Buybacks are popular, but they’re often a terrible use of the company’s cash. Share buybacks are a short-term catalyst to get investors interested in a company’s stock. A stock buyback is exactly what it sounds like. A company buys shares of its own stock in the open market. The purpose of this is to reduce the number of shares, thereby increasing the earnings per share.
Example: If a company earns $10 million and has 10 million shares outstanding, it earns $1 per share. If it buys back 1 million shares, now it has 9 million shares and the $10 million in earnings are divided by 9 million shares, which comes out to $1.11. In this case, the company’s earnings per share jumped 11% even though its actual profits stayed the same.
Dividends, on the other hand, are usually a long-term commitment. When management pays a dividend, it is setting expectations that investors will continue to get paid well into the future, even when things aren’t perfect. Management knows that if it cuts the dividend, the stock will likely get punished. A company may have some weak quarters, but if it’s managed correctly, investors will still receive a dividend regardless of what the stock price is doing.
On the other hand, stock buyback announcements aren’t even binding. When a company announces a buyback, it is not under obligation to actually buy back the shares. It can do it at management’s discretion. This discretion is up to management that has a track record of buying back shares at the absolute worst times. Typically when stocks are high. When stocks dive, it is the time for companies to repurchase shares but that’s not what they do. Because managements typically buy back shares at high prices, companies with buybacks have underperformed since 2009.
Murali Jagannathan and Clifford P. Stephens, both professors of the University of Missouri and Michael S. Weisbach of the University of Arizona found that during the booms and busts of the 1980s and 1990s, repurchases increased during rising markets and fell during declines. This is the exact opposite of what you’d hope managements would do. The professors concluded, that dividends are paid by firms with higher permanent operating cash flows, while repurchases are used by firms with higher temporary, non-operating cash flows.
Managements of large companies do not buy back shares at lower-than-average market prices because large companies are more interested in the disbursement of free cash. They just want to show the market they are doing something with the cash instead of making repurchases that create shareholder value.
Since 1936, dividends have been responsible for roughly 40% of stocks’ total returns. Over the next decade, BofA Global Research expects that figure to increase.
If you’re looking for long-term outperformance, ignore buybacks and invest in companies paying dividends.
Sven Franssen