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Don’t Lose Money With A Buyback Strategy

Published October 31st, 2016 by Dirk S. Leach

Those of us who spend some time reading (and blogging) on the subject of investments have all seen articles or forum posts from people who have sold a stock only to buy it back after its share price has fallen to some lower valuation.

Some investors claim to have done so repeatedly with the same stock.  If you could get the timing right, you should be able to generate significant returns over time.  But, is a sell-buyback strategy really making money for those investors?

This article presents the limitations of  the sell-buyback strategy and provides some income tax considerations for those employing the strategy.

The Sell-Buyback Strategy

A sell-buyback strategy is relatively straight forward to implement.  For example, an investor buys a stock at $45 per share, sells it at $65 per share with the intention, or at least the hope, of being able to buy it back at a lower price on the next dip or correction.

If such a strategy could be implemented, the advantage is obvious.  The ability to generate a 30-40% profit once or twice a year by buying and selling the same equity would create quite a following of investors.  The reality is, of course, it’s not that easy to accomplish.  Let’s take a look at the challenges and limitations of implementing a sell-buyback strategy in the real world.

One of the most obvious challenges to implementing the strategy is accurately predicting the future trajectory of a stock holding.  I’ve yet to find anyone who can reliably pull that off, and I know for certain that I cannot predict the future.  One of the many things I’ve learned over the 30+ years I’ve been investing is that, because there are so many variables and unknowns that can drive the equity markets, the short term direction of any particular stock holding is impossible to predict.

I had a recent reminder of this lesson with Realty Income (O).  I bought into Realty Income at $45.25 in September 2015 and watched it run up to $62.50 by March 2016.

I was thoroughly convinced at that time that Realty Income was over valued at $62.50 and could not have much upside remaining.  Including dividends, my total before tax gain was a healthy 41%.

As it turns out, I was wrong about how much upside Realty Income had remaining as it marched on up above $72 per share before tapping out.

Today, Reality Income is priced at about $58.50, so I’m still pleased with the return I achieved, but it serves to make the point that we cannot predict the short term direction of equity investments.

Should I Buy Back Realty Income?

Realty Income is a solid triple net lease REIT with a history of strong and consistent performance that pays monthly dividends.  You can find other quality monthly dividend stocks here.

Assuming that historical performance continues into the future, at what price point should I buy back in?  It turns out that the answer to that question is influenced by the tax man’s take of your investment proceeds.  I prepared the two tables below to show how the tax man’s take will affect a sell-buyback strategy using an original cost stock price of $45 and a trajectory similar to Realty Income’s recent run.

gains-including-taxesThe first table uses a combined Federal and State tax rate of 25%, which would be a relatively low marginal income tax burden.  The second table is based on a relatively high 45% marginal income tax burden.  While it’s possible for an investor’s marginal tax rate to be either higher or lower than my examples above, the rates I’ve used are sufficient to show how your marginal tax rate influences the buyback decision.

The results are color coded in green, yellow, and red.  Those results shown in red shading indicate your investment would be working better for the taxing authorities than they are for the investor.  Those shaded in yellow are marginally working for the investor depending on how many dividend payments the investor gave up between selling and buying back the stock.  Those shaded in green, are working out for the investor.  It is probably worthwhile to walk through the details on one set of results.

I’ll use the 45% tax rate table and the result line corresponding to a selling price of $65 per share.  While the pre-tax gain is a nice $20/share, the investor has to give $9 of that gain to his taxing authorities leaving him with $11 in addition to the $45/share he initially started with.  If the investor buys back the stock after it falls to $60/share, what has he really accomplished?  Since he has $56 remaining after paying the tax man, he has to come up with another $4/share to buy his stock back so in summary, this investor would simply be giving (losing) $4 to his tax man.

If the investor buys the stock back at $55, he is in a little better shape since he has his stock at $55 per share plus he has $1 remaining in his pocket and he has made his tax man happy after giving him $9 of his hard earned gains.  But, if this is a dividend paying stock, he has left some money on the table.  If I use Realty Income as an example, between the time I sold it in March and today is roughly 6 months which cost me $1.36 per share in lost dividends.  In that case, the investor would have been a little farther ahead, $0.36 per share to be exact, if he had simply held onto the stock and collected the dividends.  I’ll leave it as an exercise to the reader to work though the green shaded portion of this result line, but clearly the investor will make out better as the buyback (repurchase) share price drops.

Summary Take Away

The main take away from this article is simply that “Taxes Matter.”  I even considered using the “Taxes Matter” as the title of this piece, but I thought it would be a bit too obtuse.  Investors need to factor the tax consequences of selling and buying back a stock to ensure that they are not simply working for the tax man and are actually generating a positive return on their investments.

Because each individual investor’s tax situation is different (Federal marginal rate plus the State marginal rate) and because each stock’s price trajectory is different (volatility and dividend payments), there is no simple rule of thumb for stock buyback strategies that will cover all investors and all stocks.

Hopefully, this article has provided the reader with the insight necessary to make a profitable decision when considering whether to simply hold a stock for the long term or whether to take a shorter term profit and buy the same stock back at a, hopefully, lower share price.

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