Last year I wrote a piece comparing dividends and share repurchases, and I've recently read a couple of interesting reports that shed even more light on the subject of repurchases. The first, Clear Thinking About Share Repurchases, is from Michael Mauboussin at Legg Mason, and the second is a recent analysis of 2005 share repurchases from Standard & Poor's.
A detailed look at 2005
The Standard & Poor's report reveals that share repurchases among S&P 500 companies in 2005 were almost double that of total dividend payments. A surprise to me, as it may have been to you. Even more interesting, 52 of those companies retired more than 4% of their shares last year, including Dupont (NYSE: DD ) , Harley-Davidson (NYSE: HDI ) , Jones ApparelGroup (NYSE: JNY ) , and Kimberly-Clark (NYSE: KMB ) .
The report also focuses on what happens to shares after they've been repurchased -- something investors shouldn't ignore. When shares are acquired, they generally sit in treasury stock (found in the shareholder's equity portion of the balance sheet), and they can be reissued again later as options or in mergers and acquisitions. That's exactly what S&P expects to happen with most of the shares currently sitting in treasury stock. And I agree. For example, Cisco (Nasdaq: CSCO ) is now repurchasing more shares than it is granting in options, so there is a real positive effect. But those shares remain in treasury, so if the repurchases stop or slow, it won't take long for dilution to set in again. On the other side of the coin, I recently noticed that NTT DoCoMo and ChunghwaTelecom (NYSE: CHT ) cancelled some of their shares held in treasury stock permanently. That's something I don't see often.
Since S&P believes that many of the repurchased shares will eventually be used in mergers and acquisitions, it urges investors to place emphasis on management's ability to execute and integrate mergers successfully. I recommend going one step further: Investors should be sure that acquirers are paying a fair price, as well as executing acquisitions well from an operational standpoint.
A useful holistic approach to repurchases
Michael Mauboussin also notes that share repurchases now surpass dividend payments, but his report focuses on providing analysis on the different forms of share repurchases and when they are most beneficial to shareholders. It also does a good job of describing how share repurchases and dividends compare, and how, in some ways, share repurchases offer more flexibility for investors. But given that the shares are rarely retired when repurchased, determining how long term those benefits are is quite difficult.
It's impossible to do the report justice in such a small amount of space, but if you could take away just one thing, it would be the report's golden rule on share repurchases:
A company should repurchase its shares only when its stock is trading below its expected value and when no better investment opportunities are available.
Most investors understand that share repurchases need to be made when a company's shares are undervalued, and the company can take a stab at valuation to validate a repurchase. But the second part of the golden rule, "when no better investment opportunities are available," requires a bit more thought. If a company can earn a slightly higher return by reinvesting in its core business, then it makes sense to do so. I know that I, and probably many other investors, ignore this step in the thought process.
Foolish final thoughts
It's not really possible to make a blanket statement that either repurchases or dividends are better for investors. Each situation must be examined individually. I prefer a company that pays a dividend easily covered by free cash flow and augments the return from the dividend with share repurchases when it makes sense to do so. Failing that, I want a dividend or repurchase that makes economic sense for the company. In any case, when evaluating buybacks, keep Mauboussin's golden rule in mind.
While I like it when companies repurchase shares, I still focus on dividends for my own portfolio, and my colleague Mathew Emmert does as well. Mathew also leads our Motley Fool Income Investor service, and his subscribers are besting the market by more than three percentage points while assuming less risk. To view more than 50 of Mathew's favorite income stocks, enjoy a free 30-day trial of Income Investor.
NathanParmelee owns shares in NTT DoCoMo and Chunghwa Telecom, but has no financial interest in any of the other companies mentioned. Chunghwa Telecom is an Income Investor recommendation. The Motley Fool has adisclosure policy.