus funds spent on repurchases) is currently at a relatively low-level compared to the last 10 years and closest to the levels from roughly 6 years ago does not directly mean anything. The fact that market prices have recovered in advance of corporate profits over the last year or pretty fairly suggests that is entirely reasonable that the total $ paid out via dividends and buybacks would lag for a period of time until profits catch up. If that lag continues then it would also help explain why companies tend to spend large amounts on repurchases at historical market highs.

5) The real question, as correctly observed in the ECONOMPIC DATA post, is will buybacks start to pick up again? I think there are a bunch of reasons why we should expect them to do so. The unfreezing of the credit markets certainly wouldn’t hurt either. The differential between capital gains and dividend tax rates is clearly a key factor, but for the moment they’re equivalent and shouldn’t be a key factor in suggesting a change in corporate capital allocation behavior in the near-term.  Additionally, unless the US Dollar experiences a more-meaningful appreciation on top of what it has recently demonstrated, I think it’s pretty unlikely that domestic acquisitions of foreign firms becomes a major bucket for corporate capital allocation of a magnitude that materially changes the total payout yield dynamic.

Bottom line: I don’t know what the US equity markets do over the next couple of years, so if I’m going to be long plain equities, I’d much rather be long via the PKW buyback fund.

Strategies For Uncertain Times: Stock Buyback / Repurchase

Overview: This isn’t a hedged or non-equity asset class. The reason for holding stock buy-back funds is, if the market is close to directionless with low volatility, then companies that buy their own shares back have a catalyst from the repurchase activity and would probably have better EPS on a go-forward basis than if they had not repurchased shares. The stock buyback strategy depends on long-term capital gains tax rates being lower than short-term capital gains tax rates as well as ordinary tax rates, and also directly relates to dividend tax rates, because companies decide how to return excess cash to shareholders, which is ideally determined by the applicable tax rates that shareholders pay on dividends and capital gains.

Stock Buy-Back/Repurchase

Overview: The buyback fund below, while only around 2 years, has VERY favorable performance versus the S&P on a theoretical basis during declining S&P periods. Preferable to straight S&P holdings when you’re bearish, or when you think corporate cash balances are at unusually high levels and will be deployed.

• ETFs:
  • PKW: PowerShares Buyback Achievers
    • Large cap buyback ETF, only US
    • Over 200 positions, relatively low concentration
    • 0.70% annual fee
    • Essentially IS the S&P 500, same performance and volatility
    • Holdings required to have repurchased 5%+ TTM, so it’s NOT announcement fund

Strategies For Uncertain Times: THE OVERVIEW

I believe that tremendous uncertainty supports the adoption of hedge fund replication strategies.

At the end of 2008 I felt very certain that, given the oversold levels of various equity markets around the world, a basket of China, India, and LatAm (Brazil) were extremely likely to experience very solid price appreciation. Multiples for their respective indexes were lower than they were in the US (which is rare) and I knew that emerging market economies will precede the US coming out of the trough of the macro cycle. Additionally, their macroeconomic situations were comparatively healthy versus the US. In retrospect, it was a no-brainer and a huge winner. I nearly bottom-ticked those equity markets and ended up doing extremely well on a percentage/relative basis as their TTM performance has been stellar.

This year I have the entirely opposite mindset: I have ZERO idea what will happen to equities over the next two years and I think anyone who says they do is selling a theory that they can’t realistically support as actually PROBABLE. Hence, I’ve put together a list of strategies/asset classes that, in aggregate, satisfy my desire to make money over the next year or two. Some ideas are targeted at generating current income, some ideas are targeted at capturing potential equity market appreciation, and some ideas are just uncorrelated strategies or asset classes that offer non-equity means of potentially increasing in value (income plus price appreciation).

Some people refer to compiling these strategies and/or adding non-equity  asset classes  as “hedge fund replication” whereas I just call it considering your alternatives (zing). I believe that, while unlikely to repeat the huge outperformance of my portfolio this over past 12 months, this strategy should produce sold tax-managed returns with favorable volatility over the next one to two years. This is really just a study I prepared for myself (AKA The Dan-Don’t-Be-Broke-Portfolio), but you might find some interesting info for yourself.

There is a considerable amount of disagreement about the definition of the term “hedge fund replication” but, to me at least, it means any combination of three things: 1) not being exclusively long equities (long only), 2) maintaining short exposure as a hedge against bearish moves in equities or the economy overall, and 3) looking at various asset classes and strategies that seek to generate uncorrelated or low-correlation returns with equities.

Clearly 2008 demonstrated that many “hedge funds” were not appropriately hedged, if at all. If the S&P was down 30%+ in 2008 and hedge fund XYZ was down roughly the same amount, then they did not come close to producing returns for their investors that were either 1) positive on an absolute basis (greater value at end-of-period than at beginning-of-period), or 2) positive on a relative basis (lost less value on a percentage basis than the S&P, which is admirable but still fails to increase investor wealth), and 3) most likely generated a return that was highly correlated with the performance of the S&P, which is not acceptable given that investors pay high fees to hedge funds in the expectation that they do NOT produce results similar to what the overall equity market does.

This list is not inherently “fully hedged” or “market neutral” but the list (when aggregated as a portfolio) has a correlation with the S&P of less than 1.0 and potentially has the ability to increase in value even if the S&P falls.  Obviously, my allocation to each of these strategies will vary greatly depending on changes in value, and I might not even currently employ any one of them at all.

Non equity asset classes:

-Commodities

-Debt (emerging market)

-Debt (floating or variable corporate)

-Muni bonds

-Closed end fund (CEFs) arbitrage

-Private equity and/or venture capital (PE and VC)

-Currencies

-Convertible bond arbitrage

Equity-based strategies:

-Merger arbitrage and special situations

-Closed end fund Fund-of-Funds (CEF FoF)

-Biotechnology

-Stock buyback funds

Covered call funds (buy-write strategy)

Real estate (US and/or international)

Long/short equity (partially hedged or market neutral equity)

Managed futures (this can mean several things)

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I have prepared my own investment guide that spans all of these strategies. You can download it by clicking here.

Strategies For Uncertain Times

I prepared it awhile back, so it may not reflect current market conditions, valuations, or discounts. It is based on my own financial situation, goals and objectives, risk profile, and tax considerations. My picks/selections are bolded, there may be two per strategy/asset class. In many cases I prefer closed-end mutual funds (CEFs) b/c they trade on an exchange like stocks, and frequently trade at discounts to their “net assets” per-share, which occasionally creates a built-in margin of safety. I will continue to hold a good portion of emerging market equities, which I trade in and out of depending on valuation on price changes. I hold HAO for China, GML for Latin America, RSX for Russia, and EPI for India. I just typed up my handwritten notes, so there are plenty of abbreviations, typos, and short-hand notes. The format isn’t meant to be anything more than acceptable, so just call me if you have a question about what something means or what I’m thinking.