Over the past year, companies have bought hundreds of billions of dollars of their own shares in the stock market. Investment manager David Fried says these “buybacks” can be a valuable ­indicator for investors.

Reason: Extensive research shows that, on average, the stocks of companies that buy back their own shares outperform the broad market over the next four years by three percentage points annually. Fried has improved substantially on that performance by analyzing additional criteria such as various measures of each stock’s value and the size of the buybacks. In fact, his portfolio of buyback stocks over the past 15 years has produced an average annualized return of 9.9% versus 4.7% for the Standard & Poor’s 500 stock index.

Bottom Line/Personal spoke with Fried to find out why the buyback strategy can be so effective and how you can use it to benefit your own portfolio…

WHY BUYBACKS WORK

When a company buys back its own stock on the open market, it reduces the supply of its stock that is available for sale. That makes the stock look more attractive by giving an immediate boost to earnings per share, simply by spreading profits over fewer outstanding shares.

Buybacks attract investors for another reason as well—they often reflect an enormous vote of confidence in the stock from the people who know the company’s financial situation and business plans best—senior ­management.

Last year, US companies, flush with record levels of cash, spent about $450 billion on buybacks, and many saw their share prices rewarded handsomely. The S&P 500 Buyback Index, which covers the 100 companies that are repurchasing the greatest percentages of their shares, rose by 48.3% in 2013, versus 32% for the S&P 500 overall. I expect strong buyback activity this year, too, but you need to be very selective. Not all companies that announce buyback plans are worth investing in. In today’s low-growth economy, buybacks sometimes can be a marketing gimmick to boost share price and make the company look better…or a tactic to divert investor ­focus away from faltering business.

SECRETS TO INVESTING

There are certain strategies that increase your chances that buyback investing will be profitable…

Wait to invest until the company actually repurchases shares. Nearly 25% of companies that make buyback announcements never follow through. I monitor quarterly earnings reports to find out whether companies really are buying back shares. This means that I miss out on any immediate gains after the announcement of the buyback program. But there still is plenty of ­upside potential, and I don’t wind up chasing stocks of companies that don’t keep their promises to shareholders.

Make sure the size of the buyback is substantial enough to make a difference. Some companies initiate a buyback plan just to offset new shares issued to cover liberal stock options that the companies grant to employees. That won’t help investors (or help the business). Other companies like to publicize the amount of cash they are spending on buybacks—but what really matters is how much the total amount of outstanding stock shares is reduced. The higher the percentage, the better the potential for future gains in share price. Many of the stocks that I invest in have had buybacks in the previous 12 months that reduced total outstanding shares by at least 5% or more.

Look at fundamentals. Any company buying its shares should have strong enough annual cash flow to comfortably reinvest in its business and easily pay for buying back its stock. I also want to see attractive valuations, such as a lower price-to-earnings ratio (P/E) than that of other companies in the same industry.

Hold the stock at least as long as the buyback program lasts—this can take many months or longer—unless major problems arise. I reevaluate the stock when the buybacks stop, and if the fundamentals that make that company a good value are still in place, I may continue to hold it. If major problems arise, I reassess whether to keep holding the stock.

My favorite buyback stocks now…

AutoZone (AZO) provides retail auto parts to car owners through more than 5,000 stores in the US, Puerto Rico and Mexico. Since 1998, the company has authorized $14.2 billion in spending on buybacks, including a December 2013 approval to purchase $750 million in shares. Over 12 months,* the company bought back about 5% of its outstanding stock. ­AutoZone has a robust future. The average age of vehicles on America’s roads has reached an all-time high of 11.4 years, which means an increasing need for repairs, and the company has barely begun to penetrate the commercial US market, including repair shops, dealers and service stations, which provides great potential for sales growth. Recent share price: $540.80.

Flextronics International Ltd. (FLEX) offers design, manufacturing and distribution services to the world’s leading computer, telecommunications and consumer electronics companies through facilities in more than 30 countries. Examples: It makes Moto X phones for Google and assembles Microsoft’s Xbox One entertainment systems. The company repurchased 52 million shares, reducing its outstanding shares by 7%, in the 12 months through December 31, 2013. It is well-positioned to benefit from the spread of cheaper smartphones through emerging markets in the next few years. Recent share price: $8.89.

Lorillard (LO) is the third-largest manufacturer of cigarettes in the US. Its flagship brand, Newport, has a 15% share of the total US cigarette market. Although investing in tobacco companies is not for everyone, Lorillard’s stock has an average annualized return of 21% over the past decade and the company is a buyback powerhouse. It began a $500 million share-repurchase program in March 2013, then authorized an additional $500 million in May. Over the 12 months ending December 31, 2013, the company has decreased its total shares outstanding by 4.2%. While cigarette sales have declined for years, Lorillard has been able to increase its market share for 10 straight years. In addition, it is the leading manufacturer in the fast-growing business of electronic cigarettes. Recent share price: $47.72.

WellPoint (WLP ) is one of the largest managed-care organizations in the US. In September 2013, the company increased its ongoing buyback program by $3.5 billion for a total amount of $4.2 billion. Over 12 months, WellPoint reduced outstanding shares by 8%. WellPoint stands to benefit from the Obama health-care reforms. The ­expansion of the Medicaid program for the poor and subsidized coverage for the uninsured will mean $20 billion in additional revenues for the company by 2016. Recent share price: $85.31.

*Twelve-month buyback data in this article refers to the period ended September 30, 2013, the latest available, unless otherwise noted.