Let Them Eat Cake! Share Buybacks and Dividends
As companies continue to hoard cash as a means to shelter them from whatever flavour of the month uncertainty is out there (Fiscal Cliff, Debt Ceiling, multitude of European issues), dividends and share buybacks have become an increasingly popular way for companies to put their cash to work and generate returns for investors. While the two are often used in the same sentence they are very different uses of cash. Whether it is the investor’s tax situation, investor’s reinvestment strategy or a signal from the company; share buybacks and dividends hold some similarities but have many material differences. The slightly more complicated and less ‘transparent’ nature of returns generated from share repurchases may very well have resulted in an undeserved bad reputation relative to dividends.
Both strategies are a way for companies to move idle cash from the company’s bank account and transfer it to the shareholder. While dividends are usually in the form of cash payments to the shareholder, buybacks reduce the number of shares outstanding which results in an increase in the investor’s ownership and in turn leads to higher earnings per share. Typically, companies enact a buyback or dividend when there are no other opportunities that can generate a similar return. This is about where the similarities between the two end.
Signals To Investors:
The signals that these actions create can be a doubleedged sword depending on how you view them. Most investors would likely view a dividend as being a positive signal that says the company in question is confident in the future sustainability of its business and expects positive results going forward, allowing the dividend to be maintained. Beware of companies who pay a dividend just to attract investor interest, as a cut in the dividend often results in a plummeting share price. A buyback is a signal that the company feels their shares are undervalued at a certain price. While the idea that the company thinks their price should be higher could be a comment on future earnings of the company (similar to a dividend), it could also be due to some event or ‘market opinion’ that the company disagrees with and that has resulted in a depressed price. It is important to note that, even though both dividends and buybacks can be viewed as a positive signal, they can be positive for different reasons.
Contrary to the above, an investor could view these uses of cash as a signal that either the industry has matured and there are no more ‘easy’ growth opportunities, or that management is unable to find any more opportunities that generate strong returns. This speaks more to the individual investor’s point of view or returns expectation and speaks less to the underlying fundamentals and sustainability of the company.
Effects On Fundamentals:
There is no doubt that companies often undertake share repurchases as a means to make their financial metrics look ‘prettier’. This is not necessarily a bad thing and can set the company up for future success (less shares could mean a lower payout ratio and higher potential for a dividend increase) but is not a strategy that can be carried out indefinitely. This is where the investor needs to exercise prudence. Is the company buying back shares as a means to improve EPS in the short term and at the expense of long term gains? Are they trying to boost results as a means to hide other issues such as flat or declining revenues? Have they simply encountered a ‘rough patch’ and felt this was the best solution for the time being? These issues need to be examined on a case by case basis. Figure 1 provides a basic example on the effects of a 500,000 share buyback program. The book value of the shares issued is arbitrarily assumed to be $1. An example such as this quickly becomes more complicated when other aspects such as the interest earned on the cash and paying for a portion of the shares through increased debt are considered.
So Which Use Of Cash Is Best?
Unfortunately, it depends. Figure 2 shows the performance of a share buyback ETF (PKW) and dividend achievers ETF (PFM) excluding distributions to the holders. In the best effort to perform ‘apples–to–apples’ comparisons, an ETF that attempts to track companies that have a history of increasing dividends was chosen as the best comparison. This is because buybacks and dividends are events that have a surprise factor, as opposed to a larger company that has consistently been paying out a predictable dividend over the years. Admittedly, this is not a ‘clean’ comparison of returns from companies that only do share buybacks against companies that only increase dividends but scanning the fund holdings shows some material differences in the investments held. Regardless, the apparent outperformance of PKW over PFM is hard to ignore.
An investor’s preference between buybacks and dividends will also depend on their personal tax situation and in what type of account the investments are being held. A share buyback will benefit those who prefer capital gains as the returns will (hopefully) be through an increased share price, while those who prefer the special treatment of dividends will obviously gravitate toward this type of return. Finally, an individual investor should evaluate who can generate better returns with the cash: you or the company? If the past decisions of management and their abilities to value the shares properly (buyback of underpriced shares only) are trusted, a buyback may prove to be more valuable. However, if an investor feels they can generate better returns by reinvesting the dividends somewhere else, a dividend is likely preferred. It becomes apparent that there are difficulties in determining whether a buyback or dividends are preferred as each have their own merits.
Best of Both Worlds:
Even though determining exclusively which use of cash is most effective can be difficult, there is a simple solution. Look for companies that pay a dividend and take part in share repurchases. A company that does both can provide significant value to long term investors. Looking back at Figure 1, it can be seen that the reduction in share count improves EPS which should at least provide support (all things being equal) to share prices. After the buyback, the company has managed to reduce the nominal value of dividends being paid and improve the payout ratio. This helps to improve future cash flows that can be used for growth projects or increased dividends, creating a situation where the investor gets the best of both worlds. It is important to remember that if a company is undertaking this strategy, it is likely because they do not have a better way to generate returns.
Generally speaking, the bad reputation share buybacks have received is likely because it is a less tangible and more complicated use of cash when compared to a dividend that lands in your bank account every couple of months. There is no doubt that it is more difficult to ‘see’ the effects of a buyback, which can be frustrating as companies seem to be utilizing this strategy more often. Fortunately, this strategy has been endorsed by the likes of Warren Buffett who outlines the benefits in his 2011 letter to shareholders (this letter is worth a read for those interested) and helps to provide merit to the decisions of companies that take part in a share repurchase. The decision by a company on how best to return capital to shareholders is not an easy one, nor is it easy for the shareholders to determine which strategy would benefit them most. While share buybacks have some apparent advantages and dividends are great for those who prefer a ‘bird in the hand’, one may be better off with finding companies that have a history of doing both; that way investors can have their cake and eat it too!
Ryan Modesto, BBA,
Managing Partner, 5i Research Inc.