Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
It is not unusual for a listed company to announce a plan to buy back some of its outstanding shares during the next fiscal year. There are regulations surrounding the price that can be paid and the number of shares to be purchased, but the news release often results in a surge in the stock price as investors assume that the corporate buying program will put a floor under the stock.
Some commentators point out that managements with stock options are especially motivated to introduce aggressive buybacks because fewer shares outstanding make it easier to achieve earnings per share targets, which in turn should boost the value of their options. In fact, the recent corporate tax cuts introduced by U.S. President Donald Trump may not boost domestic capital spending and U.S. job creation, but instead simply result in more cash allocated to dividend increases and share buybacks.
With that as background, Canadian equity investors will be interested to learn that one of the best-performing indexes on the Toronto Stock Exchange in 2017 was the obscure S&P/TSX composite buyback index, with a total return for the year of 19 per cent compared with 9.1 per cent for the overall composite index.
The buyback index tracks the 50 companies in the TSX composite with the highest buyback ratio in the past 12 months. Buyback is defined as the cash paid for common shares in the past four quarters, divided by the market capitalization at the beginning of the quarter. The index is equally weighted and rebalanced quarterly.
The market cap of the constituent members as of year end 2017 ranged from $793-million to $149-billion with a median market cap of $6.3-billion. The biggest sector weightings were financials and industrials at about 20 per cent each. Some of the names are familiar, and not always because of favourable commentary in the news media: Bombardier and Home Capital, for example – though perhaps management should be given credit for aggressive repurchases of their own shares at a time of adversity.
The index was created in September, 2014, so there is a three-year history which favours the buyback index with an annual return of 9.1 per cent compared with 6.5 per cent for the composite index, although much of this positive differential comes from the strong return in 2017. The index has been back-tested over five and 10 years and has outperformed the composite in the range of 3 per cent to 5 per cent a year over the longer time frame.
This is not just a Canadian phenomenon. Similar indexes exist in the United States and Japan. The S&P 500 buyback index in the United States covers the top 100 buyback stocks in that market index. Somewhat surprisingly, it lagged the S&P 500 over the latest three years, but has outperformed by 3 per cent to 4 per cent a year over the five and 10-year periods ended December, 2017. Similarly, the Japanese 500 buyback index has outpaced its counterpart by 2.5 per cent a year over the past 10 years.
These incremental returns appear to be quite modest until we recall the methodology underlying the index construction: Stocks are only added after a 12-month period during which they actually followed through on their news release and purchased an above-average proportion of their outstanding shares. No forecasting is required by the investor. Companies do disclose their net purchase of shares on a quarterly basis, so it is feasible to monitor progress.
Can the individual investor profit from this simple market anomaly? It will be difficult. First, we need to recognize that the indexes are widely diversified with 50 to 100 names, equally weighted and with no transaction costs or management fees. The calculations involved are not complex, but they are data intensive and beyond the scope of the average investor. On the positive side, the constituents are all members of the larger composite index, so liquidity and trading volume should not be an issue.
Clearly, what Canadian investors need is an ETF or index fund which replicates the buyback index (or a similar strategy) with only a modest management fee to reflect the fact that it involves no active analysis by the fund manager. I have not yet tracked down an existing product, but now that the opportunity has been identified, I am sure that an enterprising ETF sponsor will introduce one shortly!
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