How You Can Beat the Market with Share Buybacks

There are an infinite number of ways to make money in the markets.

The challenge is that you have to find a successful strategy — and then stick to it, day in, day out, year after year.

The advent of various “smart beta” exchange-traded funds (ETFs) over the past few years makes doing just that quite a bit easier.

I have to confess, I am a huge fan of these types of investment strategies.

The idea of having an index-linked, mainstream market-beating strategy that does not rely on the brilliance of a Warren Buffett or a Carl Icahn — all for the relatively low fees of an ETF — has to be one the best deals in the world of investment.

Frankly, I trust these investment strategies more than I trust myself. And I think it is active managers’ egos more than anything else that have kept these and other “smart beta strategies” from becoming even more popular than they already are.

That’s also why I make extensive use of these strategies with my firm Global Guru Capital’s “American Alpha” investment program. This program invests in a portfolio of 10 market-beating “smart beta” strategies that together aim to outperform its benchmark, the S&P 500.

The Compelling Case for Share Buybacks

One of my favorite, and most profitable, “smart beta” investment strategies focuses on companies that buy back their own shares.

When a company announces that it will buy back its own shares, it means a couple of things.

First, the company is healthy enough to have sufficient cash on its balance sheet to execute the buyback.

Second, the company is focused on maximizing returns to its shareholders. By reducing the number of shares outstanding, management increases a company’s earnings per share, without the really hard work of having wrung out operational efficiencies. Share buybacks are also generally a more tax-efficient way to return capital to shareholders, compared with paying out taxable dividend payments.

No wonder share buybacks are a tool used by some of the world’s best investors. Activist investor Carl Icahn recently made headlines when he hosted Apple (AAPL) CEO Tim Cook on New York’s Upper East Side for dinner, trying to persuade him to use Apple’s $150 billion cash pile to buy back its own stock. (Icahn later stepped back from his demands.)

And in doing so, Warren Buffett has essentially put a floor under Berkshire Hathaway’s (BRK-B) price, with his promise to buy back Berkshire shares any time they drop under 1.2x book value.

In fact, Buffett bulls feel that share buybacks are Berkshire’s secret weapon. As long as the company keeps increasing its book value through its cash-rich businesses, the stock simply won’t drop below that level.

And if Berkshire ever really runs out of profitable investment opportunities, the bulls argue, it can increase its earnings per share by simply buying back its own shares.

My #1 Choice to Invest in Buybacks

Like Buffett or Icahn, you can focus on investing in individual stocks where management has announced a share buyback.

But that’s a lot of work and commitment.

I like the alternative by which you can just buy a specialized “smart beta” ETF like the PowerShares Buyback Achievers (PKW) ETF. It is also a current recommendation in my newsletter, The Alpha Investor Letter and a holding in Global Guru Capital’s “American Alpha” Investment Program.

Over the past six years, ending in 2013, PKW outperformed the S&P 500 five out of six times, often by significant margins.

PowerShares Buyback Achievers (PKW) vs. S&P 500

PKW tracks the Buyback Achievers Index, which consists of companies that have reduced their outstanding shares by 5% or more in the past 12 months.

PKW uses a modified market-capitalization methodology where the largest weighting for any company is 5% of the ETF’s assets. It re-balances these holdings quarterly in January, April, July and October, and the fund currently has about 40 holdings.

With its holdings boasting an average market cap of close to $40 billion, PKW differs from other “smart beta” products by relying much less on the well documented “small-cap effect” to generate its S&P 500-trouncing returns.

In fact, many of the companies PKW invests in are household, blue-chip names familiar to U.S. investors. Pfizer Inc. (PFE), Oracle Corp (ORCL), Home Depot (HD), AT&T Inc. (T) and General Motors (GM) are the five largest holdings in the fund, with 3.5% to 5% weightings each. And with a beta of 0.96, PKW is actually slightly less volatile than the S&P 500.

Higher returns and reduced risk offer the ultimate free lunch in investing.

Buybacks Go Global

As someone who follows stock markets around the world, I can tell you that making money in global markets consistently today is a challenge, as I try to do in my firm Global Guru Capital’s “Global Gains” Investment Program.

That’s why I was excited to learn that PowerShares is going global with its “buyback achievers” strategy through a new ETF, PowerShares International BuyBack (IPKW).

Like its domestic parent, the underlying portfolio consists of international companies that have reduced their outstanding shares by 5% or more in the past 12 months. Although this brand new ETF itself has no record to speak of, the back testing of this approach is encouraging.

And like any financial adviser looking out for his clients, I welcome any new strategy that offers a rational, and sustainable, edge.

In case you missed it, I encourage you to read my e-letter column from last week about which markets have been the most profitable so far in 2014. I also invite you to comment in the space provided below.

NOTE: Global Guru Capital is a Securities and Exchange Commission-registered investment adviser, and is not affiliated with Eagle Products.