How Buybacks Can Make You Rich

With many companies hoarding billions of dollars in cash on their balance sheets, one of the most controversial questions investors have is whether doing stock buybacks is a smart move for a company to make. Although anecdotal evidence can lead to differing conclusions, the experience of an exchange-traded fund that specializes in stocks of companies that routinely do buybacks sheds some light on whether the practice truly adds value for investors.

There's an ETF for that
With the vast proliferation of ETFs over the past several years, it should come as no surprise that you can invest in a strategy that focuses on companies that are authorized to buy back their own stock. The PowerShares Buyback Achievers Portfolio (NYSE: PKW  ) is based on the Share Buyback Achievers Index, which takes U.S. companies that trade on major exchanges and screens for those that have done buybacks for at least 5% of their common stock over the past 12 months. Companies are then weighted by market cap, with the restriction that no single stock can receive a weighting of more than 5%.

Interestingly, the ETF reveals that some sectors are more prone to do large buybacks than others. For instance, utilities, telecommunications, and energy stocks are almost completely unrepresented in the ETF, presumably because most of the companies in those sectors use dividends to return capital to shareholders rather than with buybacks. On the other hand, health-care, technology, and consumer-oriented stocks together make up more than 85% of the fund's assets.

So does it work?
With the fund having started in December 2006, we now have almost five years of performance to study. At least thus far, the results look quite promising. After getting off to a rocky start in 2007, the PowerShares Buyback ETF has outperformed the S&P 500 each year since and currently leads the index so far this year as well. Over the past three years, the ETF has put up average annual returns of 19%, well in excess of the 13% annual return for the S&P over the same period.

The strategy certainly doesn't prevent losses, as its 12% swoon during the just-completed third quarter shows. But overall, it has produced dampened volatility along with its outpaced returns.

Why does it work?
At least recently, the strategy seems to owe much of its success to the health-care companies it owns such large positions in. UnitedHealth (NYSE: UNH  ) , Bristol-Myers Squibb (NYSE: BMY  ) , and WellPoint (NYSE: WLP  ) have all seen 20% annual gains over the past three years, even with all the current uncertainty over health-care reform.

However, the index is passive and mechanical, and so it makes no attempt to weed out losing stocks from the mix as long as they keep meeting the 5% buyback test. Hewlett-Packard (NYSE: HPQ  ) is the most egregious offender in the ETF's portfolio, having lost nearly half its value over the past two years alone. But relatively weak returns since 2009 from Lowe's (NYSE: LOW  ) and Walgreen (NYSE: WAG  ) confirm that buybacks alone can't guarantee that a stock's price will go up strongly in the long run.

Are buybacks not so bad after all?
Given all the horror stories you've heard about company managers having horrendous timing in buying back shares at their highs, you might well have thought that share buybacks were never a good idea. But at least from the experience of the PowerShares Buyback ETF, the answer isn't near as cut and dried. Moreover, given that the ETF manages to overcome a somewhat pricey annual expense ratio of 0.6% to deliver strong results, a broad index-based approach may well outperform the broader market. That's certainly good news for the companies that espouse buybacks -- and it goes a long way toward showing that dividends aren't the only way to make shareholders happy.

The world of ETFs has lots of interesting choices these days. Take a look at The Motley Fool's free special report on ETFs for some great examples of promising ETFs for your consideration.