Why Dividends Are Better Than Buybacks

Editor’s Note: Here at the Club, we embrace dynamic discord.

In other words, it’s okay to disagree as long as you’re respectful about it.

Last Thursday, Anthony Summers’ point of view on share buybacks ruffled a few of Chief Income Strategist Marc Lichtenfeld’s feathers.

Today we bring you Marc’s nothing but respectful and dynamic rebuttal.

– Donna DiVenuto-Ball, Associate Club Editorial Director

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Last week my good friend Anthony Summers wrote about stock buybacks. It started off promising enough. Anthony bashed an op-ed piece written by two senators who proposed that Congress slap restrictions on stock buybacks. (Because the government knows how to manage finances better than anyone, right?)

But then my esteemed colleague went off the rails, suggesting that stock buybacks are better than dividends.

Anthony points out that “Investing in buyback stocks could be seen as a marriage between the benefits of both value investing and insider buying. It relies on the ability of the company’s management to know its own intrinsic value and to invest when market prices fall beneath that value.”

That’s cute.

It would be great if it were true. If management teams routinely repurchased shares when their stocks and/or the markets tanked, it would create long-term value for shareholders. But that’s not what happens with most companies.

CEOs are just like everyday investors. They get too optimistic when things are going well, and they buy at the top. They get too scared when things aren’t great, and they don’t buy back stock when it’s cheap.

Consider that in 2016, Macy’s (NYSE: M) repurchased 7.9 million shares for $316 million – an average price of $40 per share. Today, the stock trades near $25, roughly 38% below where the company blew more than $300 million of shareholders’ cash.

When Walmart‘s (NYSE: WMT) stock climbed above $100, it bought back five times as many shares as it did when it was cheaper.

And ConocoPhillips (NYSE: COP) is the poster child for buying back shares at the wrong time.

You can see that when the stock was 25% lower, management barely bought any back. But it opened up the cash spigot when the stock was at a five-year high.

In 2009, when equities were dirt cheap, few companies were buying back stock. In 2013, six years into the bull market, S&P 500 companies bought $500 billion worth of stock, which was close to the record set in 2007, at the top of the market.

Five years of rip-roaring markets later, S&P 500 companies bought back more than $720 million worth of stock in the 12 months ending September 2018. Each of the first three quarters of last year set a record for buybacks.

2019 is expected to be another record year.

In my book Get Rich with Dividends: A Proven System for Earning Double-Digit Returns, I note that in a 2011 paper published for the Center for Financial Studies, Azi Ben-Rephael, Jacob Oded and Avi Wohl conclude that large companies do not buy back shares at lower-than-average market prices because large companies are “more focused on the disbursement of free cash.”

In other words, the CEOs think it’s more important to show that they are doing something with the cash than to use it intelligently.

Murali Jagannathan, Clifford P. Stephens and Michael S. Weisbach in the Journal of Financial Economics stated, “Dividends are paid by firms with higher ‘permanent’ operating cash flows, while repurchases are used by firms with higher ‘temporary,’ non-operating cash flows.”

That was backed up several years later by Bong-Soo Lee and Oliver Meng Rui, who wrote in the Journal of Financial and Quantitative Analysis, “We find that share repurchases are associated with temporary components of earnings, whereas dividends are not.”

So we know that, generally speaking, CEOs have bad timing when it comes to buying back shares. Sometimes, however, the timing is very purposeful – to lower the share count in order to boost the earnings per share.

Here’s how that works. Let’s say a company earns $50 million and has 10 million shares outstanding. That means it earns $5 per share. If the company buys back 1 million shares, it now earns the same $50 million divided by 9 million shares instead of 10 million.

Although the company didn’t make any more money (it still earned $50 million), earnings per share now rise to $5.55.

In many cases, management teams are rewarded for earnings per share growth or a higher stock price. At the very least, they usually own a lot of stock, so if they can manipulate the stock price higher by repurchasing shares, they can sell their stock at higher prices. They use the company as an ATM to cash in.

A buyback, when done well (when the stock is undervalued), can be a great use of capital.

However, considering CEOs are human and susceptible to the same fear and greed as the rest of us – and are often burning the company’s funds to manipulate the stock price in order to sell shares at an artificially higher price – I’d rather be paid the dividend in cash.

Let me decide if the stock is a good value. If it is, I’ll reinvest the dividend. If not, I’ll use the cash somewhere else where I can get a better return.

A declaration of a dividend is a statement by management that it is confident in the company’s ability to produce cash flow in the future.

At best, a share buyback is a reflection of management’s belief that its stock is undervalued. At worst, it’s manipulation for management’s own benefit.

Ten years into a bull market, most stocks are not undervalued. If there is excess cash, in most cases it should be returned to shareholders and not plowed into a share buyback with no thought as to price or valuation.

Share buyback or dividends? I trust my (and your) decision making when it comes to purchasing stock more than a CEO’s with a conflict of interest.

I’ll take the dividend every day and twice on Sunday.

Good investing,

Marc

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