Cash returns are still king

Apologies for returning to the world of Exchange Traded Funds (ETFs) for the second week in a row but the latest intriguing product launch is worthy of note for several reasons. On Monday (10 Nov), Invesco's PowerShares Global Buyback Achievers UCITS ETF listed on the London Stock Exchange, with the EPIC code of BUYB.

The 'smart beta' tool provides clients with access to a portfolio of firms that seek to create value by buying back their shares and follows specially-created indices rather than the standard equity benchmarks with which we are all so familiar.

This is a further example of how the ETF and tracker business continues to change, although it also raises the prickly issue of whether clients should prefer share buybacks, dividend payments or a combination of the two.

In the coming years, it will be fascinating to see how PowerShares Global Buyback Achievers ETF performs relative to the SPDR Global Dividend Aristocrats ETF. Clients will doubtless be delighted if it can deliver the gains and outperformance offered by the NASDAQ US Buyback Achievers index since its inception in 1996.

Heavy stock buyback programmes have delivered outperformance in the US

Source: Thomson Reuters Datastream

Their future performance statistics, taken over a suitably lengthy time horizon, might help settle the debate once and for all, especially as actively managed global equity income funds are thrown into the equation.

The best performing global equity income ETFs over the past year

EPIC		Market cap £ million	One-year performance	Dividend  yield	Total expenseratio	Morningstar rating	Replication method
SPDR S&P Global Dividend Aristocrats UCITS ETF (USD)
GLDV		57.2	7.7%	3.7%	0.45%	n/a	Physical
Vanguard FTSE All-World High Dividend Yield UCITS ETF (USD)
VHYD		134.5	5.9%	3.7%	0.29%	n/a	Physical
db X-trackers Stoxx Global Select Dividend 100 UCITS ETF 1D USD
XGDD		351.2	5.8%	n/a	0.50%	*****	Synthetic

Source: Morningstar and ETF.com, for the Global Large-Cap Value Equity and Global Equity Income categories.

The best performing global equity income funds over the past year

ISIN			Fund size £ million	One-year performance	12-month dividend yield	Ongoing charge	Morningstar rating
Artemis Global Income Class I (Dist)
GB00B5N99561			1,019.9	12.2%	4.2%	0.87%	*****
Guinness Global Equity Income Z
IE00B754QH41			63.3	11.7%	3.1%	0.74%	n/a
Fidelity Global Dividend Fund W (Acc)
GB00B7GJPN73			100.2	10.8%	3.2%	0.95%	n/a
Sarasin Global Higher Dividend Fund P (Acc)
GB00B84ZSV39			433.3	9.4%	4.7%	1.74%	***
Aviva Investors Global Equity Income Class 2 (Acc)
GB0030442098			65.7	8.4%	3.0%	0.91%	***

Source: Morningstar, for the Global Equity Income category. Clean funds only.

Cash returns

At a time of low bond yields and returns on money in the bank, any firm which is generating more cash than it needs is likely to be highly prized, as they can then reward shareholders by returning this liquidity to them.

Buybacks are therefore in vogue and a report published by Peter Garnry, Head of Equity Strategy at Saxo Bank, asserts that the 100 S&P 500 constituents companies who spent the most on share buybacks, as a percentage of market cap, have outperformed the US benchmark index by around two percentage points in 2014. Garnry then says the top 20 spenders on buybacks have in total outstripped the index by three percentage points, on equal-weight basis.

Prominent names here include telecom equipment giant Cisco, internet behemoth Yahoo!, Marathon Oil, media firm Time Warner and drug developer Celgene. In a year when the S&P 500 is up by 10.3%, many clients will be coveting those additional returns.

This makes the launch of the PowerShares Global Buyback Achievers ETF particularly timely. The instrument tracks a basket of securities which comprises the constituents of both the NASDAQ US Buyback Achievers and the NASDAQ International BuyBack Achievers indices.

The NASDAQ US Buyback Achievers Index is comprised of corporations that have effected a net reduction in shares outstanding of 5% or more in the trailing twelve months. the NASDAQ International BuyBack Achievers Index is comprised of corporations that have effected a net reduction in shares outstanding of 5% or more in their latest fiscal year. The International Buyback Achievers index was launched on 12 December 2013 and the Global Buyback Achievers benchmark this August.

Reach for yield

Yet buybacks are not to everyone's taste and the debate over which is “best”, dividends or buybacks rages on. A client's tax situation and long-term investment goals will have a large say here, but the arguments in favour of dividends (and their reinvestment) remain compelling.

Two weeks ago (31 Oct), this column flagged the London listing of four dividend-weighted ETFs by Wisdom Tree Europe, two focusing on each of Europe and the USA. In a conference call this week (11 Nov), Director of Research Jeremy Schwartz quoted data from Professor Jeremy Siegel's book Future for Investors which show how the highest yielding US stocks have consistently outperformed market on a 50-year view, and done so while offering lower-than-average volatility, as benchmarked by beta.

Stocks with the highest dividend yield have consistently outperformed in the USA

Dividend yield (quintile)	Return (per year)	Beta
Highest	12.8%	0.93
High	12.6%	0.84
Mid	9.8%	0.91
Low	9.2%	1.07
Lowest	9.5%	1.23

Source: Professor Jeremy Siegel, Future for Investors. Shows average annual total returns from 1957 to 2013, dividing S&P 500 index into five quintiles, weighted by market capitalisation.

The benefits of dividends and their reinvestment can also be demonstrated in a UK context. Since the institution of the FTSE All-Share in 1962, the index has generated a compound annual capital return of 7.1%, with a 3.8% yield average annual yield supplementing that. The table below shows what would have happened had a client put £1,000 into the market in 1962 and generated the same returns with and then without dividend reinvestment. The gap, which excludes fees, commissions and tax (barring the 10% dividend withholding tax) for simplicity's sake, is startling. By way of comparison, the chart also includes returns on cash, based on the average Bank of England base rate for each given year.

Basic mathematics shows patient dividend accumulation and reinvestment is a winning strategy

Source: Thomson Reuters Datastream, Bank of England, AJ Bell Research

Pros and cons

Besides the positive case that can be made in favour of dividends, several criticisms can be levelled at share buybacks.

History shows companies have a habit of buying stock back during bull markets (when their stocks tends to be more expensive) and not doing so during bear ones (when their stock tends to be much cheaper). Should any client doubt this, please direct them to a September posting on the ever-interesting www.aswathdamodaran.blogspot.co.uk site. The opening chart looks at dividends and buybacks in the US going back to 1980 and shows how buybacks peaked in 2007 and collapsed in 2008 and 2009 only to accelerate again in 2011 and 2012.

This exposes clients to the risk management teams are buying high rather than low and in my opinion, too many commentators and analysts slavishly assume buybacks are always a good thing, in the view they represent a statement from a management team that their company's shares are undervalued. As someone who has covered stocks as a fund manager, analyst and journalist for over 20 years, I have yet to meet a chief executive who thinks his stock is overvalued and thus would exercise more caution.

My preference would be to side with Terry Smith of Fundsmith, who will be appearing at next week's AJ Bell Investival, to be held on 20 November at London's Millbank Tower (if you are not attending you can still put questions to him by tweeting them using the hashtag #AJBellInvestival.

In a paper dating back to 2011, Smith argues buybacks only work if the shares are trading below their fair value and the repurchase offers the best use of available cash. This in turn echoes sentiments expressed by master investor Warren Buffett, who in his 2012 letter to Berkshire Hathaway shareholders wrote: “Charlie [Munger] and I favour repurchases when two conditions are met: first, a company has ample funds to take care of the operational liquidity and needs of its business; second, its stock is selling at a material discount to the company's intrinsic business vale, conservatively calculated.”

Winning formula

In sum, buybacks work best when

• Highly visible cashflows and a strong balance sheet mean the business can easily support the extra debt
• The business does not require major capital investment to remain competitive
• The balance sheet is genuinely inefficient and can take on more debt, subject to the two points above
• The shares are 'intrinsically' cheap

Meanwhile, dividends can be cut just as quickly during market and economic downturns so companies' income policies require careful research too, to ensure dividend cover is adequate and the shareholder distributions safe.

It is unlikely clients or advisers have the time to assess every buyback or dividend payment plan so active or passive funds which target income or buybacks serve a valuable purpose. In the case of the latter, the PowerShare ETF's basket of stocks will contain some firms where the buyback does make economic sense and perhaps others where management teams are doing little more than goosing the earnings per share (EPS) metric, if only so they can cash in their stock options as a share price is pumped higher. Equally some income funds will inevitably feature companies where the shareholder payout is cut and others where the distribution grows consistently, ideally with the net result the portfolio provides consistent income and some element of capital appreciation for good measure.

Russ Mould, AJ Bell Investment Director.