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The Science of Hitting
The Science of Hitting
Articles (572) 

Dividends Over Buybacks?

The preference for dividends over repurchases among investors and managers

April 24, 2017 | About:

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 (NASDAQ:MORN).

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 (NYSE:KO), 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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About the author:

The Science of Hitting
I'm a value investor with a long-term focus. My goal is to make a small number of meaningful decisions a year. In the words of Charlie Munger, my preferred approach is "patience followed by pretty aggressive conduct." I run a concentrated portfolio - a handful of equities account for the majority of its value. In the eyes of a businessman, I believe this is sufficient diversification.

Rating: 5.0/5 (3 votes)

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Comments

snowballbuilder
Snowballbuilder - 2 years ago    Report SPAM

Hi science really interesting question

My short answer: unless the CEO is a real great capital allocator I prefer dividend.

Why ?

- becouse generally , in reality, CEO are not good at doing buyback

(buyback were "few dollars" in 2009 - 2010 and many time as much in 2007 and 2016)

- because buyback are usually used to hide share dilution by executive compensation

- becose with dividend i ve the cash back to reinvest wherever I think is Better in the whole investing universe

- because for a long term focused investor like me dividend is beiing payed for waiting and bringing some money back without reduce my position

of course teorically aggressive and opportunistic buyback is lot more effective and tax efficient than dividend but... aggressive and opportunistic buyback are rare in real world.

As for my holdings only one (tip spa) has a really talented and rare capital allocator who over the years has opportunistically made big buyback , payed dividend , distributed warrant, collocated bonds.

Doing this he has really accelerated the per share value creation.

My other holdings wich are all run by really great operating executives (but maybe less talented as capital allocators) have a more standardized capital allocation with a 20% to 50% dividend payout and reinvesting back in the business the other cash... and this simple choise is still working pretty good and is less difficult that doing opportunistic and aggressive Buyback. ( usually in reality there is some power in simplicity).

hope to have added some interesting thoughts. Best snow

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Snow,

That makes a lot of sense. Thanks for sharing your two cents!

batbeer2
Batbeer2 premium member - 2 years ago

@Snow

Yes.

I would add that it depends a bit on the investor. If you're Buffett you want the dividend. You are capable of investing at a higher rate of return than the CEO.

If you're not Buffett.... then it becomes more difficult.

I try to solve this problem by only buying stock of companies with CEOs who are very obviously much better capital allocators than myself. If that's the case then I don't want the dividend.

In other words, if you prefer dividends then you've been buying companies with sub-par management.

Also it is possible that you need the income. Again this depends on the investor.

Just some thoughts.

jtdaniel
Jtdaniel premium member - 2 years ago

Hi Science,

Thank you for the excellent article. Express Scripts has a perfect opportunity to demonstrate the validity of its no-dividend policy. The shares are now under-priced and the time is right to accelerate the repurchases.

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Batbeer2,

"I try to solve this problem by only buying stock of companies with CEOs who are very obviously much better capital allocators than myself. If that's the case then I don't want the dividend."

You have a great skill for summing up what I've tried to say in hundreds of words in a single sentence. As always, thanks for the comment!

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Jtdaniel,

One problem with ESRX (as I see it): they have a stated leverage target that will require them to pay down debt in the near term as a result of losing Anthem. Besides that, do you think they would repurchase shares in a big way? Thanks!

jtdaniel
Jtdaniel premium member - 2 years ago

Hi Science, ESRX has reduced its number of outstanding shares by a total of 16% over the last five years so there is some precedent. I am not giving up on the Anthem contract just yet. There is plenty of time and room left for negotiation - nothing new for either company.

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Jtdaniel,

Fair enough. When they broke out the details, pretty amazing to see how attractive that business has been in the past few years. I've never done a deep dive on ESRX (have difficulty understanding the space), but valuation seems quite reasonable even if you back out Anthem. Retaining the business (even with the ~$1B annual price concession) would clearly be a positive development.

jtdaniel
Jtdaniel premium member - 2 years ago

Science,

My favorite lines on the Express Scripts income statement are advertising and R&D expenses-- zero for the last 20 years. Now that is what I would call an efficient operation.

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Jtdaniel,

Can't argue with that :)

I presume you've owned ESRX for some time. If you don't mind me asking, are you a buyer after the sell-off over the past ~24 months?

jtdaniel
Jtdaniel premium member - 2 years ago

Hi Science,

I have followed ESRX for about 15 years, but only began buying shares in the last few months. I only found out about it because my father bought shares around 2002 and asked me to monitor it (he had a good broker that got him in early on Home Depot and early enough on ESRX). My cost basis is around $66.50, but I am looking to bring it down very soon.

The Science of Hitting
The Science of Hitting - 2 years ago    Report SPAM

Jtdaniel,

Thanks for sharing. I have more work to do, but I'm definitely interested by what I'm reading. As always, I'm hoping for lower prices to make my job a bit easier :) Have a great weekend!

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