With a sluggish economy, companies are hesitant to reinvest much cash, so it's been building up by the truckloads on corporate balance sheets. Since the returns on cash are near zero, it's certainly not creating shareholder value - and that's led companies to return cash to shareholders at record levels.
S&P 500 companies paid shareholders a cash yield of 5.1% last year. That came from a combination of a 2% dividend yield and 3.1% from stock buybacks, according to FactSet, a research firm that issues quarterly reports on buybacks. Total cash returned was more than three times the recent 1.6% yield of the Barclays Aggregate Bond Index, and far more than most dividend strategies can produce.
That suggests a new strategy advisors can use to generate income from a portfolio. Fair warning, though: It's an unusual approach that requires following a complex story line.
The two ways for corporations to return cash are dividends and stock buybacks, where the company repurchases its own shares on the open market. By focusing on the buybacks, advisors can generate income for clients in a more advantageous, tax-efficient way than with a traditional dividend strategy.
Here's a simplified example: Say your client owns 100 shares of CashCo, which has 10,000 shares outstanding - that's 1% of the company. Your client purchased the stock at $8 a share more than a year ago, and it's now trading at $10. CashCo was profitable and wants to return $5,000 to shareholders, or 50 cents a share. If it paid a dividend, every shareholder would get 50 cents per share. Your client would get $50, which would be taxed at the 15% or 20% qualified dividend rate, and the stock price, absent any other news, would decline by that same 50 cents to $9.50 a share.
Instead of issuing a dividend, however, CashCo could decide to use the $5,000 to buy back 500 shares at the $10 price. Your client could decide to sell five shares (to CashCo or anyone else) and collect that same $50, and would still face a tax of 15% or 20% - but this time it would be on a smaller dollar figure: a $10 (or $2 per share) long-term capital gain. So the client gets the same $50, but pays far less in taxes.
Another advantage: The stock price would not decline by the same 50 cents as in the dividend scenario because CashCo now has fewer shares outstanding. Your client now owns 95 shares of the 9,500 shares outstanding - which, by no coincidence, is the same 1% of the company that he owned before the stock buyback.
Princeton economist Burton Malkiel, author of A Random Walk Down Wall Street, agrees that stock buybacks are more tax efficient than dividends for returning cash to shareholders. And because buybacks tend to increase share price, they are more favorable to management with stock options, Malkiel notes. Option holders don't benefit from dividends; in fact, they suffer, actually. Research shows that, absent any other news, a share price declines when a dividend is paid, decreasing the value of the option. So both management and shareholders are better off with stock buybacks.
Yet while stock buybacks are theoretically superior to dividends for returning cash, shareholders usually strongly prefer dividends. That's because dividends are seen as more permanent; management knows the stock price will be punished if the company decreases or eliminates a dividend.
Case in point: Valentine's Day was not so sweet this year to CenturyLink (CTL), which chose that day to announce that it was increasing the cash it would be returning to shareholders. Shareholders reacted angrily after the company said it would find the cash to buy back more of its shares by cutting its dividend by 26%. The stock tumbled 23%. Companies are not punished as badly when they reduce buybacks.
According to FactSet, S&P 500 companies repurchased $386.2 billion of their own stock in 2012. That represented 79% of their free cash flow, suggesting they had little interest in building up more cash on their balance sheets.
ExxonMobil led the way, returning $21.1 billion in stock buybacks - more than twice the $10.1 billion it returned in dividends. The combined figure represents a total yield of 9.2%. ExxonMobil ended the year with 4.9% fewer outstanding shares. Thus, if your clients owned ExxonMobil, they could have collected the dividend to receive 2.4% yield and then, at the end of the year, sold 4.9% of their stock. They would have received a 7.3% cash yield while maintaining the same percentage ownership of the company. The chart above shows the 10 companies with the biggest stock repurchases.
While buying back some shares, most companies are also simultaneously increasing shares through other means, including management's exercise of stock options. FactSet data shows the total number of shares of S&P 500 companies only decreased slightly since 2005 - meaning new shares have nearly offset purchases. Companies paying high dividend yields also issue new shares, Malkiel points out. This means that a strategy aimed at collecting high dividends will dilute a client's ownership percentage even more than would selling the percentage of stock ownership the company is repurchasing.
There are several ways to help clients cash in on these stock buybacks. You could, for example, buy the 10 stocks shown here with the biggest buybacks. Or you could take the companies with announcements of highbuybacks - think of Apple's recent announcement to buy back $60 billion of its stock.
In either case, your clients hold the stocks for more than a year (to get long-term capital gains treatment) and then get the income by selling the proportion of stock that the company actually bought back. Note that a company does not actually have to repurchase the amount it announces, so be sure not to sell shares until after the actual buyback amount has been reported.
This strategy has a major drawback, however: lack of diversification. A more diversified strategy is to buy the market sectors having the highest percentage of stock buybacks. For instance: Consumer discretionary, health care and information technology sectors each repurchased more than 4% of their shares outstanding last year, according to FactSet. (The chart above shows the details.) You could buy these sectors via ETFs and then sell the percentage they buy back next year.
A third strategy is to buy a fund such as the PowerShares Buyback Achievers ETF (PKW), which buys stocks that have repurchased at least 5% of their shares over the past year. These stocks have a lower dividend yield of 0.98%, but to generate income you could sell 5% of this ETF each year. Incidentally, this ETF has trounced the S&P 500 total return over the past one-, three- and five-year periods.
The strategy I prefer is to own a much broader basket - such as the S&P 500 itself or even a broader total U.S. stock index fund. That eliminates the diversification risk from securities selection. After the buyback reports are released (and, again, after a full year had passed), you can sell the amount of shares repurchased in aggregate - such as the 3.1% purchased in 2012 by the S&P 500. (The S&P 500 accounts for about 85% of U.S. stock buybacks, notes FactSet research analyst Michael Amenta; if you were using the total stock market index fund for this strategy, you'd have sold only about 2.8% of the fund last year.)
Vanguard discourages periodic trading in its mutual funds, Malkiel notes, but will allow you to sell quarterly. You could also use ETF share classes with no trading restrictions, but Malkiel points out that commissions and bid-ask spreads could cut into returns.
Admittedly, when I discuss this strategy, I often get objections. Many are based on misconceptions. This is not a "safe withdrawal" strategy and is not meant to replace the 4% withdrawal "rule" (which Morningstar now says is 3%). I also don't mean to imply that companies' 5.1% cash yield is stable over time. Repurchases plummeted in 2008 and 2009 - which, ironically was when the companies would have repurchased at the best prices.
David Ikenberry, dean of the University of Colorado's Leeds Business School, agrees that stock buybacks are a smart substitute for a dividend strategy. And I believe this substitution is far better than buying dividend stocks or equity income funds that give clients the comfort of receiving quarterly checks while, under the covers, diluting their ownership share. This strategy is also far better than chasing income by buying long-duration bonds, which could get clobbered by rising rates, or the same junk bonds that blew up in 2008 - just when clients really needed a shock absorber for their stock losses.
This strategy is merely an investment in American capitalism- and a better way to collect the cash that is returned to shareholders, while gettingmore favorable tax treatment.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct faculty member at the University of Denver.