Hitching a ride

Share buybacks signal confidence in a company's future

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When companies announce they will repurchase their own shares, it’s the corporate world’s version of paying yourself first. Investors usually consider share buyback programs, as they are also known, as a buy signal for the stock.

Market experts note that companies executing buybacks tend to be financially strong, which in turn leads to superior performance. The programs can reduce the number of outstanding shares, and sometimes boost earnings per share.

Other legitimate reasons for buyback programs include: offsetting shares issued to employees who exercise stock options, preventing further dilution of ownership; reducing the amount required for ongoing dividend payments, providing more flexibility for future use of cash flow; and increasing tax efficiency for shareholders as an alternative to paying dividends.

But the catch with many buyback programs is that they are announced but not implemented right away, making it difficult for mom-and-pop investors to cash in. One way to profit from repurchase programs is to buy a basket of stocks from companies that have historically bought back their shares.

“Working with Standard & Poor’s, we’ve developed key criteria for buyback companies,” says Robert K. Burke, vice president and manager, defined portfolio marketing, at John Nuveen & Co., Chicago. “First, we narrow the field to companies with $500 million or more in market capitalization, eliminating very small companies. Then we screen for quality: companies must have an S&P senior debt rating of AA- or better as well as an S&P quality ranking of A or A+, which shows a strong history of earnings and dividends growth and stability.”

Screening for a superior debt rating eliminates companies that buy back stock so they can increase their financial leverage, that is, take on more debt, according to Braverman. And highly ranked firms tend to be solid, dividend-paying companies posting excellent earnings. “However, some companies that meet these tests are expensive, so buybacks can be used as a value screen,” he adds.

Using this analysis, Nuveen puts together a package of quality buyback companies each month and sells these “defined portfolios” to investors. Thus, for as little as $1,000 you can own shares in all the companies meeting these specific criteria. As of October 15, there were 14 companies that met Nuveen’s quality buyback criteria. The company offers new buyback trusts once a month.

Interested investors can buy these defined portfolios through many brokers, banks and financial planners. Alternatively, if this approach is appealing, you can research the companies and invest in whichever ones you prefer. But this can be a very expensive and tedious process to do on your own.

Investing in companies meeting such criteria can reap great rewards. “From 1982 through 1998,” says Burke, “the Dow Jones industrials gained nearly 19% per year. A ‘quality buyback strategy’ using the companies meeting all of our criteria would have gained 21% per year during this period, beating the Dow 12 out of 17 years, with no negative years.”