How To Profit From The $630 Billion Buyback Frenzy

David Sterman's picture

Wednesday, May 28, 2014 - 11:00am

by David Sterman

Companies are deep in the throes of buyback fever. 

Just released data from S&P Capital IQ suggest that the dollar value of buyback activity in the first quarter of 2014 was the highest in nearly seven years. Companies spent $158 billion on their own stock, which works out to an annualized pace of around $630 billion.

This is a trend that keeps on recurring. Last summer, I noted that companies had spent $455 billion on buybacks in the 12 months ended June 30, 2013. 

Back then, I recommended a pair of exchange-traded funds (ETFs) that were well-positioned to profit from this trend. Both the PowerShares Buyback Achievers (NYSE: PKW) and the AdvisorShares TrimTabs Float Shrink ETF (NYSE: TTFS) have delivered great returns to investors, according to Morningstar. 

The AdvisorShares fund lacks the long-term track record of the PowerShares fund, but we do know that since it opened for trading on Oct. 5, 2011, at a price of $26.44, it has risen 91%. In that time, the PowerShares fund has risen 86% while the S&P 500 Index is up 70%. Arguably, these two buyback-focused ETFs are equally suitable for investors.

Or are they?

A closer look reveals some key differences, and helps tilt the balance toward one of these ETFs. 

At first blush, the PowerShares fund's 0.70% expense ratio is a better deal than the Advisor Shares fund, which carries a too-high expense ratio of 0.99%. The difference can be explained by the fact that the PowerShares fund has been around a lot longer (since 2006) and has had more time to build assets under management, now totaling $3 billion. A higher asset base allows for better amortization of transaction costs and smaller expense ratios, so the AdvisorShares fund will presumably see a drop in the expense ratio as it matures. Still, the advantage goes to PowerShares.

Yet the AdvisorShares fund has some powerful advantages of its own, starting with portfolio concentration. This fund ensures that no single holding accounts for more than 1% of the portfolio. That greatly reduces the chances that any one stock will tank and bring down the fund's performance.

In contrast, the PowerShares fund has roughly 20% of the portfolio tied up in just four companies ((Oracle (NYSE: ORCL), AT&T (NYSE: T), Home Depot (NYSE: HD), and Pfizer (NYSE: PFE)). 

The PowerShares fund is a market-weighted fund, which means that the size of the company will dictate the amount it will be represented in the portfolio. But as the AdvisorShares' strategists point out in their fund fact sheet, "A market-cap-weighted portfolio tends to overweight overvalued components and underweight undervalued components."

And on a more qualitative level, the AdvisorShares fund scores more points. The ways these two funds are constructed is an important consideration. Here's a quick summary.

PowerShares Buyback Achievers (NYSE: PKW)
The PowerShares Buyback Achievers ETF buys shares of companies that have already purchased at least 5% of their shares outstanding over the past 12 months. The goal is to avoid companies whose buybacks go solely toward offsetting stock option grants and never really shrink the share count. One obvious flaw: This fund may buy shares of companies that have already finished up their buyback program. Many companies produce multiple buyback programs, but many do not.​

 

AdvisorShares TrimTabs Float Shrink ETF (NYSE: TTFS) ​
The AdvisorShares TrimTabs Float Shrink ETF applies the laws of supply and demand. Candidates for inclusion are those that companies that have reduced the supply of shares (mostly through buybacks but sometimes through spin-offs). The key distinction is that companies buying back stock out of free cash flow will be considered, while companies issuing debt to fuel buybacks will not. That adds a margin of safety in the event that these companies hit a rough patch and suddenly find themselves with too much debt.​

Risks to Consider: These are clearly built for bull markets. For example, the PowerShares fund fell 33% in 2008, so don't expect these two ETFs to deliver huge gains if the market rally stalls out.

Action to Take --> Both of these funds are excellent vehicles to capitalize on the buyback trend. But the AdvisorShares TrimTabs Float Shrink ETF carries smaller portfolio concentration risk and has a slight bias toward cash flow generators and away from debt issuers. Its modest outperformance more than offsets its slightly higher expense ratio, and as a result, this ETF which rarely gets the same buzz as its larger PowerShares counterpart, but should be considered first among equals.

No strategy can protect investors from all market turmoil, but this one comes close. After months of research, my colleague Nathan Slaughter has proven that investing in dividend-paying companies that buy back shares and pay down debt has helped shelter investors from even the worst downturns. Not only has the strategy returned an average of 15% per year since 1982, but it's outperformed the S&P during the dot-com bubble and the 2008 financial collapse too. To learn more about his "Total Yield" investing strategy, click here.

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.