‘Good’ Vs ‘Bad’ Buybacks

Share buybacks can help investors identify stocks with the potential to outperform—but there's a difference between "good" and "bad" buybacks, says Janet Johnston.

Johnston is a portfolio manager at TrimTabs Asset Management, a boutique ETF issuer that runs two active equity ETFs, the $125 million TrimTabs All Cap U.S. Free-Cash-Flow ETF (TTAC) and the $12 million TrimTabs All Cap International Free-Cash-Flow ETF (TTAI).

Johnston will be a panelist at the upcoming Morningstar Investment Conference, held May 8-10 in Chicago. Here she shares her perspective on how to tell the good buybacks from the bad, as well as her thoughts on what investors can expect for the second half of 2019.

ETF.com: What can share buybacks tell you about the health of a company?

Janet Johnston: First, that there are good buybacks, and there are bad buybacks. You could say the same thing about dividends. Sometimes they're not sustainable: Companies are too aggressive, and their cash flows aren't growing fast enough to sustain the dividends.

In our research, we look for the companies doing buybacks with their free-cash flow. Those are the ones we prefer, because they have organic growth, versus more engineered growth. If the only option [a company has] is to buy back stock, then those probably aren't the companies we want.

So we look at a company's free-cash flow growth and balance sheet strength. We want to avoid companies that are leveraging up to buy back their stock, because then, they're basically engineering earnings per share growth.

ETF.com: Last year, we saw companies buying back their shares in record amounts, in large part due to the tax reform bill passed in 2018. Should we expect to see this pace of buybacks continue through 2019 and beyond?

Johnston: We’re continuing to see buybacks, but, one of the things we look at is actual share reduction. We don't look at announcements or what a company has done in the past, because announcements may be an indication of what a company is going to do, but you don't always know the timeline, and it's no guarantee.

But we’re continuing to see share buybacks. As investors, we like owning a bigger piece of the pie. Our caveat is that we want the good buybacks, the ones that are being done with free-cash flow versus debt.

ETF.com: How does the buyback factor fit into your multifactor strategies?

Johnston: For us, the share reduction is one factor in our multifactor model. By far the strongest factor in our model is free-cash flow. Buybacks are like any other factor; sometimes they work and sometimes they don't. But it works better if it's combined with free-cash flow, which is a stronger factor.

We think of our ETF positions as core, high quality investments. Our goal is to generate alpha over the Russell 3000 over the long term.

ETF.com: Looking ahead to where the market will go for the rest of the year, some folks are optimistic, some are pessimistic, some haven't made up their minds. Where do you fall?

Johnston: We’re constructive on the market. We expect things to continue, maybe moving higher. But we also saw that people got far too bearish in the fourth quarter [of 2018]—not just in terms of market sentiment, but in terms of expectations for earnings and the economy.

However, the GDP [gross domestic product] number keeps creeping up. Actual earnings for the first quarter keep creeping up. We've seen a very solid consumer in the U.S. and globally. And we're starting to see some global indicators pick up too. The consumer is very strong in the U.S., but the consumer is very strong in China too.

ETF.com: So the U.S.-China tariff war hasn't had much impact?

Johnston: It doesn't seem to be impacting the consumer. In the U.S., you've got record low unemployment; you've got the best balance sheets in 40 years; you've even got increasing wages. The U.S. consumer is in a very strong position.

At the same time, Lululemon, for example, is expecting to quadruple its sales in China. And there are other companies saying similar things in cosmetics, high-end spirits, shoes, retailers—Starbucks. When you hear companies say things like that, it seems we're seeing a consistent theme.

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Contact Lara Crigger at [email protected]