Corporate cannibals – a term affectionately coined for companies that devour their own shares through aggressive buybacks – offer a fascinating opportunity for investors. But, as you could probably guess, not all share buybacks are created equal. Some are a savvy move aimed at rewarding shareholders, while others are a bright red flag. Here’s how to know the difference and how to profit from the firms that eat their own.

First, a quick primer on share buybacks.

At its core, a share buyback is exactly what it sounds like: a company purchasing its own shares from the open market. The move reduces the total share count, effectively increasing each shareholder’s ownership stake. Think of it like slicing a pizza into fewer pieces – the remaining slices get bigger.

So why do companies buy back their shares? Well, it’s often a vote of confidence from management, signaling they believe the stock is undervalued and that the company’s future is strong. Buybacks also help optimize a firm’s capital structure, allowing it to put excess cash to work or adjust its debt-to-equity ratios.

For shareholders, buybacks can be more tax-efficient than dividends, because they don’t create any immediate tax liabilities. Plus, buybacks can offset the diluting effects that can come with stock-based compensation programs, keeping shareholders’ stakes intact. The chart below illustrates the exponential increase in returns that shareholders see when a company buys back a higher percentage of its outstanding shares, assuming there’s no change in the firm’s earnings or price-to-earnings (P/E) multiple. For example, buying back 50% of shares results in a 2x return, while repurchasing 99% yields a 100x return, demonstrating the powerful impact of share buybacks on shareholder value.

Next, here’s why corporate cannibals are attractive.

Done right, buybacks can be a powerful way to generate returns for investors. When a company shrinks its share count, each remaining share has a bigger claim on the company’s profits. This can lead to a higher earnings per share (EPS), which investors often reward with a loftier stock price.

Another perk of buybacks is their ability to improve shareholder returns, especially when shares are repurchased at undervalued prices. A disciplined buyback strategy demonstrates that management knows how to allocate capital efficiently, focusing on what creates the most value – whether that’s reinvestment, dividends, or buybacks.

There’s also a tax advantage for some investors. Unlike dividends, which are taxed immediately, buybacks don’t directly impact shareholders’ tax bills, making them a more efficient way for companies to return capital.

So, here’s where you’ll find corporate cannibals.

Certain industries and types of companies are more likely to engage in big-scale buybacks.

• Mature industries like utilities, consumer staples, and telecoms often turn to buybacks as a way to deliver steady returns when organic growth opportunities are limited. These companies typically have stable cash flows but fewer reinvestment avenues.
• Cash-generative businesses like established tech firms and financial institutions also favor buybacks. With steady free cash flow and relatively low capital expenditure needs, these companies have the financial flexibility to return excess cash to shareholders. Ulta Beauty is an example of a solid, cash-generating business that has cannibalized a third of its shares in the past decade.
• Sectors with high free cash flow – think technology, healthcare, and energy – often fund buybacks while continuing to invest in growth efforts like innovation and expansion.

So now that you know where to look, the question is: how do you get started?

Begin with the numbers. Look at a company’s free cash flow (FCF) as a percentage of revenue. A high FCF indicates a business’s ability to fund buybacks without compromising other priorities.

Next, check debt levels. Is the company maintaining a healthy balance sheet, or is it taking on excessive debt to fund buybacks?

Finally, review the timing of past buybacks. Has the company been opportunistic, repurchasing shares during price dips, or has it overpaid?

That’s the quantitative stuff, but qualitative factors are just as important. Strong management is key – so you’ll want to look for leadership teams with a track record of disciplined capital allocation. Also, consider whether the company is still investing adequately in growth, even as it makes aggressive buybacks. A great corporate cannibal doesn’t just devour shares: it balances this strategy with long-term growth.

Alternatively, you can also invest in ETFs that try to capture the companies with the highest buyback yields like the Invesco BuyBack Achievers ETF (PKW; 0.62%) or the Amundi S&P 500 Buyback UCITS ETF (ticker: BYBU; expense ratio: 0.15%)

Finally, some red flags to watch for.

Remember: not all buybacks are good buybacks. Some do more harm than good.

When companies overpay for their shares, that’s a major red flag. If buybacks happen when the stock is trading at inflated prices, the value created for shareholders diminishes – or worse, disappears. Ideally, buybacks should be timed when the stock is undervalued, but not all companies get this right.

Another warning sign is overleveraging. If a company borrows heavily to finance buybacks, it can stretch its balance sheet to dangerous levels, especially during economic downturns or when interest rates are rising. It’s worth checking debt levels and whether the company is taking on unnecessary risk.

A lack of growth investment can also be a bad omen. Some companies prioritize buybacks at the expense of innovation, research and development (R&D), or acquisitions. This short-term focus might boost EPS, but it risks stagnation in the long run.

Earnings manipulation is another issue to watch for. Buybacks can artificially inflate EPS, masking problems like falling revenue or slowing growth. Management incentives matter here, too – if buybacks are primarily benefiting executives with stock-based compensation rather than shareholders, that’s a red flag.

Some of the most successful corporate cannibals include companies like Apple and Berkshire Hathaway. Apple has mastered the art of balancing buybacks with innovation, repurchasing billions in shares while continuing to deliver new products and expand its ecosystem. Under Warren Buffett, Berkshire Hathaway has become known for its disciplined approach, buying back shares only when they’re trading below their intrinsic value.

On the flip side, there are cautionary tales like General Electric (GE). In the 2000s, its aggressive buybacks were funded by debt, leaving the company vulnerable during the financial crisis. The result? A sharp decline in shareholder value.

Investing in corporate cannibals can be incredibly rewarding, but it requires a discerning eye. Share buybacks are a tool – a powerful one when used responsibly, but a dangerous one when mismanaged. Ultimately, investing in corporate cannibals isn’t just about buybacks; it’s about understanding the bigger picture.