New Tax… In August a new law was passed. Included in the legislation was a one percent tax on share buybacks. This modest tax should not significantly impact the benefits to shareholders. Share reductions appear to add five percent additional returns to investors. This tax may reduce this excess return to 4.95%. It appears that share repurchases generate the highest source of capital gains tax returns for the government. The government is unlikely to disturb this golden egg.

There was a time when everyone was a value investor. One investment approach during the value era was based on three criteria: A decent company, bad company news, a sharp decline in security price. The investor buys after the news-impact decline and soon has an above-average profit due to the security’s recovery. For thirty-five years I used this approach on individual security research.

Forty years ago, the SEC simplified the process for companies to repurchase their shares. Immediately two papers from Harvard University appeared. The Business School thought that share repurchases were the best financial action that management could perform. The Economics School thought that repurchases were a terrible idea because there had to be a better use for the funds. At that time, with a fifteen-year successful history of security repurchases of options, bonds and preferreds, I saw the advantages of the repurchases. I built a share reduction model.

The popularity of share repurchases increased over the decades. In the past four years, one thousand companies in the S&P 1500 stock index reduced share count in at least one year. Even more companies did share repurchasing but not enough to lower their share count. There is a substantial difference between share buybacks [repurchases] and share reductions. Two-thirds of share repurchases are resold to employees through a variety of company stock and option programs.

The ideas that the Harvard Economics paper expressed, the remembrance of market manipulations during the Roaring Twenties, and the popularity of an old idea — paying employees with options — created background noise against share repurchasing. Most of this negative news was not supported by the data. Most of the positive views were supported by the data. Then I realized that unlike the bad news opportunities in the past, this background noise was impacting all companies conducting share repurchases. This negative background is a benefit. We are able to purchase securities at lower than usual pricing. And over the past twenty-five years we have obtained better than the expected five percent excess returns due to share repurchasing.

Thanks for the bad news.

Katz Family Financial