March 17th, 2020 | by Ashvin Viswanathan, CFA
Turning Shareholder Yield into an Investment Strategy
Share buybacks have become a major theme in the US stock market in recent years. Share repurchases reached a new peak in 2018-2019, helped along by the sharp cut in corporate tax rates that took effect in January 2018. But what motivates companies to buy back shares? We conducted research on this question and came up with some interesting answers and related investment strategies.
First, let’s consider how the media tend to report the phenomenon of share repurchases. The coverage is typically negative: for instance, a common press assertion is that buybacks are tools for corporate executives to manipulate their company’s share price to enrich themselves, especially since the company stock and options they hold incentivizes them to push up their company’s share price. The media also tend to report the numbers in absolute terms, without the context of company size: for example, a $1 billion stock buyback is large for a $10 billion market-cap company (i.e., 10% of the stock float), but not so for a $100 billion firm (1% repurchase).
Let’s first define the concept of shareholder yield, or total return of capital to shareholders. We may define it as the sum of share buybacks over the past 12 months and the company’s dividend yield. Example: Over the past year, Apple bought back about 7% of its outstanding shares; since the stock’s dividend yield is 1%, Apple’s shareholder yield is approximately 8%.
What Our Research Shows
Based on the results of our research, we would have to say that the chief motivation for company managements to buy back shares is that they believe that their company’s share price is cheap (i.e., a type of value factor); in other words, executives are behaving rationally. Exhibit 1 presents some of our findings.
For this study, we divided the largest 500 companies in the US market into deciles, and over 20 years we calculated the shareholder yield of each decile on a monthly basis to obtain averages. The graph presents the average monthly shareholder yields of the cheapest (top decile by value) and most-expensive deciles.
The shareholder yield of the cheapest decile, in blue, averaged +2% during the two decades, whereas that of the most expensive 10% of companies (red line) was negative 5.6%. (A negative number results from net issuance of shares). Stocks that are consistently cheap have higher shareholder yields than their expensive counterparts. Thus, managements are behaving rationally: On average, companies with “cheap” stocks are buying back shares and those with expensive securities are issuing shares, which makes intuitive sense since when the stock price is high a company can raise capital relatively cheaply by issuing more stock.
Finally, in search of an actionable investment strategy, we examined the relationship between shareholder yield and investment returns. We looked back 50 years and divided the US market into quintiles. Quintile 1 represents companies buying back the greatest amount of stock; Quintile 5 is corporations issuing the greatest amount of shares. We found a perfect linear progression: As share buybacks decrease, (relative) returns fall; as shareholder yield rises, stock returns increase (Quintile 1 returned 14.9% annualized, twice the return of Quintile 5). Quintile 1 also has quite a high “batting average,” beating the market in over 92% of rolling 5-year periods, 98% of 7-year time frames, and 99% of 10-year rolling periods. Therefore, an investment methodology of buying top-decile stocks in terms of shareholder yield (and avoiding those aggressively issuing stock) appears to be an appropriate strategy.