Friday, January 24, 2014

Dividends or Buybacks?

Ginger or Mary Ann? Dividends or Share Repurchase Programs? Just some of the great questions of life.

I am old school. I trust dividends. Stock price is not real until you sell your shares for a loss or a gain. Dividends are real. They are money you can hold in your hand. You can spend that money on something like a new car or choose to reinvest it more shares of dividend paying stocks. If a company is not willing to share its profits with the shareholders, I am usually not especially interested in owning shares in that company. I like to receive that quarterly dividend. I like to see the dividends increase proportionally to the increasing profitability of the company. There is only one problem with dividends, they are taxable income. I can’t spend or reinvest that money until after the taxman gets his cut.

I tend to be suspicious of share repurchase programs (sometimes called buybacks) because I don’t get anything real that I can hold in my hand. Company management sometimes for a variety of reasons buys back shares in their company. This can be a very good thing for the investor (or not). The company can also choose to dump these repurchased shares back into the market when management decides that is a prudent decision.

Buybacks are a pretty common way for management to give something back to the shareholders without losing control of that money. It can be a very good way to increase shareholders value without the specter of the taxman’s cold dead hand. If the share price is undervalued, buybacks will increase that price through several mechanisms. First of all when a buyer (in this case the company) is purchasing large blocks of stock, the price will increase through simple supply and demand. Even after the buyback is complete there are now fewer shares available to the general public. This should tend to hold the price at a higher level. Also the company (now the shareholder) is paying dividends to itself. This gives the company’s managers more money to invest in new projects or to increase dividends at some later date. In essence the company is doing dividend reinvestment for its shareholders without any income taxes. In this scenario, if the shareholder decides to sell then he will pay capital gain taxes. Most likely this will be at a lower rate than income taxes.

If a prudent investor believes that the share price of a company is too high, buybacks would not be in her interest, since she would not choose to reinvest her dividends back into overvalued shares.

It comes down to a question of control. Dividends give the shareholder more control. He controls what happens to that dividend check. In addition, while it is easy for a company to increase its dividend, it is very difficult for management to cut the dividend. This action frequently results in bloodshed along executive row. Through buybacks management maintains better control of expenses (like dividend payouts). Dividends can grow too large. If a dividend is not sustainable, it will ultimately bleed a company white. Sometimes, companies choose to bleed themselves to death on purpose. For example, if faced with the possibility of an enormous lawsuit management may choose to sell off their assets, pass the proceeds onto the shareholder, leaving the plaintive and their attorneys holding an empty bag. However, that is very unusual.

Generally speaking, both increasing dividends and share repurchase programs are a good thing for the investor. In either case it is wise to ask, “Why are they doing that?” Dig into the news story. If something smells fishy, you might want to sell before it is time to pay the piper. What I really like to see is a company that has both a steadily increasing dividend and steadily increasing profits. For example, Dividend Aristocrats are companies that have increased their payouts for 25 consecutive years! This list is a very good place for the novice investor to begin buying shares in individual companies, after building a solid foundation of low cost index funds.

But remember a Dividend Aristocrat is a Dividend Aristocrat until it isn’t. I could tell you a story about GE. I took a beat down on that former Dividend Aristocrat.

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