Dividends Vs. Buybacks: Who Wins? - High-Yield Dividend Investing Commentary July 2, 2010
Here's something for investors to chew on: What would you rather have, a cash dividend that basically represents free money you didn't have to work for or a stake in a company that regularly repurchases its own shares? Before you immediately answer in favor of dividends, let's take a look at what a buyback is.
When a company repurchases its own shares, its reduces the amount of shares outstanding, thereby increasing the percentage of the company you own. Share buybacks are also helpful in terms of boosting a company's per share earnings. With less shares out in the market, a company can deliver what appear to be stronger earnings. Here's an example: ABC Inc. has 10 million shares outstanding and posted a profit of $50 million last quarter. That translates to $5 in earnings per share. If ABC earns $50 million next quarter, but repurchases 5 million shares, then earnings jump to $10 a share.
Share buybacks are also useful in that they tell us that a company's management team views the shares as undervalued and there are no tax consequences with buybacks. As we all know, Uncle Sam loves to sink his teeth into our dividend income, so there is something to be said for share buybacks. At the end of the day, if you're not getting a dividend, investing in a company that has penchant for buybacks is a fine alternative.
Still, the debate of dividends vs. buybacks rages on and with good reason. Proponents of buybacks will cite many of the same reasons I just mentioned. No tax consequences. A slight increase in ownership. Fine points, but there is something gimmicky about buybacks. Companies often repurchase shares because they use those shares for employee stock options. Bloomberg News calls this "backdoor compensation" for shareholders.
Companies also buyback their own stock only to turn around and use those shares to make an acquisition, which dilutes current shareholders and dilution is never a good thing. In fact, share buybacks don't guarantee a smaller amount of shares in the market. In advance of writing this piece, I came across an old Bloomberg piece that said in 2004, when share buybacks were on the rise, the number of shares outstanding in the S&P 500 actually INCREASED.
Let's look at a recent example of how share buybacks can actually hurt a company. From 2005-2008 BP (NYSE: BP) repurchased $37 billion worth of its own stock. Today, those shares are worth about $15 billion and with BP facing a considerable cash crunch right now, a secondary offering can't be ruled out. Unfortunately for investors that are long BP, the company would commence a dilutive secondary offering with shares that aren't worth nearly as much as they were just two years ago.
What I'm saying is that there is a legitimate argument in favor of share buybacks, but they aren't always everything they're cracked up to be. I won't dance around the fact that dividends carry some risk. If you own shares in a company that cuts its dividend, that stock is probably going to fall after the dividend cut is announced. Hence why we have a no dividend cutters policy for our Dividend Genius portfolio.
Fortunately, companies that are primed for dividend cuts are easy to spot and I'll certainly address dividend red flags at a later date, but for now, I'm going to make my case for why dividends are VASTLY superior to buybacks. Beyond the fact that buybacks won't generate regular income for your portfolio, the evidence is simply astounding that dividends work in your favor of extended time frames.
One of the pundits' favorite statistics is that dividends account for 40% or more of a portfolio's returns over long-term time horizons. No one ever cites a comparable statistic for buybacks.
More importantly, a buyback cannot be reinvested by you, the shareholder. Last week, Jim highlighted the power of reinvesting your dividends and I've included another chart that bolsters the case.
This chart is courtesy of Standard & Poors
Of course, in a perfect world, companies would consistently repurchase their own shares AND raise their dividends. This is a scenario worth embracing and plenty of marquee names have done what I call the double-dip this year. General Mills (NYSE: GIS), PepsiCo (NYSE: PEP), Petsmart (Nasdaq: PETM) and Tiffany (NYSE: TIF) have all announced dividend increases accompanied by buybacks.
The double dip is more the exception than the rule and if you find yourself faced with the choice of adding a chronic dividend raiser or serial repurchaser to your portfolio, do the right thing. Choose the dividend.