Wall Street beauty contest: A tale of two funds

Let’s say a web site had a contest, and it worked like this. The site ran pictures of 100 people, and asked you to pick the most beautiful person. Whoever won the contest gets $1,000.

You picked the photo of someone you thought was exceptionally beautiful. And you lost, because that’s exactly the wrong strategy for this contest. You should have looked for the photo of someone you thought everyone else thought was the most beautiful.

by Unknown photographer, bromide print, 1933
by Unknown photographer, bromide print, 1933

John Maynard Keynes, economist and investor, used the analogy to describe how the stock market works. Your stock may be an exceptional value, with a fine dividend, low price-to-earnings ratio, and a CEO with a dazzling smile. But if that company, or that sector, is out of style, your stock will lag the broad market.

Let’s illustrate this by looking at two funds. The first is ProShares Dividend Aristocrats ETF (ticker: NOBL). The fund invests in stocks of companies that have raised their dividends every year for the past 25 years.

The second is PowerShares Dynamic Buyback Achievers (PKW). This fund invests in stocks that have shrunk their amount of outstanding stock by 5% or more.

For long-term investors, the Dividend Aristocrats should rule. A dividend is money in your pocket, and a company that raises its dividends regularly is clearly focused on its investors. Moreover, Wall Street normally shoots companies that cut their dividends, throws them out the window, and then shoots them again. A company that raises dividends has to be exceptionally confident that it has the financial wherewithal to keep paying the dividend.

Buybacks, however, may or may not affect stock price. And buyback programs tend to be ephemeral — here one year, gone the next. And companies that do buy their own stock may or may not be savvy buyers of their own stock. When stock prices were in the third parking level of historical norms in 2009, buybacks virtually ceased.

Which fund has done better? The buyback fund, of course. NOBL, the dividend fund, has gained 0.88% this year, vs. 3.2% for the Standard and Poor’s 500 stock index with dividends reinvested. PKW, the buyback fund, has gained 3.6%.

The reason, of course, is that buybacks have become the most popular strategy on the block the past 12 months. Companies bought back $148 billion of their own shares in the first quarter, topping the record set in the second quarter of 2007. (Quiz: What major market event started in the third quarter of 2007? Anyone?)

PKW is not without its beauties. It buys shares of companies that actually shrink their share count, rather than those that simply announce new buyback programs. (Companies often announce new programs, but don’t get around to actually buying all the shares they promise to.)

But the lesson of this story is that, at least for the moment, share buybacks are what other investors think is the most beautiful strategy on Wall Street. And for that reason, PKW is the winner.