Share repurchases are one of the financial world's most controversial subjects. On the one hand, there are those who believe that share repurchases are the best way for companies to return excess capital to investors because they are tax-advantaged.
On the other hand, other investors believe that buying back stock is a waste of money and instead of reinvesting cash, companies should distribute excess income to investors via dividends.
In theory, both buybacks and dividends are equally beneficial to investors. However, theory is a lot different from reality.
For dividends to have the same wealth-creating impact as buybacks, money distributed would have to be reinvested as soon as the dividend is paid (on the ex. dividend date), so there is no money lost in paying more to buy more stock. Dividends also need to be paid without dividend tax deducted first. From this perspective, with a dividend tax rate of 15%, investors are immediately 15% worse off receiving a dividend that buyback reinvesting.
There is also the reinvestment argument to consider. The choice between dividends and buybacks depends a lot on how much the company is generating in profit for every $1 invested in the business, compared to how much you as an investor can produce from the same dollar. If a company can achieve a return on capital employed of 20% or more, the chances of you as an investor being able to make the same kind of gain are slim.
I don't expect this article to solve the debate on buybacks vs. dividends, but I want to explore another angle: the quality of management.
Buffett on buybacks
In Warren Buffett (Trades, Portfolio)'s letter to Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) shareholders in 1984, he praised the actions of managers who used excess cash to buy back stock citing this action as a mark of a quality manager. Here's the full quote:
"The companies in which we have our largest investments have all engaged in significant stock repurchases at times when wide discrepancies existed between price and value. As shareholders, we find this encouraging and rewarding for two important reasons - one that is obvious, and one that is subtle and not always understood. The obvious point involves basic arithmetic: major repurchases at prices well below per-share intrinsic business value immediately increase, in a highly significant way, that value. When companies purchase their own stock, they often find it easy to get $2 of present value for $1. Corporate acquisition programs almost never do as well and, in a discouragingly large number of cases, fail to get anything close to $1 of value for each $1 expended.
The other benefit of repurchases is less subject to precise measurement but can be fully as important over time. By making repurchases when a company’s market value is well below its business value, management clearly demonstrates that it is given to actions that enhance the wealth of shareholders, rather than to actions that expand management’s domain but that do nothing for (or even harm) shareholders. Seeing this, shareholders and potential shareholders increase their estimates of future returns from the business. This upward revision, in turn, produces market prices more in line with intrinsic business value. These prices are entirely rational. Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings than for one in the hands of a self-interested manager marching to a different drummer. (To make the point extreme, how much would you pay to be a minority shareholder of a company controlled by Robert Wesco?)
The key word is “demonstrated”. A manager who consistently turns his back on repurchases, when these clearly are in the interests of owners, reveals more than he knows of his motivations. No matter how often or how eloquently he mouths some public relations-inspired phrase such as “maximizing shareholder wealth” (this season’s favorite), the market correctly discounts assets lodged with him. His heart is not listening to his mouth - and, after a while, neither will the market." Berkshire Hathaway shareholder letter."
So, while some investors might still prefer dividends over buybacks, this advice is worth considering. Good managers know when buying back stock is a more efficient use of funds than diversifying or paying out dividends.
Disclosure: The author owns shares in Berkshire Hathaway.
