Stocks and Shares

Don’t ignore stock buybacks when investing

Too many people ignore stock buybacks when they make their investment decisions. Stock buybacks are a big deal, especially in the US market. Investors need to take account of both buybacks and dividends when assessing likely returns on their stocks. Figures for the S&P 500 in recent years show why.

“Why should I buy that stock when the dividend yield is only 2%?” This is the sort of question that I come across on a regular basis. And it’s a fair question, especially for income investors. But, before deciding whether or not to buy a stock, there are other essential factors to take into account beyond the dividend yield.

First of all, investors need to look at the businesses growth prospects. If a mature company has relatively low growth, say 3% a year, then adding 2% dividend yield will only result in 5% a year total return (all other factors aside, such as changes to valuation ratios). That’s not enough for any stock.

But if growth looks set to be 7% a year or more, then we’re looking at 9% a year total return, at a constant price-to-earnings (P/E) ratio. That’s 2% a year from dividend income and 7% a year from capital gains, as the price rises as earnings grow. That would be in line with the long-run performance of the S&P 500.

But there’s another crucial element to take into account. That’s stock buybacks (or “repurchases”). These are just another method of distributing excess corporate cash to investors. Unlike a dividend payment, buyback cash doesn’t go to remaining shareholders. Instead, stock is bought in the markets and cancelled.

The value of the company is then spread across the lower number of remaining shares. That leaves them more valuable than if dividends had been paid in the same aggregate amount.

Technically speaking, buybacks don’t increase the value of a stock. They just don’t reduce that value in the way that a dividend payment does. Just before a cash distribution, a stock’s value should include an accrued amount for the impending payment.

In the case of a dividend payment, this is what’s meant by a stock being “cum dividend”. Part of the price includes the value of the next dividend payment. When a company announces a dividend, it also announces three important dates for shareholders. These are the “ex-dividend” date, the “record date” and the “payment date”.

On the ex-dividend date, the value of the dividend per share (DPS) drops out of the share price, all other things being equal. On the record date, which is the following day, a record is taken of who the shareholders are, and hence who should receive the dividends. On the payment date – which can be anything from a few days to a few weeks later – the actual money is paid to the recorded shareholders.

So a dividend reduces a stock’s price, but the investor gets cash instead.

In the case of a stock buyback, there is no price drop linked to the cash distribution. Let’s say the same amount of money is paid out of the company as for a dividend payment, on an aggregated basis across all shares. The number of shares is reduced by the same percentage as the equivalent dividend yield. The value of the whole company has reduced by the same amount – being the cash out of the door. But the remaining value – essentially, the value of future, expected distributions – is now divided between fewer shares.

Whether a company distributes cash as a dividend or a stock buyback, remaining shareholders get the same benefit. A dividend causes a price drop in exchange for cash. A buyback doesn’t cause a price drop, but there is no cash income. Net-net, they’re the same.

Well, in actual fact there are some differences. The principal one is for stockholders that pay taxes on income and capital gains, especially if the tax rates are different. Also, income is taxed shortly after its receipt, whereas capital gains are only taxed after a share sale, when the gain is realised.

This gives a slight advantage to stocks with high levels of buybacks, since the returns are more weighted to capital gains, especially over long periods. This is because they don’t have the ongoing drip of small price falls each time a dividend is paid, or the taxes immediately due on that dividend income. The result is that tax charges are deferred until sale, which results in a higher level of compound profits for the investor – especially over long periods.

Another important factor is a particular company’s buyback policy. Ideally, companies should make all cash distributions via buybacks when their stock is cheap, meaning below fair value. This creates value for shareholders.

The flip side is that they should make all cash distributions as dividends when the stock is expensive, meaning above fair value. Buying back expensive stock destroys value for remaining shareholders. In other words, beware companies that do big buybacks, even though their stock is trading at a high market valuation.

(Unfortunately, the bulk of buybacks are pro-cyclical, in aggregate. Most are done when optimism is high and stocks are expensive, which helps to maintain stocks at high levels. The least are done when pessimism hits, such as during a recession, and stocks are cheap. This means there is no price floor, just when most investors would welcome it. This is value destructive behaviour on the part of corporate managements, which mostly buy when stocks are high.)

Even if we assume stock buybacks are a good thing for a particular company, there’s something else to watch. Many companies do big gross buybacks but then re-issue a lot of that stock, often to senior management. In effect, they transfer company value from outside investors to corporate insiders. It’s the net buyback yield that counts, after taking account of this dilution.

The effect of stock buybacks is often ignored by investors. This is excusable for non-professionals, since the information is harder to access. But it’s completely inexcusable for anyone who claims to be a stock analyst. I regularly come across commentary and research on stocks that completely ignores the important issue of stock buybacks.

It’s easy to find the dividend yield of a stock on practically any market data website (although the data is often wrong and should be checked, in my experience). But understanding a company’s buyback policy and total distribution yield means looking at detailed financial accounts and corporate policy statements. Any professional stock analyst that doesn’t do this is either lazy or incompetent, and possibly both.

US stock performance is heavily influenced by stock buybacks

Stock buybacks are a particularly big deal in the US market. This is because the law was relaxed in the early 1980s, making buybacks much easier to do. It’s also because US corporate executives receive a large portion of pay in the form of stock or stock options.

Below is a chart that I put together a couple of years ago. It clearly illustrates what a big deal buybacks are in the US, compared with other stock markets. (I haven’t updated it because this kind of data is difficult to get hold of.)

Source: OfWealth

As explained above, distributing cash via buybacks results in a higher stock price than distributing the same amount of cash as dividends, all other things being equal. A higher stock price makes executive stock options much more valuable.

Also, stock-based compensation schemes – whether using options or actual stock – mean that stock has to be passed to company insiders. Using buybacks to do this means the company doesn’t have to issue new stock in the markets.

Back in 1977, only 5% of total cash distributions by US corporations were in the form of stock buybacks. The other 95% were in the form of dividends. By 2007 this had changed dramatically, with 70% directed to buybacks and just 30% to dividends. In recent years, the (gross) buyback / dividend split has been around 60/40.

Despite this big shift in how cash distributions are made, the total cash distribution yield has remained surprisingly stable. Typically, it’s been in the range of 4% to 5% a year.

Since around 2002, the dividend yield of the S&P 500 has consistently been around 2% a year. Sometimes it’s been a little above, sometimes below, but 2% is the average.

That’s a very low level when compared with the long-run average. Going back to 1871, the median dividend yield for US stocks was 4.3%. But the difference has been made up with (net) stock buybacks.

S&P 500 (or equivalent index) dividend yield since 1871

Source: multpl

In other words, although the current dividend yield is relatively low when compared with history, the total cash distribution yield of US stocks is little changed from the average level before the 1980s, when buybacks were rare.

(Incidentally, this also makes direct comparisons between the S&P 500 dividend yield and yields on US treasury bonds irrelevant. Assuming there’s still any value in such comparisons – which I doubt in the age of QE – the stock distribution yield should take account of net buybacks as well as dividends.)

We can see this effect on stock returns in recent information provided by investment bank Goldman Sachs. Analysts compared median earnings growth for companies in the S&P 500 index to median growth of earnings-per-share (EPS).

Since buybacks reduce the share count – even after new stock issuance due to capital raises or stock compensation plans – EPS has grown meaningfully faster than earnings.

The finding is that EPS outperformed earnings by 260 basis points a year over the 15 years to the end of 2018. There are 100 basis points in a percentage point, so 260 basis points are equal to 2.6%. Also, over the last five years, EPS growth outperformed earnings growth by 290 basis points (2.9%) a year.

Clearly, there’s some rounding in the table shown in that chart. If EPS grew 10% and earnings grew 8%, as shown, then the difference is 200 basis points, not 290. So we can assume the unrounded figures are close to 10.45% a year for EPS (which rounds down to 10%) and 7.55% a year for earnings (which rounds up to 8%).

But the key point is that net buybacks are a big factor when it comes to total returns on US stocks. Over the past 15 years, the dividend yield averaged 2%. But the total cash distribution yield, net of stock dilution, was 4.6%. Over five years, the dividend yield also averaged 2%, but the total, net distribution yield was 4.9%. These figures are pretty consistent with past analysis that I’ve done on the effect of stock buybacks on total investor returns (for example, see here).

It’s clear that all investors – especially in US stocks – need to take account of stock buybacks. It’s not enough to look at dividend yield or P/E alone. This becomes even more important at the individual stock level.

Incidentally, those earnings growth figures are impressive, and well above the long-term historical averages. That’s especially true going back 15 years, which included the period of the global financial crisis.

Next time I’ll take a closer look at the factors which are likely to have boosted company performance in the US, and whether they’re likely to continue in future.

More to come…

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.