The Buyback vs. Dividend Debate

There seems no shortage of things to worry about these days. Is China’s economy decelerating? What will an increase in interest rates do to the stock market? And let’s not forget the ongoing political upheaval in the Middle East. But in the midst of this angst, it is important to remember that Corporate America is doing just fine, thank you. Corporate profits are at record levels and company balance sheets are in good shape with debt manageable and cash levels ample (see chart below).

All this good fortune is helping companies return record sums to shareholders in the form of dividends and share repurchases. According to a recent study by Goldman Sachs, S&P 500 companies used approximately $800 billion to pay out dividends and repurchase shares in 2014. And the good news is the firm expects that number to rise to $975 billion this year.

This is causing quite a debate among economists and money managers alike. Critics complain that the growing trend of paying dividends and buying back shares is crimping investment in more productive, job-creating endeavors. Supporters claim that cash should be returned to firm owners if higher returning projects are lacking. So which is it? Like many issues, the answer here depends.

Stock dividends are a pretty straightforward way of returning cash to shareholders over the long term. Share buybacks, however, are a little less clear. By reducing the share count, repurchases boost each investor’s share of company earnings and a higher earnings per share tends to lead to higher stock prices. While authorizations are approved by Board of Directors, managements are under no obligation to actually repurchase shares. Further, many share buyback programs simply offset the share dilution which results from awarding stock options to management and other employees. The greater flexibility of buyback programs can be a real plus for managements concerned about earnings volatility. But critics claim these capital return policies can also lead to short-term thinking as managements manipulate share counts to meet earnings per share targets – targets that are often tied to compensation. Further, managements’ track record with share repurchases has not been great; the most recent peak of buybacks occurred in late 2007 just when share prices reached multi- year highs.

Our thinking here is that managements’ primary job is to invest company funds in projects whose returns exceed the cost of those funds. Fortunately, companies as a whole continue to find productive projects. A recent report by Fidelity on 2,700 global companies found that for $1.00 of depreciation in 2015, companies were reinvesting $1.40.

But attractive investment opportunities are not available at all points of the business cycle. Further, some industries (think technology or biotech) simply have greater return potential than others. When possible, we prefer management to return cash to shareholders in the form of dividends. Share buybacks may translate into higher earnings per share but this outcome is not guaranteed. With cash from dividends, shareholders can themselves decide how best to spend the corporate profits.