Share Buybacks in Perspective – Measuring the Buyback Risk Premium
By Wilshire Funds Management, sub-adivsor of the AdvisorShares Wilshire Buyback ETF (NYSE Arca: TTFS)
Investors typically appreciate it when management distributes wealth to shareholders provided that these actions are in shareholders’ best interest. Paying dividends and buying back shares are the two most common approaches to wealth distribution. While many investors understand the concept of paying dividends, the mechanics, benefits and potential risks of share buybacks are less well known. In the following sections, we introduce the share buyback concept; we show that companies that buy back stock have historically outperformed their counterparts consistently over the past decade, and we demonstrate that even with some recent concerns overshadowing this segment of the market, companies that are buying back stock as a whole still appear attractive from a valuation perspective relative to the market.
Introduction to Share Buybacks: Mechanics, Motivations, Risks and Benefits
In a share buyback, a company repurchases shares either through a tender offer or in the open market, thereby reducing the outstanding shares available in the market. A share buyback directly increases the percentage of ownership for existing shareholders in the company. Although buyback activity only adds value for shareholders if the stock price is undervalued compared to the company’s intrinsic value, in the short-term, the law of supply and demand would indicate that a share buyback pushes prices higher, all else equal, assuming that the same number of investors are seeking to invest in a smaller number of shares. Buying back shares is also potentially a more tax-efficient approach to returning wealth to shareholders relative to paying taxable dividends. More importantly, share buybacks may serve as an indicator that management believes that the company’s share price is undervalued.
While share buybacks may be an attractive way of returning wealth to shareholders, this approach has been subject to scrutiny at times, as there are examples of ‘bad behavior’ when management’s short-term motivations to push up share prices are contradictory to generating long-term shareholder value—a classic principal-agent problem. Management may actually destroy shareholder value to the degree that it chooses to engage in share buybacks simply to further boost equity-based compensation when the company’s share price is already highly valued. Despite examples of bad behavior, our analysis uncovers that a diversified portfolio of companies engaging in share buybacks, which we define as buyback beta in the next section, has historically outperformed the broader equity market.
Measuring Buyback Beta
Beta is a measure of the risk arising from exposure to general market movement, commonly referred to as non-diversifiable or systematic risk, as opposed to stock-specific risk which can be mitigated through diversification. The Wilshire U.S. Large Cap IndexSM measures the performance of the U.S. large cap equity market, and therefore serves as a sound metric of U.S. large cap equity market beta. Similarly, the breadth of the universe of companies engaging in share buybacks is large enough to diversify away stock-specific risk, thereby capturing the risk arising from exposure to the general market movement of companies engaging in share buybacks, which we refer to as ‘Buyback Beta’. Exhibit A shows the Wilshire U.S. Large Cap Index relative to the performance of an equally-weighted portfolio of all the companies in the Wilshire U.S. Large Cap Index that are engaging in share buybacks, which is shown as the Buyback Universe1. The Buyback Universe has outperformed the Wilshire U.S. Large Cap Index in 10 of the past 12 years, or more than 80% of the time, and the average of median calendar year returns of companies in the Buyback Universe has been materially higher over the same period of time, as shown in Exhibit B. This data indicates that there is a noteworthy “Risk Premium” that investors would have earned by having exposure to the Buyback Universe relative to the broad U.S. equity market.
1Buyback Universe is an annually rebalanced, equal-weighted portfolio of all companies in the Wilshire U.S. Large Cap Index that exhibit a reduction in floating shares outstanding, as a proxy for companies engaging in share buybacks. It is shown as a measurement of the performance of the universe of companies engaging in buybacks for research purposes, and does not represent the performance of an actual portfolio or client accounts. Past performance is not indicative of future results.
Valuations of the Buyback Universe
Companies engaging in share buybacks have faced increasing scrutiny in recent years, as journalists and practitioners have criticized share buybacks for driving market valuations higher, and in some cases, for manipulating financial results (i.e. a lower number of shares may result in a higher earnings per share). Although it is important to recognize the principal-agent problem that we highlighted, historical valuations (price-to-earnings) indicate that the Buyback Universe is typically cheaper relative to the Wilshire U.S. Large Cap Index, as shown in Exhibit C. Currently, based on data as of the most recent month-end (04/30/2017), the Buyback Universe is reasonably cheaper than the Wilshire U.S. Large Cap Index, with median trailing 12-month price-to-earnings ratios of 19.96 vs. 21.59, respectively. More recently, the decline in the number of companies engaging in share buybacks has fueled concerns that equity valuations have become too rich. While we agree that the reduction in buybacks may be an indication that equity market valuations are higher than average, the cheaper median 12-month price-to-earnings ratio of the Buyback Universe indicates that this segment of the market may still provide investors with relative value opportunities when compared to the U.S. large cap equity market.
In closing, we can make the following observations about share buybacks:
1) Share buyback activity serves as a potential signal of value from management, and can serve as a tax-efficient approach to return capital to shareholders by reducing supply and boosting demand. This approach has been subject to scrutiny at times, as there are examples of ‘bad behavior’—principal-agent problem.
2) The breadth of the universe of companies engaging in share buybacks is large enough to diversify away stock specific risk, thereby capturing ‘Buyback Beta’.
3) Historical data indicates that there is a noteworthy ‘Risk Premium’ that investors would have earned by having exposure to the Buyback Universe relative to the broad U.S. equity market.
4) Historical valuations (price-to-earnings) indicate that the Buyback Universe is typically cheaper than the broad U.S. large cap equity market, as measured by the Wilshire U.S. Large Cap Index.
5) Although the reduction in buyback activity may be an indication that equity market valuations are higher than average, current data indicates that this segment of the market may still provide investors with relative value opportunities when compared to the U.S. large cap equity market.
Wilshire Funds Management (“WFM”) is a business unit of Wilshire Associates Incorporated (“Wilshire®”).
Wilshire is a registered service mark of Wilshire Associates Incorporated, Santa Monica, California. All other trade names, trademarks, and/or service marks are the property of their respective holders.
This material contains confidential and proprietary information of Wilshire. It may not be disclosed, reproduced or redistributed, in whole or in part, to any other person or entity without prior written permission from Wilshire.
This material represents the current opinion of Wilshire based on sources believed to be reliable. Wilshire assumes no duty to update any such opinions. Wilshire gives no representations or warranties as to the accuracy of such information, and accepts no responsibility or liability (including for indirect, consequential or incidental damages) for any error, omission or inaccuracy in such information and for results obtained from its use. Information and opinions are as of the date indicated, and are subject to change without notice.
Wilshire Funds Management uses mathematical and statistical investment processes to allocate assets, select managers, and construct portfolios and funds in ways that seek to outperform their specific benchmarks. Past performance does not guarantee future returns, and processes used may not achieve the desired results.
This material is intended for informational purposes only and should not be construed as legal, accounting, tax, investment, or other professional advice. This material may include estimates, projections and other “forward-looking statements.” Due to numerous factors, actual events may differ substantially from those presented. Past performance does not guarantee future returns.
Copyright© 2017 Wilshire Associates Incorporated. All rights reserved.