Rock bottom interest rates have driven income-seeking investors away from bonds and toward dividend paying stocks.

 

#-ad_banner-#Trouble is, the shift has pushed stock prices much higher and their valuations are getting rich. Shares of the SPDRS S&P Dividend ETF (NYSE: SDY) increased more than 12% over the last year and trade for 20.7 times trailing earnings.

 

As an income investor, I fear that rising rates will dim the appeal of dividend-paying stocks. As investors start to again look to bond yields for safety, the appeal of that quarterly paycheck may not be enough to support valuations.

 

Fortunately, there is another side of the cash yield equation.

 

Nearly three-quarters of the companies in the S&P 500 repurchased their own shares in the third quarter of 2014. On a trailing twelve month basis ended September 2014, $567 billion in stocks was bought back. That represented an increase of 27% over the same period in 2013, bringing the buyback yield over 3% and nearly a full percent above the dividend yield.

 

Companies that repurchased shares over the 10 years to 2014 outperformed both the S&P 500 and companies that did not make repurchases, according to Factset Research.

 

Share buybacks bring another benefit: They don’t generate taxes in your portfolio, as dividend payments do. Buybacks are also popular with management from an image perspective: Scaling down a buyback program is often overlooked, whereas a dividend reduction typically has a negative impact on share prices.  

 

Another plus: investors haven’t squarely focused on buybacks as they have dividends, and as a result, valuations have not reached the lofty levels seen in dividend-producing companies. The SPDR S&P 500 Buyback ETF (NYSE: SPYB) tracks the top 100 stocks in the S&P 500 with the highest buyback ratio over the last twelve months. It currently trades for 17.7 times trailing earnings, a discount of 14.5% to the dividend fund.

 

High Cash Yield Without Taxes
It turns out, two of my favorite stocks are also two of the best buyback stocks I’ve ever seen. Through strong cash flow, these two companies have been able to aggressively repurchases shares and drive returns for investors.

 

VeriSign, Inc. (Nasdaq: VRSN) has decreased its share count by 51% over the ten years to 2014 and has returned a 10% annual average cash yield over the period. The cash yield has been relatively volatile, but has only dropped below 5% on one occasion in the last decade.

This company faced a setback in 2012 when the Internet Corporation for Assigned Names and Numbers (ICANN) re-approved the company as the primary registry of domain names, but disallowed a price increase until 2018.

 

 

 

A near monopoly on internet domain registrations ensures stable sales and cash flows. While the dot-com domain fee is set for the next few years, the company is increasing dot-net fees by 10% annually. The company is a cash machine, averaging $520 million in free cash flow over the last three years. Two-thirds of the company’s total assets of $2.16 billion are in cash and short-term investments.

 

AutoZone, Inc. (NYSE: AZO) has decreased its share count by 58% over the past decade and has returned a 9% annual average cash yield in that time. The cash yield has fallen since 2009 as the shares rebounded after the financial crisis, but is still above 6% of the market capitalization.

 

 

Autozone has generated an average of $913 million in annual free cash flow over the last three years, even after boosting investment spending by a compound annual rate of 11.6% over the period.

 

The company is the dominant player in the do-it-yourself auto parts industry with 50% more belts, batteries and hoses sold than its next closest competitor. The average age of cars and light trucks hit a record 11.4 years in 2013 and should translate into strong demand for replacement parts for some time to come.

 

Risks To Consider: Buybacks can be volatile since management doesn’t face the same stigma as a dividend cut. The two stocks above have protected their buybacks even during tough economic times, but a cash flow crisis could see a temporary reduction in the repurchase activity.

 

Action To Take –> Do not overlook share buybacks as an important part of total cash return to investors. Look for management that is quickly “taking the company private” and giving you control of your tax bill.

 

Share repurchases are such a powerful tool that StreetAuthority devoted an entire newsletter to identifying shareholder-friendly firms that pay dividends and buy back shares. These stocks, which we call Total Yield stocks, have proven to beat the market — even during the 2008 financial crisis and the dot-com bubble — and serve as reliable income investments. To find out more about Total Yield investing, click here.