Saturday, January 26, 2008

The Buyback Bubble Motherload

Excessive share buybacks have reduced dividends and caused U.S. stocks to become over-priced relative to their payoffs, and I'm convinced that the current crash represents the recognition of this problem by investors. A good medium-term play would be to sell short the companies with the largest buybacks in order to get the maximum payoff from this decline.

The Power Shares Buyback Achievers fund (ticker PKW) is an ETF which has collected all of the worst buyback offenders into one basket, allowing investors to buy them (or short them) as a group with one click. Companies have to buy back at least 5% of their shares per year in order to be included in the fund's lineup. Not surprisingly, the dividend yield of the group is anemic - less than 0.5% - and that makes it particularly attractive for selling short.

This ETF includes some well- known powerhouses. Microsoft, Exxon, Time Warner, Goldman Sachs and Prudential together comprise nearly one-quarter of the holdings. At first glance it might seem crazy to bet against this group of titans, but it makes sense when you consider what's been happening over the past few years. These companies have been generating enough cash to buy back 5% of their own market capitalization every year. In the best case scenario, without any options dilution, these buybacks have been increasing shareholder stakes in the companies by 5% per year. Thus, after 4 years of buyback activity, long-term investors now own 22% more of these companies, and have been collecting (best case) a 0.5% dividend yield in the meantime.

Had these corporations paid dividends with that money instead, investors would have been pocketing at least 5% per year in cold, hard cash. The question is: would investors rather own $1000 of a company that pays a 5.0% yield ($50 per year), or $1,220 of the exact same company paying a 0.5% yield ($6 per year)? That 8-to-1 difference exemplifies the dividend bubble, and I think it is the reason why investors are finally heading for the exits. If I'm right, then PKW should be hit harder than most in the coming months.

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