Stock buybacks have been increasing in frequency lately, which is not by itself that unusual considering the condition of the economy. If growth potential is low but a company has excess cash, management may decide to return some of that value to the shareholders. This can be done in several ways, one of which is a stock repurchase or buyback plan. These activities can be similar in effect to issuing a shareholder dividend.

[VIDEO] Stock Buybacks

A buyback benefits shareholders by increasing the percentage of ownership held by each investor by reducing the total number of outstanding shares. In the case of a buyback the company is concentrating its shareholder value rather than diluting it.

Here is a simple example to help explain the principles of a buyback. Imagine that you own one share of company ABC that has 10 shares total outstanding. Company ABC’s market cap is $1,000,000 which means that each share is worth $100,000. ABC’s management team and board agree to buy back 1 share of their outstanding stock leaving 9 outstanding shares. Now that same market capitalization of $1,000,000 is spread across fewer shares (9) which increases their value to $111,111 per share.

A stock buyback is not the golden ticket to easy stock market profits but it does indicate a favorable attitude towards shareholders by company management and an ability to generate profits that can be used to buy back stock. A diversified portfolio of stocks conducting buybacks has been shown to reduce volatility and increase returns in the long term compared to large cap market indexes like the S&P 500.

While it is certainly possible to find one stock at a time issuing buybacks it is probably more convenient for investors to buy an ETF or fund that indexes these kinds of firms within a larger pool. For example, the Invesco Buyback Achievers Portfolio ETF (PKW) offers diversification across more than 100 stocks in the fund that have recently entered into share repurchase plans. This could simplify the process considerably.

PKW is a good example because it has outperformed large cap indexes during the recent market volatility and has shown in actual results and backtesting that over the last 14 years stocks issuing buyback plans outperformed the S&P 500 by more than 100%. This is a great illustration of the value of a moderate level of fundamental analysis and proper diversification.