Investors have been arguing about the differences between dividends and stock buybacks for many decades, and I don't expect the argument to reach a conclusion anytime soon.
On one side of the debate, there are those investors who believe that every company should pay a dividend, and those companies that don't are not worth considering for any portfolio.
The other group of investors thinks share buybacks are the best way to return capital to shareholders because these minimize frictional costs and taxes.
No set outcome
It is so difficult to reach a conclusion in this debate because every investor has a different goal, and there is no uniform rule for companies. Some businesses might do better to return all of their excess profits to shareholders if they have nothing better to do with the cash, rather than reinvest at a low rate of return.
Other companies should be focusing on reducing debt and acquisitions rather than distributed profits. You can only really determine whether or not a company is taking the right course of action on a case-by-case basis.
According to Warren Buffett (Trades, Portfolio), there is one rule that defines whether or not a company should be using its money to buy back stock. As he explained in the 2004 Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) annual meeting of shareholders:
"I think the best use of cash, if you don't have a good use for it in the business, if the stock is underpriced, is to repurchase it. And if it is overpriced, you have no business buying in a single share. But a lot of companies do it."
The Oracle of Omaha made this statement in response to a question from a shareholder who wanted to know his opinion on companies using their cash for dividends versus stock buybacks. Buffett tried to make it clear that he believes buybacks should only be conducted when a company's shares are trading below intrinsic value.
But when it comes to dividends, his thoughts on the topic are a little more complex. He says that when a company gets into an "exceptional situation," it does make sense to return cash to investors, but for most public companies, "it doesn't make sense to bounce around the dividend from year to year." This is what most private companies do because it provides flexibility. "We do it ourselves with our subsidiaries," Buffett told his audience. "Some subsidiary can pay us a lot of money one year, and not so much money the next year," he added.
The problem is, most public companies cannot adopt the same approach because a lot of investors buy dividend stocks for predictability, which makes it very difficult for managers to vary dividend policy significantly every year.
After issuing his thoughts on dividends and buybacks, Buffett asked his right-hand man, Charlie Munger (Trades, Portfolio), for some input. Munger added:
"Dividends are a very interesting subject. If you count the unnecessary stock trading, and the cost of investment advice, and the cost of making a lot of errors, and the cost of trading in and out, I don't think we would be too extreme to say that now the total amount that's paid out in dividends is roughly equal to the amount that is wasted in all this trading and investment advice.
So that the net dividends that come to the shareholders are approximately zero. This is a very peculiar way to run a public company. And very few people comment about it."
This is something Buffett agrees with. Dividends might look attractive, he said, but in aggregate, the frictional costs of issuing dividends substantially reduce the amount shareholders actually receive. This is something to consider next time you buy a stock for its income credentials.
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:Â
Buffett: The Only Way Smart People Can Get Clobbered Is With LeverageÂ
Charlie Munger: Liquidity Is Not Needed for Good InvestmentsÂ
Finding Wonderful Businesses: Invert, Always InvertÂ
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