Investors: You're Being Duped by Share Buybacks

It's a debate almost as old as the stock market itself. What's a better use of capital: paying a dividend or enacting a share buyback? There are valid points to be made for both, which is ultimately the source of the continued debate.

Dividends vs. buybacks ... fight!
Dividends provide corporations a way to share some, or all, of their net profits with their shareholders. The amount of the dividend is subtracted from the share price on the distribution date, and shareholders are taxed at a 15% rate on the payout. Dividends, however, provide almost instant gratification for shareholders.

Share-repurchase programs don't reduce a stock's share price, nor are they subject to the secondary taxation that dividends are (profits are taxed at the corporate level as well). Their purpose, simply, is to reduce the amount of shares outstanding to drive up earnings per share and make the company appear cheaper. Share repurchases often don't have as "instant" of an effect on shareholders pocketbooks as dividend payments do.

While I agree to some extent that both methods reward shareholders, I believe that corporations are purposefully duping investors into believing that share repurchases are an equal reward to dividend payouts, when in fact they aren't.

Don't get me wrong. There is a time a place for share buybacks. In fact, my Foolish cohort Chris Hill, along with Jim Gillies and Jeff Fischer, recently highlighted five companies that are doing a good job of enhancing shareholder value through buybacks. Even Warren Buffett, highly regarded as one the top investing moguls, has turned to share repurchases with his conglomerate, Berkshire Hathaway (NYSE: BRK-B  ) (NYSE: BRK-A  ) , sporting around $38 billion in cash.

However, aside from those few instances where it makes sense, share buybacks have inherent flaws that many investors often overlook.

It demonstrates a lack of growth and innovation
Let's start by looking again at Berkshire Hathaway's decision to repurchase its own shares if they are at 110% of book value, or less. In 2011, when Buffett commented on the decision to enact share buybacks, he also noted that "not a dime of cash has left Berkshire for dividends or cash repurchases during the past 40 years." So why initiate a buyback now? Buffett simply believed that "the underlying businesses of Berkshire are worth considerably more than this."

The logic makes sense, as does Buffett's intent, but I took this buyback to mean something completely different. In the past, Berkshire had kept all of its income for reinvesting in its business. With the enactment of a buyback, that signaled to me that Berkshire is having difficulty finding new paths to growth.

But if it's any consolation, Buffet and Berkshire aren't alone. More than a handful of companies have turned to share buybacks to boost EPS because, frankly, they haven't exactly figured out how to jump-start their business.

For example, take Best Buy (NYSE: BBY  ) , which is currently struggling with the transition to online retailing. Best Buy does pay a dividend that's currently yielding 3.5%, but it's spent the vast majority of its cash in recent memory on share buybacks.

Source: Morningstar. All figures in millions.

In just six years, Best Buy has reduced its share count by 27.5% to 366 million, but net income has gone nowhere despite incremental rises in revenue each and every year. Reducing the outstanding share count had a positive impact on driving EPS growth, but it falsely lured growth investors into a stock that had been suffering through declining margins.

Poor timing
That brings me to my second point: poor timing.

Companies will often inform investors that the reason for enacting a share-repurchase program is that they think their shares are undervalued. If share prices rise after the buyback, no one tends to complain -- but what happens if they get even cheaper?

The fact is, many companies are really bad at timing their stock purchases. Best Buy is a perfect example. It began aggressively repurchasing its shares in 2008, when its share price dipped briefly below $20 per share, but it also repurchased roughly 87 million shares with its share price ranging from $23 to $48. With its share price now slightly above $18, that move isn't looking too hot.

Best Buy isn't alone. Plenty of companies that could probably use the cash right about now have repurchased shares at very inopportune times.

Sears Holdings (Nasdaq: SHLD  ) began aggressively repurchasing its shares in 2008 and has reduced its share count by 50 million shares since then. The problem with these repurchases is that almost all of them occurred with Sears' stock north of $60. That's more than $3 billion in cash, possibly even more, spent on share buybacks from a company that's closing up to 120 stores to reduce expenses and generate cash.

Sprint Nextel (NYSE: S  ) is another prime offender and may even take the cake for the worst-timed purchase. In 2006, Sprint's board of directors passed a repurchase plan allowing the company the ability to buy up to $6 billion in stock. By the time the plan expired in 2008, Sprint had repurchased 185 million shares at an average price of $18.77 and costing $3.5 billion. Sprint now trades for less than $4 per share.

Dividends are more conducive to shareholder investment -- at least in this environment
The final aspect investors are overlooking is the historically low lending rates. With the Fed Funds rate hovering around 0.25%, companies should be investing heavily in growth and making large strides at boosting their dividend payouts. With most CDs yielding less than 1% and Treasury bonds at historic lows, dividends offer possibly the safest form of inflation-beating growth. If companies really want to spur investment and drive their share price higher, they should be considering dividends instead of share buybacks in this low-rate environment.

But are companies doing this? You guessed it -- nope!

Sources: Robert Shiller's Irrational Exuberance, Standard & Poor's.

Currently, companies in the S&P 500 are paying out what amounts to a few basis points over 2% in yield, which is well below the historical average. Share buybacks, however, are on the rise. In 2011, nearly 2000 companies repurchased $397 billion worth of their own stock -- the third-highest year on record, behind only 2006 and 2007. Buyback totals dropped moderately through the first half of 2012, but dividend increases have remained relatively tame.

If companies were smart in their pursuit of higher share prices, they'd be boosting dividend payments and drawing investors to purchase their stock as opposed to repurchasing their own shares and offering little incentive to shareholders in an already low-rate environment. To put it another way, it's no secret why the high-yielding utility sectors keep heading higher.

Show me the money
With global growth slowing and interest rates in the U.S. at historic lows, I say keep your lousy share buybacks and show me the money.

If you want to be shown the money right now, and you can't find your DVD of Jerry Maguire, then feel free to get your free copy of our report detailing nine rock-solid dividend-paying stocks hand-picked by our analysts at Motley Fool Stock Advisor. Trust me -- it'll complete you!

Fool contributor Sean Williams owns SPDR puts that mirror the performance of the S&P 500, but he has no material interest in any other companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.

The Motley Fool owns shares of Berkshire Hathaway and Best Buy. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (11) | Recommend This Article (26)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 25, 2012, at 11:35 AM, RavenManiac1968 wrote:

    Could it be that senior executives are initiating share buy-backs in an effort to boost specific ratios that would allow them to reach incentive package milestones thus increasing already massive bonuses?

    Would this be ethical?

  • Report this Comment On July 25, 2012, at 4:45 PM, Seanickson wrote:

    I dont believe investors are being duped but it makes the calculation of value even more important. Don't trust that the company will always make the most rational decision when it comes to share buybacks, especially as they are beneficial to executive compensation.

  • Report this Comment On July 25, 2012, at 5:31 PM, Mega wrote:

    "With the Fed Funds rate hovering around 0.25%, companies should be investing heavily in growth and making large strides at boosting their dividend payouts."

    While interest rates affect borrowing decisions, they don't have anything to do with the decision to buy back shares, pay a dividend or reinvest profits.

    The decision process is simple.

    If their expected ROI is high, they should be reinvesting in the business.

    If the company's earnings yield is high, they should be buying back stock.

    If the expected ROI and earnings yield are low, they should be paying a dividend.

  • Report this Comment On July 25, 2012, at 11:09 PM, GETRICHSLOW2 wrote:

    I have never bought the buyback line of bull. Shareholders should be screaming about this. We should be voting on this at the annual meeting. I will take the dividend any day but the fat cats want to retain control of the money so they can manipulate the numbers or pad their own pockets with bonuses or options.

    What a scam!!!!

  • Report this Comment On July 25, 2012, at 11:30 PM, GETRICHSLOW2 wrote:

    Companies conducting buybacks should have to agree to a 5yr period in which their share count can only increase through open market purchases of treasury shares at the same price as everyone else.

    No new share issues. No freebies to the fat cats. If you want company stock, buy it, just like everyone else.

    Only then would their true intentions be shown.

  • Report this Comment On July 25, 2012, at 11:36 PM, GETRICHSLOW2 wrote:

    Concerning the 15% tax on dividends. Most middle class investors hold their stock market investments through tax sheltered retirement accounts making the tax irrelevant(at least for now). Those who are wealthy enough to hold investments outside of retirement accounts and are concerned about taxes might consider stocks that don't pay dividends.

  • Report this Comment On July 26, 2012, at 12:32 AM, TerryHogan wrote:

    It's easy to cherry-pick some really bad examples of share buy-backs. That's like saying your grandma and a few cousins lost a lot of money in the stock market therefore it's no good. Are there any studies of share performance and buybacks?

    Plus, a share buy-back is guaranteed to have a favourable impact on EPS, whereas seemingly good company investments can turn into boondoggles. I bet MSFT wishes it spent its $6 billion on buybacks instead of aQuantive.

    A buy-back also gives the investor the choice on when to realize their gains and pay their taxes, while a dividend forces investors in taxable accounts to pay their taxes right then and there.

    Another reason that companies initiate buybacks instead of dividends is their flexibility. A company that institutes a $5B buy-back one year and then none the next is barely noticed, but a company that cuts its dividend is usually killed by the market.

    Having said all that, I usually prefer dividends, but that's just my irrational investor psychology that likes seeing the cash go into the account.

  • Report this Comment On July 26, 2012, at 3:57 AM, TheDumbMoney2 wrote:

    Me likey the money. Send me the checkey! (Making Homer Simpson pie-drool noises.)

  • Report this Comment On July 26, 2012, at 9:17 AM, TMFHelical wrote:

    As a dividendophile I too have bashed buybacks in the past, but they can and sometimes are done effectively. So here are two changes I would make.

    1) Companies should list in the 10K the returns on past share buybacks (10 years?).

    2) CEOs who authorize buybacks should have their 'bonus' compensation tied to the long term return on the buyback.

  • Report this Comment On July 26, 2012, at 11:09 AM, aldwords wrote:

    The thing about share buybacks is that - yes, they increase EPS - but when there is a loss, they also increase LOSS per share. It's sort of like leverage: it's helps when the company does well and it hurts when the company doesn't do well.

  • Report this Comment On July 26, 2012, at 11:52 AM, jsn1080 wrote:

    To devote such a short article to this topic does anyone who reads it an injustice.

    To better understand this topic and to determine whether a share buyback, dividend (or increase thereof), or company reinvestment is the LOGICAL and RATIONAL decision, one should read about the management tenets presented in the book, The Buffet Way.

    I've paraphrased part of the section below.

    -----

    The most important management act is allocation of the company’s capital. Deciding what to do with the company’s earnings—reinvest in the business or return money to shareholders—is an exercise in logic and rationality.

    If a company is in the "mature" or "decline" stage, retaining earnings in order to reinvest in the company at LESS than the average cost of capital is completely IRRATIONAL.

    If the extra cash, reinvested internally, can produce an above average return on equity, a return that is higher than the cost of capital, then the company should retain all of its earnings and reinvest them. This is the ONLY logical course. Retaining earnings in order to reinvest in the company at less than the average cost of capital is completely irrational. It is also quite common.

    A company that provides average or below-average investment returns but generates cash in excess of its needs has three options: (1) It can ignore the problem and continue to reinvest at below average rates, (2) it can buy growth, or (3) it can return the money to shareholders. It is at this crossroad that Buffett keenly focuses on management’s behavior. It is here that management will behave rationally or irrationally.

    Buffett is skeptical of companies that need to buy growth. For one thing, growth often comes at an overvalued price. For another, a company that must integrate and manage a new business is apt to make mistakes that could be costly to shareholders.

    In Buffett’s mind, the ONLY reasonable and responsible course for companies that have a growing pile of cash that cannot be reinvested at above-average rates is to return that money to the shareholders. For that, there are two methods available: raising the dividend or buying back shares.

    -----

    I would prefer buybacks over dividends if the company's shares are selling below intrinsic value - BV is a good bench mark to determine to guage this metric. If shares are selling substantially higher than BV (i.e. > 2x BV), I would prefer to receive the dividend.

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