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the long view

The buyback express, which carried many investors to spectacular returns over the past few years, appears to be slowing down.

No one is saying it's time to jump off the train quite yet, but the recent deceleration does underline the growing questions around one of the most successful investing strategies of the past decade.

Advocates of the buyback approach like to purchase stock in companies that are snapping up their own shares. The bigger the buybacks, the better, according to fans of the strategy.

Their reasoning rests on a few key assertions: Buybacks help to create demand for a company's shares and thereby drive up their price. Buybacks return money to shareholders. Buybacks are just an alternative – and often more tax-efficient – form of dividends.

Whatever you make of those claims, the buyback strategy has left the market in its dust. In Canada, the S&P/TSX composite buyback index, which tracks the 50 stocks with the highest buyback ratios in the S&P/TSX composite index, has generated a total return of 10.98 per cent a year over the past decade, beating the market by more than three percentage points a year on average.

In the United States, the S&P 500 buyback index, which tracks the 100 stocks with the highest buyback ratios in the S&P 500, has produced a total return of 11.99 per cent a year since 2005, outpacing the market by an average of more than 3.5 percentage points a year.

The lesson of history seems simple: Buy companies that are aggressively repurchasing their own shares and you'll make more money than your timid index-hugging friends.

However, that lesson isn't working quite as well this year as it has in the past.

Since the start of 2015, the plain-vanilla S&P 500 has actually fared a bit better than its buyback-loving sibling. Meanwhile, the gap between the performance of the S&P/TSX composite and its buyback counterpart has narrowed to a couple of percentage points.

To be sure, the results of a few months don't discredit a strategy that has worked for years. What is more concerning, however, is the possibility that buyback investing is reaching the limit that theory predicts.

According to theory, it should be difficult for a company to gain any consistent advantage by buying back its own shares. All the company is ultimately doing is swapping its own cash for pieces of itself.

This swap should, in normal times, be a more or less neutral proposition. The company's expenditure of cash reduces its assets. But the purchase of shares means there are fewer shareholders with claims on those assets. So things balance off, with nobody being substantially richer or poorer than they were before the transaction.

However, that's not always true.

If a company seizes on the opportunity to buy its shares when they are unusually cheap in comparison with their intrinsic value, it creates wealth for its shareholders. In contrast, if the company persists in purchasing its own equity even when the price becomes expensive, it destroys wealth.

And that brings us to today's situation: With stocks now trading at levels that appear distinctly expensive, many companies with aggressive buyback strategies are likely destroying value. If that's the case, it would be smart to steer clear of buyback-loving companies, despite their stellar recent track record. Buying shares at elevated prices is not usually a good idea.

At the very least, investors should no longer see a buyback program as a guarantee of a surging share price. Urban Carmel, who writes the Fat Pitch investing blog, looked at the 10 U.S. companies with the largest buyback programs and found only three beat the market by a significant margin in 2014. (They were Apple Inc., Intel Corp. and Wells Fargo & Co., for those keeping score at home.) International Business Machines Corp. and Exxon Mobil Corp. lost money for investors despite massive buyback programs.

If you still want to ride the buyback express, it makes sense to be more discriminating than in the past. One factor to watch is whether a company is actually reducing its net share count with buybacks or just using buybacks to offset the shares it has issued to top managers through executive share options.

Patrick O'Shaughnessy of O'Shaughnessy Asset Management in Stamford, Conn., says investors should deduct new share issuance from buybacks to calculate a company's net buyback yield – the net dollars it is pouring into buybacks as a percentage of its market capitalization. He says the most attractive potential investments are those with a high net buyback yield, high quality of earnings and – most important – reasonable valuations.

"You should never buy stocks trading at very expensive multiples no matter how significant their buyback programs," he writes.

A simple screen for companies in Canada with declining share counts and reasonable valuations suggests Magna International Inc., Telus Corp. and WestJet Airlines Ltd. may warrant a closer look.

Investors who want a more diversified assortment of companies with buyback appeal may want to look across the border at exchange-traded funds such as the PowerShares Buyback Achievers Portfolio ETF (PKW-NYSE) or the TrimTabs Float Shrink ETF (TTFS-NYSE).

But whichever buyback route you choose, it would be wise to brace for a slower and perhaps bumpier ride than in the past.