When buying back its own shares, a company uses its cash or raises debt. A buyback is often an alternative to a cash distribution or payment of a special dividend. Once purchased by the company, the number of outstanding shares decreases, all else being equal. Reduced number of shares translates into a lower P/E ratio (in theory, remaining shares are worth more). Sometimes a buyback simply offsets shares created for employee incentives or management compensation.
Often times, investors feel a share buyback is evidence the corporation thinks the stock is underpriced. Despite an announcement, companies do not always complete the share buyback. If the stock rises in the interim, the company may decide the stock is now too expensive and delay or not follow through.
Research by David Ikenberry of the University of Colorado Bolder shows that, on average, companies announcing share buybacks had a total return of 12 percentage points higher than the overall market four years later. Buyback announcements do not always lead to a price increase. According to Ikenberry, the best returns came from companies with share buybacks that had a low price/book ratio.
PowerShares Buyback Achievers ETF invests in companies who have repurchased at least 5% of their shares over the past 12 months. AdvisorShares TrimTabs Float Shrink ETF focuses on companies whose buybacks are not offset by share creation elsewhere.
Corporate insiders must disclose buys and sells of their company stock; this information can be found at www.sec.gov. Insider activity may help investors interpret other corporate actions. For example, insider selling by a company’s executive officers may offset positive company news.
H. Nejat Seyhun from the University of Michigan studied the months between 1975 and 1994 when company executives were net buyers of their own stock as well as the months when they were net sellers. Seyhun then looked at the stock’s price 12 months after the executive selling or buying. Just a month after the net insider buying, he found the stock’s total return to be 24% from the previous 12 months. After the sell months, the total return was 15%. Whether buying or selling, the 12-month return for stocks in general was 19%.
For the 3-year period after a buyback announcement, companies with net insider buying returned 16.9 percentage points more than the market on average; companies with net insider selling returned just 1.2 percentage points more than the market (note: these are cumulative numbers for 3 years and represent companies that announced a stock buyback program 3 years earlier). Guggenheim Insider Sentiment ETF tracks a stock index of companies with positive insider buying trends.
In the case of stock splits, Ikenberry’s research indicates stock splits generally result in market outperformance for years after a split. Some academics believe a split means company executives have confidence in the stock’s price and a fall in price is not expected after the split. The value of a stock split strategy may now be limited since fewer companies are splitting their stocks.