One of my favorite new podcasts is “Invest Like the Best” (found it a few weeks ago, so I am still catching up). The host, Patrick O’Shaughnessy, does an excellent job finding thought-provoking guests across different fields of interest. Back in February, the podcast featured Joe Mansueto, the founder and longtime CEO of Morningstar (MORN, Financial).
During the interview, O’Shaughnessy asked Mansueto about his thoughts on dividends and share repurchases. His response, posted below, is what I would like to discuss in this article.
“My preference is repurchases over dividends if the price is reasonable. We do a valuation of our stock, just like we do other stocks, and if it’s at fair market value or below then we can buy back shares. And to me that’s better because then shareholders can time when they want to have a taxable event. If I pay a dividend to shareholders, Uncle Sam is going to take a third of that, or whatever percentage, and the shareholder has no choice. If I give it back to the shareholder in a repurchase, they can choose not to make that a taxable event and let it ride. So I think it’s a bit more shareholder friendly if your stock is selling at fair value or below to do a repurchase."
O’Shaughnessy followed up with a reasonable question: Given the logic presented for share repurchases, why do you think dividends are so prevalent at public companies? Here was Mansueto’s response:
“I think it’s inertia, it’s legacy, it’s people not really understanding how all this works. A lot of people running companies are experts in their field, but they might not understand investing. I think management’s that have more of an investing bent or understanding would favor [repurchases].”
I think this conclusion is spot on. Simply put, dividends are the safe choice when returning capital to shareholders. Unlike share repurchases, where you may be forced to defend your decision, nobody really questions dividends. For most individual investors, it seems safe to assume their preference is for dividends over share repurchases. Why?
Assuming a company repurchases shares at fair value, the overall value of your investment is identical in each scenario (the per-share value rises by an identical amount as the dividend payment). The only difference, as Mansueto noted, is paying a dividend forces the individual investor to incur a taxable event. Why do so many prefer this less attractive option?
I think one of the main reasons is because dividends are “real.” It is cash in your bank account that is no longer in the hands of the company. If the stock does not go anywhere - or even worse, down - you still have the dividends. As the saying goes, you are “paid to wait.”
Share repurchases, on the other hand, can feel less real. The company does not cut you a check, and you own the same number of shares as you did the day before. The per share value is higher, but here is the problem: intrinsic value is a “fluffy” number. The dollar in your pocket is certain; the incremental increase in intrinsic value, on the other hand, is not necessarily reflected in the stock price. While intrinsic value is what matters over time, short-term swings in the market are a meaningful event for most investors. A small increase in intrinsic value offers little comfort to the individual investor when stock prices are moving lower and they are losing money.
This discomfort with repurchases is exacerbated by a generally poor track record for corporate America. Most companies seem to follow a straightforward approach to buybacks: the funds for repurchases should be based on what you have left over after paying dividends. Importantly, the dividend payout is usually based on a percentage of normalized earnings. In the good years, when earnings power is outsized, that means the capacity to repurchase shares is higher; unsurprisingly, the good years tend to come with higher stock prices. The outcome is outsized repurchases at higher prices with limited funds for buybacks when stock prices are truly depressed. In defense of these managers, the urge to quickly spend any available resources to “increase shareholder value” has likely been exacerbated by the rise of activist investors.
We can see a clear pattern when we look at the repurchase record for S&P 500 companies:
My sense is the average corporate executive views this as an acceptable outcome. In some cases, they have apparently convinced themselves all this activity does not matter anyways. We are talking about major companies like Coca-Cola (KO, Financial), where the former CFO said the following:
“Our view on share repurchases is that share repurchases are value neutral. It is not something that grows value. It does for the short-term holder, so maybe you can get a buck in the share price, but for the long-term holder it is not something that's value enhancing.”
Misunderstandings about share repurchases apparently extend to the C-suite as well.
Conclusion
William Thorndike’s book “The Outsiders” discusses how the repurchase strategy of outlier CEOs differ from the average:
“Fundamentally, there are two basic approaches to buying back stock. In the most common contemporary approach, a company authorizes an amount of capital (usually a relatively small percentage of the excess cash on its balance sheet) for the repurchase of shares and then gradually over a period of quarters (or sometimes years) buys in stock on the open market. This approach is careful, conservative and, not coincidentally, unlikely to have a meaningful impact on long-term share values. Let’s call this caution, methodical approach the 'straw.'
The other approach, the one favored by the CEOs in this book and pioneered by Singleton, is quite a bit bolder. This approach features less frequent and much larger repurchases timed to coincide with low stock prices – typically made within very short periods of time, often via tender offers and occasionally funded with debt. Singleton, who employed this approach no further than eight times, disdained the 'straw,' preferring instead a 'suction hose.'"
I will not hold my breath for meaningful change. The major takeaway is that "suction hose” repurchases are quite rare. When you find a company with a CEO (and board of directors) that understands the importance of capital allocation decisions, keep them in your sights.
Disclosure: None.
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