Last week, I somewhat skewered Google (NYSE: GOOG ) , Microsoft (Nasdaq: MSFT ) , Hewlett-Packard (NYSE: HPQ ) , and Apple (Nasdaq: AAPL ) for their dividend policies, which for all four are either nonexistent or inadequate. It's putting a damper on valuations, I reckoned.
Some readers fired back: Dividends might be small, but for at least a few of these companies, buybacks are big -- and that's rewarding shareholders in ways similar to dividends.
It's a fair point -- to a point. Some of these companies are providing real value through buybacks. Based on three-year average share buybacks, HP, for example, will repurchase its entire current market cap sometime within the next decade (based on current shares prices, of course). Things could turn disastrous, but in all likelihood these repurchases are a tremendous deal for shareholders.
But that isn't the norm. Buybacks are beneficial if done when shares are cheap. If they're done when pricey, well, it's scarcely different from when you or I overpay for stocks: You don't get your money's worth.
Can you guess which group most corporate managers fall into?
This chart, representing all S&P 500 companies, sums it up:
Sources: Standard & Poor's and Yahoo! Finance. Subsequent two-year return is the return of the S&P 500 as a whole.
The trend is clear: Managers repurchase the most amount of stock when shares are the most expensive, and abandon buybacks when shares are the cheapest. Buybacks exploded to record highs in 2007 when the market peaked, only to nearly cease when shares were at decade lows in 2009. Some individual examples are astounding. In late 2007, Citigroup (NYSE: C ) struck an expensive deal with the Abu Dhabi Investment Authority to raise $7.5 billion in equity after shares plunged. Ironically, that was nearly the same amount Citi spend repurchasing its own shares over the previous two years at substantially higher prices. Hindsight is 20/20, but this was a colossal waste of money.
You could say these buyback swings are simply a matter of earnings swings. S&P 500 buybacks were high in 2007 because earnings were high; they stopped in 2009 because earnings evaporated. But this theory doesn't quite hold. Earnings are now at an all-time high, yet share buybacks are roughly half as much as they were in 2007.
Instead of repurchasing shares, what if managers had focused solely on dividends?
The drawback from shareholders' perspective is that dividends are taxed at up to 15%, while buybacks avoid the additional pass-through tax layer altogether.
But there are benefits. With dividends, those who wish to keep reinvesting in the company -- as share buybacks do -- can simply reinvest their proceeds. For companies with DRIPs, this doesn't get any easier. More importantly, those dividend reinvestments are up to you. Think shares are cheap? Reinvest your dividends. Think they're getting pricey, but you still don't want to sell the stock? Stop reinvesting and accrue cash dividends. The decision becomes yours, not management's. You may still fail -- but it's your failure, not theirs.
The question is whether preferring dividends over buybacks is worth the potential 15% haircut from dividend taxes. For some companies -- HP, for example -- it probably isn't. In general, though, it very well may be. Management is that bad at repurchasing shares. That's what the chart above emphasizes.
Are you happy with how management allocates capital? Let loose below.