A curious thing happened after the financial crisis in 2008. When stocks fell, the buying opportunity of a lifetime presented itself to people who could buck the sour mood—as Timothy Geithner writes in his recent book, serious investors began discussing buying gold and burying it in your backyard as a real investment option. Few investors did this, which is partly why equities remained so low in 2009 and took several years to recover.

For those who had the appetite for risk and believed equities could return, the question wasn’t whether to buy or not; it was what to buy. Just buying an index fund offered a 5-year CAGR of about 17%. Over that time horizon, that kind of return is often considered impossible, but from 2009 to 2013, it was as simple as buying shares in SPY.

Stock selection, of course, could allow for a much stronger return. For instance, a portfolio of just Apple (AAPL) and Google (GOOG) offered a CAGR over double what SPY offered. More complex long-only portfolios would offer returns that outperformed the index; since 2009, the doomsayers have been silenced by the performance of the bulls.

Of course, a portfolio of GOOG and AAPL has poor risk protection, and other long-only portfolios can be criticized as offering too much exposure to a bear market.

Another strategy to hedge risk would be to offer greater diversification amongst sectors, size, and markets. Yet diversification for the sake of diversification will not produce alpha over the long term; the idea behind the diversification must be strategic.

One strategy for diversifying while remaining in a long-only portfolio also has the paradox virtue of outperforming in a sluggish economy. It’s also helpful because it correlates well with deflationary environments, which is also usually bad for stocks. It’s also very simple: buy buyback achievers.

Stock buybacks are a simple concept: a company can put shares in the market, and they can remove those shares from circulation. Removing shares is called a stock buyback, and requires using cash on hand or debt to buy back stocks.

Why would a company do this? There are three main reasons:

  1. The company believes its stock is undervalued to intrinsic value, so the stock is a good buy.
  2. The company believes sales will not grow at a healthy rate, so it wants to increase its earnings per share by lowering the total number of shares in the market.
  3. The company wants to return capital to shareholders, but does not want the inflexibility of increasing dividends.

In each of these cases, share buybacks are very good for shareholders. On the one hand, it’s a case of supply and demand; with less supply of a company’s stock in the market, its price is likelier to rise. On the other hand, it’s a case of making capital work more efficiently in a sluggish economy.

Share buybacks have become increasingly popular with large cap companies in recent years, and those who anticipated this trend and saw its value for shareholders have profited handsomely for the insight, with minimal effort and research required. Compared to SPY, the buyback achiever ETF (PKW) has offered a CAGR of over 21%—an alpha of nearly 4% over 5 years by buying a single index fund, even with a high expense ratio and while remaining a comparable risk profile and market exposure.

What’s particularly interesting is how stock buybacks have only outperformed post-crisis; before the recession, PKW was a dog:

PKW

Click on image to zoom

In 2007 and 2008, SPY’s return was far better than PKW’s, but that all changed in 2009, and the spread between the two has widened every year since. This is partly a result of low borrowing costs and partly a result of major cash on hand. Companies can buy back their stock by issuing bonds at historically low rates. A year ago, AAPL issued $17 billion in bonds paying between .5% and 4% while buying back $100 billion in stock, locking in very cheap money while moving some of its $144 billion in cash reserves to stockholders.

When looking at how bond yields influence stocks, most investors think of the search for yield and the reallocation of capital towards greater risk. That is part of the story, but not all. Additionally, low yields allow corporations to restructure their capital allocation higher up the capital chain; in other words, they can swap common stock for preferred stock and bonds in a way that actually costs them nothing, and will actually increase their margins in the long run. This is partly how stocks have been able to outperform even while the economy remains sluggish.

This trend has had one other funny effect on markets—the price-to-sales ratio has gone haywire. The S&P 500 P/S ratio has gone higher and higher every quarter, which has signaled to some bears a market top. Yet those bears need to calculate the total number of shares outstanding and adjust for the higher rate of increased share buybacks since 2009. Such a calculation would be very hard to do, requiring complicated math and a lot of data. This is why any analysis of this aspect of the market will be limited to in-house, buy-side analysts, and the results will be kept under lock and key.

Those analysts who do figure this out, and who can adjust the P/S level for the changing volume of shares, will have an incredibly valuable market edge that will offer even greater alpha in the future.