When it comes to capital allocation menus, public companies have a few selections of where to allocate resources to optimize shareholders. Over time, these decisions could have a tremendous impact on the long-term shareholders’ returns:

1. Organic growth through capital, research and development (R&D) investment
2. Inorganic growth through acquisitions
3. Buyback shares
4. Raise dividends
5. Pay down debt

One of the key priorities of management is to ensure the long-term growth and viability of the business. As a result, proper capital investment and selective acquisitions are at the top of the list to allocate capital to play offensive for growth. That said, historically public companies’ track record when it comes to acquisitions is quite questionable, around two-thirds of acquisitions actually failed to create above-average results over time, and there are not many names like Constellation Software (CSU) and Boyd Group Services (BYD) that have consistently created value through M&A. Organic growth and R&D could be considered a safer way to deploy capital to grow, however, investors also need to make sure this capital is spent on worthwhile projects, not just moonshot, “pet projects” of the executives.

On the defensive side, paying down debt increases equity value over time, but companies should also take advantage of the financial leverage that debt can provide. Depending on the predictability of the business, we prefer companies that know to take advantage of debt financing with a conservative approach instead of paying down all outstanding debts.

Therefore, the last two options stand out, most investors prefer dividends over buybacks, because it is “tangible”, and predictable (dividend is paid on a quarterly, monthly basis). But dividends can also be highly tax-inefficient over time as dividends are considered largely as income which would be taxed at a higher rate than capital gain.

This leaves investors with the last, optimal choice in the capital allocation menu. Buyback is highly preferred for a variety of benefits including: 1) Tax efficient (capital gains are taxed more favourably, and the gain is captured at the option of the shareholders 2) Management that is consistently repurchasing shares over the years does indicate a shareholder-friendly mindset, which shareholders tend to reward the company with higher valuation multiples relative to peers 3) Buyback when being done at proper valuations can create tremendous value for shareholders.

Below we have screened for companies with the following criteria:

• Repurchased shares for more than 4% of the market cap in the last twelve months
• Market cap larger than $100 million
• Shareholder yield
• Dividend yield
• Net debt to EBITDA ratio below 4.0x times

Here is the screener:

The criteria above reflect companies that have repurchased their shares for cancellation of more than 4% of the shares outstanding within the trailing twelve-month period. Share buybacks not only signals that management believes shares are currently undervalued but also that management is creating value for shareholders safely by unlocking that discount to intrinsic value. Psychologically, share buybacks also makes it comfortable for investors to continue owning the stock when it goes down or even add to the position. It is because the lower the share price drops, the more shares the company can repurchase given the same amount of dollars spending.

In addition, a healthy financial position lowers the company’s cost of capital, as well as helps the company get through tough times when capital is hard to access. Lastly, as usual, we prefer companies that are over $100 million in market cap, as these companies have proven themselves to be more mature, self-sustainable entities.

Members will recognize some of the names that we cover in our Model Portfolios and coverage list such as: BRP Inc. (DOO), Toronto-Dominion Bank (TD).

It is critical to note that although we do like accretive acquisitions or capital investment as an offensive strategy. However, it takes years to evaluate whether those M&A deals make sense strategically or whether the capital/R&D investment really creates value for shareholders. Therefore, we think share buybacks are one of the safest ways to return capital to shareholders in a tax-efficient way.

Lastly, these companies on the list are not recommendations, but rather a starting point that helps investors generate potential investment ideas.

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Disclosure: The analyst(s) responsible for this report do not have a financial or other interest in the securities mentioned.