The solution in short is: share repurchase.
I am not as bullish as the next guy about share repurchases (see The Case against Share Buybacks). The reason is that the management, on average, is very bad at timing share repurchases. They end up buying at quite lofty prices and sometimes they need to dilute shareholders near the bottom. The banking stocks during 2002 to 2009 were a very good example of this apparently stupid way of rewarding shareholders (also GE). Other times, there are ulterior motives behind repurchases like a) supporting the share price b) making the ratios look prettier c) hiding dilution due to share/option rewards to the management d) and infrequently, it is the fashionable thing to do.
Another gripe I have is that no company mentions the price at which they are willing to buy their shares. When Buffett announced his repurchase plans he clearly stated that he is going to buy Berkshire stock up to 110% of the book value. This lack of an upper bound is sorely missing from many of the share repurchase announcements. There needs to be a significant shift in the mentality of the management. They need to buy shares opportunistically, even when they have cash in their buyback program. I mean, if they don’t want to buy it for their own account, why are they buying it for the company account on behalf of the shareholders?
On the positive side, share repurchases do make sense. Especially for a company which sees itself as a dividend growth investment. I want to talk about such a situation here by taking an idealized example.
Let us imagine a company which has stagnant sales and stagnant income. Preferably, it has a few well-known brands and it does not need to spend too much money to maintain its current business. The company has no growth opportunities and it is smart enough not to get into un-related business to increase sales.
How is the company going to reward its shareholders with increasing dividends in such a scenario?
Let us make the situation a bit more concrete. The company trades at a price-to-earning ratio of 10 and the dividend yield is 5%. Furthermore, the company has low capex and it represents 25% of the earnings. For simplicity, assume that the company has 100 shares and each one of its shares trade at $100. Also, assume that there is no inflation affecting sales, earning or capex.
In a previous article (Oblivious Dividend Growth Investing), I discussed that dividend growth investors need to realize that their company has to increase sales and earnings by a significant amount to keep increasing their dividends. The only other way is to buy back shares.
About the author:I started investing in December 2009
and my first stock CreditSuisse (CS) tanked to almost half its
value. This nudged me to start learning about investing from the ground
up. I am a long term value investor and am planning to generate sustainable amount of money from investment income by the time I am 40 years old i.e., 2025.