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Thursday, September 19, 2013 - 08:30

The Easiest Way To Profit From $455 Billion In Stock Buybacks

Thursday, September 19, 2013 - 8:30am

Over the past few years at StreetAuthority, we've been chronicling the remarkable pace of share buybacks. So many companies are buying back $500 million or even $1 billion in stock that this trend has become one of the most powerful themes of the current investing era.

The collective result of all of those individual corporate actions is simply staggering. Analysts at J.P. Morgan report that a hefty $455 billion in shares has been reacquired by companies in the Russell 1000 in the 12 months ended June 30. That's a 32% increase from the prior 12-month period.

In fact, if you go back to the start of 2009, companies have reacquired $1.4 trillion of their stock. That "far exceeds the net equity withdrawals by investors," noted J.P. Morgan's analysts. In effect, these analysts have concluded that in the absence of buybacks, this stunning market rally would never have existed.

What can you expect in the years ahead? Many more buybacks. Companies remain loath to pursue acquisitions, even with huge amounts of cash parked on their balance sheets. So an increasing amount of annual cash flow is heading towards buybacks (and dividends).

Yet with the major market averages now up so sharply since the start of 2009, should investors look at buybacks as a wise use of corporate capital? The sage response: You can't time the market. The market tends to rise over time, and if companies wait for the moment that their stock pulls back sharply to lower levels... well, that day may never arrive.

As noted, JP Morgan analysts suggest that the sharply reduced amount of shares trading hands explains this bull market. After all, share prices are affected by supply and demand, and a reduced supply of stock pushes up prices, according to economic theory.

Yet there's another, more obvious reason why buybacks boost share prices: the impact on earnings per share (EPS). The percentage of shares that are being bought back will boost per share profits by that exact same percentage (offsetting stock option grants notwithstanding). Simply put, a steady series of buybacks can help a slow-growing company deliver the kind of EPS growth that is usually reserved for faster-growing companies.

Take do-it-yourself home retailer Home Depot (NYSE: HD) as an example. Since 2004, its shares count has fallen more than 30%, to 1.5 billion. The company earned $3.10 a share in its fiscal 2013 -- but were it not for that massive stock buyback program, per-share profits would have been 30% lower.

We periodically highlight companies that are pursuing massive stock buybacks, most recently last month.

But there is an even more direct way to benefit from the trend: buyback-focused exchange-traded funds (ETFs). Let's take a closer look.

1. PowerShares Buyback Achievers (NYSE: PKW)
This fund is quite picky, loading up only on shares of companies that have already purchased at least 5% of their shares outstanding over the past 12 months. The approach is a bit curious.

You would presume that the best time to buy a stock is when a buyback is announced, not after a program has been underway for quite some time. This approach stems from the fact that many companies announce huge buybacks plans -- but tend to use them to offset lavish grants of stock options to executives. By waiting for confirmation of a reduced share count, the risk of a smoke-and-mirrors buyback announcement is eliminated.

Current top holdings include Amgen (Nasdaq: AMGN), ConocoPhillips (NYSE: COP) and Oracle (NYSE: ORCL), each of which accounts for roughly 5% of the portfolio. The fact that fully one-third of the portfolio is made up of consumer discretionary stocks highlights the robust pace of buybacks in that sector. (Financials make up another 20% and tech stocks make up another 16%.)

Despite the patient wait-and-see approach to executed buyback plans, this ETF has racked up some solid numbers. The PowerShares Buyback Achievers has outperformed the S&P 500 index on a one-, three- and five-year basis. The 15% annualized return over the past five years (which includes the horrendous market action of late 2008 and early 2009) makes this ETF one of the top-performing domestic large-cap ETFs around. The 0.7% expense ratio is reasonable in light of that robust performance.

2. AdvisorShares TrimTabs Float Shrink ETF (NYSE: TTFS)
You can understand why investment research firm TrimTabs got into this niche. The firm has been tracking fund flows for nearly two decades on the belief that share prices rise and fall directly as a result of the underlying supply and demand for shares. Indeed, TrimTabs' "Liquidity Theory" rests on two basic principles: "Increasing supply of stocks can be a bearish sign for stocks," and "increasing demand is positive for stocks, except when flows become extremely high as investors chase momentum."

Buybacks play a key role in that logic, cutting the supply of shares while also boosting demand for them (as companies take them off the hands of other investors to retire them).

This ETF was launched less than two years ago and hasn't built up the long-term track record of the PowerShares Buyback Achievers ETF. But the 68% gain since its October 2011 launch beats the S&P 500's 49% gain in that period.

The AdvisorShares TrimTabs Float Shrink ETF takes a slightly novel approach, focusing only on those companies that are buying stock out of free cash flow, and not from debt issuance.

It's debatable whether this approach reduces risk (as is intended), as companies that seek to issue debt to buy back stock typically have strong cash flow characteristics anyway. The judicious use of debt can help boost profits, and the only time such firms are imperiled is when the economy slumps badly.

As a result, this is likely the safer ETF in a bleak economy. This ETF also does a better job of avoiding portfolio concentration. For example, top holding Las Vegas Sands (NYSE: LVS), accounts for just 1.13% of its assets. The 0.99% expense ratio is a bit stiff.

Risks to Consider: These are bull-market ETFs. The PowerShares Buyback Achievers ETF slumped badly in late 2008 and early 2009, and the TrimTabs would likely also fare poorly in a falling market.

Action To Take --> The distinct approaches taken by these ETF providers each has real merit. Yet neither is ideal. It's a shame that the PowerShares fund decides to wait a full 12 months before snapping up shares of holdings, and the TrimTabs ETF's focus on cash-flow-fueled buybacks shrinks its potential universe. But both of these ETFs appear built to deliver solid gains as long as the buyback frenzy continues.

P.S. -- ETFs like the ones mentioned above seem like they require minimal effort -- but how would you like for your portfolio to be able to beat the stock market while spending just 12 minutes a month on your investments? That's the objective of Amy Calistri's Stock of the Month advisory: Provide one quality stock pick each month, with in-depth analysis in plain English that investors can understand. Click here for all the details.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.