There are an infinite number of strategies to beat the stock market. The challenge is to find one that does so on a consistent basis. Many investors throw in the towel, take Vanguard founder John Bogle's advice and invest in a cheap index fund.
That's a reasonable decision. After all, you will match the market and thereby outperform most professional investors.
Still, several investment strategies have a proven track record of beating the S&P 500 over the span of many years. And thanks to the advent of exchange-traded funds (ETFs), these strategies are only a mouse click away.
Why Buybacks Beat the Market
One of the most famous of these market-beating strategies is the "buyback strategy."
At its core, this strategy simply invests in public companies that are buying back their own shares. The rationale for this strategy is clear.
First, it signals that management believes its shares are undervalued. That's why the stock price often rises after a buyback announcement.
Second, by reducing the number of outstanding shares, a company's earnings per share improves even in the absence of revenue growth.
Consider the following simple example. Assume a company has 10 million shares outstanding, with a net income of $1 million. That means its earnings are 10 cents per share. If you reduce the number of shares outstanding to 7.5 million through stock buybacks, earnings per share soar by 30% to 13 cents per share.
Buying back stock is an easier and less risky way for a company to boost earnings per share than, say, launching a new line of business.
Buybacks Out of Fashion
Like everything else in finance, stock buybacks go in and out of fashion. Today, large enterprises spend tens of billions of dollars on stock buybacks.
Apple (NASDAQ:AAPL) and General Electric (NYSE:GE) spent $7.2 billion and $4.3 billion, respectively, on buybacks in just third-quarter 2016. That's just about 10% of the $115.6 billion S&P 500 companies spent overall on stock buybacks in Q3.
Although these numbers look big, stock buybacks fell to their lowest levels since the first quarter of 2013. Compared to just a year earlier, buybacks tumbled an eye-popping 28%. That was the biggest annual drop for any quarter since Q3 2009 - right after the market bottomed following the financial crisis.
The Trump Effect
Yet, the negative stock buyback tide may be about to turn. Stock buybacks could get a substantial lift if President Trump can pass tax reform in 2017.
Stock buybacks will boom if tax reform includes a one-time tax on repatriating the foreign profits of U.S. multinational firms, a position Trump has advocated.
In a note published last year, Goldman Sachs pointed out that the Homeland Investment Act of 2004 also provided for a repatriation tax holiday of 5.25% tax versus 35%. Stock buybacks soared by 84% that very year and by 58% the next year.
How to Profit from the Coming Buyback Boom
Any increase in buyback activity would be a boon for the ETFs that focus on buyback strategies. Even with buybacks near record lows, buyback ETFs have had a terrific five years.
PKW and TTFS against the S&P 500 over the past five years
There are two major buyback ETFs with five-year track records:
The PowerShares Buyback Achievers Portfolio ETF (NASDAQ:PKW) tracks companies that have reduced their number of shares outstanding by 5% or more in the last 12 months. This ETF is up 81.63% over the past five years.
The AdvisorShares Wilshire Buyback ETF (NYSEARCA:TTFS) invests in stocks based on three trends over the past 120 days: decreasing outstanding shares, increasing free cash flow, and shrinking leverage. The first trend matters most in the methodology and makes it a buyback fund. This ETF is up 96.77% over the past five years.
Both of these positions outperformed the S&P 500 as measured by the SPDR S&P 500 Trust ETF (NYSEARCA:SPY), which rose only 71.11% over the same period.
Betting on Five Top Buyback Stocks
Any strategy that outperforms the market over five years should catch your attention.
But I wanted to take the buyback strategy one level deeper. So I decided to look at the top five overlapping holdings of each of the leading buyback ETFs.
When two independent buyback strategies select the same stock, it is a greater vote of confidence than if it is selected by just one.
Top Five Common Holdings of PKW and TTFS versus the S&P 500 over six months
The results I found were both surprising and remarkable.
Here's how the top five common holdings of PKW and TTFS performed over the past six months:
- HCA Holdings (NYSE:HCA), up 11.36%
- American Express (NYSE:AXP), up 22.05%
- American International Group (NYSE:AIG), up 12.17%
- United Continental Holdings (NYSE:UAL), up 59.17%
- United Rentals (NYSE:URI), up 67.23%
By way of comparison, SPY gained only 6.15%.
Every single one of these top five positions outperformed the S&P 500 over the past six months by almost 2 to 1. Two out of the top five selections beat the S&P 500 by just about 10 to 1!
Remember, these results come after a mere six months.
Of course, no one can guarantee that the favorite ETF buyback stocks will continue to trounce the S&P 500. Still, with President Trump's tax reform likely to boost stock buybacks soon, buyback strategies are worth a hard look in 2017.