How to cash in on stock buybacks

October 10, 2013, 11:41 AM UTC

Share buybacks have been generating buzz lately. In September activist investor Carl Icahn turned up the heat on Apple CEO Tim Cook to boost the company’s share repurchase program, already the largest in U.S. history; Microsoft made a splash by earmarking an additional $40 billion for its massive program; and Walt Disney’s stock jumped on news that it was planning a sharp increase in buybacks. Those are just the latest in a long line of large companies that have ratcheted up their repurchases. For shareholders, that generally bodes well, and these days it’s easier than ever to capitalize on the trend.

Big companies are sitting on a record $1.3 trillion in cash, giving them plenty of ammunition to repurchase shares on the open market. Buybacks shrink the number of shares outstanding, making each remaining share more valuable. A slew of research has shown that they typically lead to stock price outperformance. For instance, researchers at Fidelity analyzed buybacks in S&P 500 companies from 1990 to mid-2013. It found that total returns for companies that repurchased shares were 0.83 percentage points above those of the broader index over the following 12 months. Larger buybacks, the study showed, had greater impact: Returns for companies that repurchased more than 5% of their shares beat the S&P by 4.8 percentage points.

You can attempt to cash in by investing in individual companies, but you’ll need to do a fair amount of due diligence. For starters, the mere announcement of a buyback is no guarantee that a company will follow through with actual purchases, or buy as much stock as initially announced. And many companies use buybacks to offset the share dilution created by employee stock option grants; the net effect is no reduction in overall share count and of no benefit to investors. If management overpays for the shares it buys back, returns could suffer.

An easier, more diversified approach is to buy a fund like the PowerShares Buyback Achievers ETF, which holds stocks of companies that have repurchased at least 5% of their shares over the past year. The fund has generated a 16.4% annualized total return over the past five years, far outpacing the S&P 500’s 10.1% over the same period and justifying the above-average 0.71% expense ratio. (The ETF has also handily outperformed the PowerShares Dividend Achievers fund, which invests in companies that consistently raise their dividend payouts, the major nonbuyback method for returning cash to shareholders.) Another option, the AdvisorShares TrimTabs Float Shrink ETF, not only screens for companies that have reduced their share count, but also considers factors like free cash flow and balance sheet strength. The fund, which carries a 0.99% expense ratio, has gained 30% so far in 2013. To be sure, those kinds of returns can’t last forever. But history shows that paying close attention to buybacks is likely to give you an edge in just about any market.

A former compensation consultant, Janice Revell has been writing about personal finance since 2000.

This story is from the October 28, 2013 issue of Fortune.