A version of this article was published in the December 2015 issue of Morningstar ETFInvestor. Download a complimentary copy of ETFInvestor here.
Big U.S. stocks are in the midst of a buyback bonanza. According to S&P Dow Jones Indices, S&P 500 firms spent a collective US$553.5 billion on their own shares during the 12-month period ended June 2015.
There are a host of cyclical factors driving this trend. Years into an economic expansion, corporate profitability remains robust, borrowing costs are low, and firms are flush with cash. But growing buybacks also reflect a long-standing shift in how companies are giving cash back to their shareholders.
Share buybacks now account for more than half the aggregate amount of cash that corporations are returning to shareholders. Prior to 1982, when the Securities and Exchange Commission changed its rules with respect to share price manipulation so as to allow companies to more freely invest in their own stock, more than 90% of the cash that companies gave back to shareholders came in the form of dividends.
What does investment theory tell us about how we should view this shift in corporations' preferred method of doling out cash to shareholders? And what are its implications for the investment practice?
Theory vs. practice
The dividend irrelevance theory put forth by Merton Miller and Franco Modigliani in 1961 posits that shareholders should be indifferent when choosing between dividends and stock buybacks. As both dividends and capital gains (buybacks) have an identical effect on investors' returns (assuming perfect markets, no taxes, a fixed investment policy and zero uncertainty regarding future cash flows), they should consider them to be perfect substitutes.
In practice, of course, things are quite different. For example, investors must consider the tax implications that Miller and Modigliani ignored in their analysis. If the stock is held in a taxable account, investors have to pay taxes on dividends. In the case of a stock buyback, only investors that opt to sell their shares might experience a taxable event. Ongoing investors can defer realizing capital gains.
Taxes are just one of a host of considerations that investors must take into account when assessing the trade-off between dividends and share buybacks as a means of getting "paid" by the firms that they own. It's also important to understand the message that each method sends to the marketplace, as well as the commitments and challenges they present to a company.
Dividends
Commitment. Paying a dividend is a serious and (one hopes) ongoing commitment on the part of the payer. A steady and increasing dividend signals management's confidence in the long-run prospects of its business as well as its dedication to returning cash to shareholders. Of course, a firm's willingness to return cash to shareholders in the form of a dividend might not always align with its ability to do so. Cash-strapped companies will often have to slash or suspend dividends when times are tight in order to preserve liquidity, sending a distress signal to the marketplace.
Discipline. Dividends might also serve to reinforce management discipline. When some portion of a company's cash is already earmarked for shareholders, it is less likely to be put to use in funding pet projects or empire-building acquisitions that might ultimately fail to create value for shareholders.
Certainty. Researchers Myron Gordon and John Lintner's dividend relevance theory states that risk-averse investors prefer the certainty of dividends over the uncertainty of future capital gains. As such, they assumed that investors will prefer dividend-paying stocks and that these stocks will command a premium over their non-dividend-paying counterparts.
Taxes. Investors in tax-deferred accounts should be unmoved by dividend tax-related considerations. However, investors in taxable accounts will be acutely sensitive to this issue. Preferences will change based on prevailing tax rates on capital gains and dividends, as well as the relative levels of the two. At present, the rates give a slight edge to capital gains for higher income earners.
Share buybacks
Flexibility. While dividends indicate commitment, buybacks afford a firm some latitude as to when and how they will give cash back to their shareholders. On one hand, this flexibility is positive in that it allows a firm to dial back its buybacks and preserve liquidity in the face of deteriorating market conditions. On the other hand, this approach can send mixed signals to the marketplace.
Taxes. Buybacks give taxable shareholders discretion as to when they might realize a taxable capital gain. In theory, deferring capital gains for an extended period should ensure that investors are rewarded for their patience. In practice, buybacks may or may not build lasting value for shareholders.
Long-run value creation? I intentionally pose this as a question to emphasize that creating shareholder value through share buybacks can be immensely challenging. In order to add value for ongoing shareholders, share repurchases must be executed at a price that is below a company's intrinsic value. This is easier said than done. In his 1999 letter to 
Berkshire Hathaway (BRK.B) shareholders, Warren Buffett wrote:
"Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason: to pump or support the stock price. The shareholder who chooses to sell today, of course, is benefited by any buyer, whatever his origin or motives. But the continuing shareholder is penalized by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around."
Buffett thinks buying those same dollar bills for $0.80 is the way to go. I can't argue with that, though firms that do so consistently are a rare breed.
Much as Buffett took a dim view on the motives and impact of the buyback craze of the late 1990s, today's frenzy appears to be yielding similarly disappointing results for shareholders. This has been meticulously documented by Research Affiliates in their recent research paper, Are Buybacks an Oasis or a Mirage?:
"The reality is that publicly traded companies in the United States are issuing far more new securities than they are buying back, diluting existing investors' ownership and reducing growth in earnings and dividends per share well below the growth of their reported profits. There is, in fact, no net transfer of cash from the coffers of U.S. corporations to the wallets of U.S. equity investors."
Buybacks are booming, but in aggregate they are not mopping up all the new shares being issued for compensation programs, net new investment and merger-and-acquisition activity. Of course, these are aggregate figures. Not all buybacks are created equal.
A false choice, clear preferences
In practice, many firms return cash to shareholders through some combination of dividends and buybacks. The companies that are best able to share the value they create with shareholders tend to be high-quality firms that possess sustainable competitive advantages. They tend to generate strong, steady cash flows and have access to low-cost external financing.
The most relevant example in the ETF space is PowerShares Buyback Achievers ETF (PKW). The fund has a portfolio of 200 names that are decreasing their number of shares outstanding in a meaningful way by regularly buying back their stock. PKW's index screens for companies that have reduced their share count by at least 5% over the previous 12 months by way of buybacks. This criterion weeds out many of the firms that are buying back stock as a means of managing their numbers and focuses on those that are trying to create value for long-term shareholders. And buybacks aren't the only way these companies are giving cash back to shareholders; PKW's portfolio is loaded with dividend-payers as well. The fund's current 12-month yield is around 1.2%.
