In this episode of Industry Focus: Financials, host Michael Douglass and Fool.com contributor Matt Frankel discuss the ways companies can choose to use their capital, including share buybacks, dividends, organic growth, and mergers and acquisitions. When is each one a good idea, and when is each a red flag for investors?
A full transcript follows the video.
This video was recorded on Oct. 9, 2017.
Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Monday, Oct. 9, and we're talking about capital allocation -- or, put a different way, what gets companies and investors paid. I'm your host, Michael Douglass, and I'm joined in the studio by Fool.com's Matt Frankel. Matt, thanks for being on the show today.
Matt Frankel: Thanks for having me, it gives me an occasion to wear my headset.
Douglass: Awesome. We had a listener question -- by the way, thank you for writing in -- about buybacks and dividends. This was spurred by last week's discussion on whether banks should be able to chart their own course on buybacks and dividends or whether they should ask the federal government for permission. The question basically came down to, are share buybacks, and for that matter, dividends, a good thing? Great question. By the way, folks, if you ever have any questions based on any of our episodes, email@example.com. We thought we'd address that issue even more broadly by looking at the capital allocation across the board. Companies can spend money, generally speaking, in one of four ways. They can do share buybacks, they can institute a dividend, they can do mergers and acquisitions -- which we call inorganic growth, you're buying growth -- and they can do organic growth, or, think of that as home-grown growth, like when a business decides to go into a new business line, or in some other way try to create growth without buying it from somebody else. But when does each make sense? Matt, you're a talker, I'm a talker, so we're going to have to commit to running through this stuff pretty quickly. Let's start with the initial question, share buybacks and dividends, and let's start with share buybacks specifically. When do share buybacks make sense?
Frankel: There's a few situations where buybacks can make sense. First of all, dividends and buybacks together are kind of ways of a company to admit that they don't need the money as much to grow anymore. In other words, it's kind of a sign of a maturing company. That's why you see companies like Procter & Gamble and Johnson & Johnson pay dividends, but companies that are trying to put all their money into growth like, say, Netflix, don't.
Douglass: I would even argue that it's a sign, when a company basically says, "We're making more money than we can redeploy into the business itself," that's when buybacks and dividends really make sense. It's essentially saying, "Hey, we're making $1 billion, we can't spend more than $800 million of it effectively for the business, so let's return the rest."
Frankel: Right. Another reason buybacks make good sense is when a stock is trading less than its net asset value, less than its book value, or less than the company thinks it's worth. A good example of that is Berkshire Hathaway (BRK.A -0.16%) (BRK.B -0.34%), where they set a specific level, I think it's 140% of book [value], if I'm remembering correctly.
Douglass: It's moved around a little bit over the years.
Frankel: Yeah, it moves over the years, and it's honestly probably going to go up again soon. But, where Warren Buffett says, "OK, now it's at a discount to what it's actually worth, so we can use money on share buybacks." So, that's another good example of a reason where buybacks would make sense.
Douglass: I'll also throw out there, occasionally in a financial engineering sense, buybacks can make a good sense. Let's just draw a scenario and take an example. A company is paying a 4% dividend, and they can take on debt at 1%. In that case, it would make sense for them to buy back shares, and perhaps even buy back shares taking on some debt so that they could then reduce their dividend exposure, because they're trading -- let's say it's 4%, let's say it's $4, make it easy -- $4 per share of dividend expense, and trading it for $1 per share of interest expense. And that can basically free up more money that they can then use more effectively. Now, on the flip side, buybacks don't often make a lot of sense. One of the key things you pointed out, Matt, is that companies can use buybacks effectively when the company is trading for less than it really should be worth. But management is notoriously bad at timing this kind of thing. I would also say, a lot of the times, companies think they're worth a great deal more than they really are. A great example of this is Bank of America (BAC -1.02%) from 2003 to 2007, they bought back around $40 billion in shares. And as a result of doing so, they reduced their share count significantly. But, a year and a half later, the financial crisis hit, and the Federal Reserve required them to raise more money. So, at a quarter of the price per share, they ended up having to raise about $48 billion. So, they had retired 768 million shares, and they then had the issue 3.5 billion new shares. So, this was a case where, what might have seemed to make sense in the short term really didn't in the long term, and it effectively destroyed shareholder value.
Frankel: It's also interesting to point out that, at the time you're referring to, Bank of America was trading at about double its book value. So, the writing was kind of on the wall that it might not be a great time to buy back a ton of shares.
Douglass: Absolutely. The other piece that's key to remember with share buybacks is that management is often incentivized with shares. And to be fair, this isn't necessarily a bad thing. It essentially says, guess what, a significant portion of your compensation is going to be tied to these shares. Drive shareholder value and you will drive value for yourself as well. So, it's intended to align management's goals, financially and personally, with shareholders. But, all too often, the share buyback is essentially just papering over that dilution and buying back the shares that management has. So, what you really want to see with the share buyback for it to be really effective is for it to actually reduce share count.
Frankel: Definitely. It's usually easy to keep track of a company's share count over time, if you look at a Yahoo Finance or pretty much any kind of stock quote that's out there, you can usually see the share count at the end of each fiscal year. It's also in the company's annual reports. So, that's kind of a good metric to check on.
Douglass: Yeah, absolutely. One more point about share buybacks, one of the things that makes them attractive to companies in a lot of ways is that they aren't as difficult to cut as dividends. Whereas dividends, there's sort of a different expectation. Let's talk about dividends a little bit.
Frankel: Sure. Dividends are kind of the most visible way to return capital to shareholders, which could be a good thing or a bad thing. It's a good thing if a company can pay a reasonable dividend, establish a good record of increasing their dividend payments. There's a whole group of stocks called the Dividend Aristocrats, which have all increased their dividend payments annually for at least 25 years, some much more than that. In that case, it can be kind of a selling point, in a way, for investors. Here's predictable, steady, rising income. Of course, it's not guaranteed. But it definitely looks good as an investment.
Douglass: Absolutely. By the way, if you're interested in a list of the Dividend Aristocrats, send us an email at firstname.lastname@example.org and we'll be happy to shoot you a list. Again, that's email@example.com. The other thing is, dividends can be attractive for income investors. Those are often retirees, or people who are looking for some minimum annual return on their investments. If it's a 2% dividend or 3% dividend, they know, barring something crazy happening, they're probably going to get paid at least that. And that can really help them from a financial planning standpoint. On the flip side, dividends often stop making sense. And that's when companies have to cut them. Essentially, as we said earlier with share buybacks and dividends, it's this realization that a company cannot spend all of its money in accretive ways to the company. So, instead, they're going to do share buybacks and dividends. Well, sometimes, companies are in a spot where that's no longer the case, and they actually don't have enough cash flow to be able to grow appropriately with these sort of capital allocation decisions they previously made. Teva Pharmaceuticals (TEVA 1.93%) from my own healthcare is a great example. They substantially cut their dividend just a couple of months ago, specifically because they're weighed down with interest expense, they made a big acquisition, and they had so many expenses that it was hampering their growth. So, cutting their dividend was the only way for them to be able to really invest in growth appropriately. Of course, the stock got creamed when that happened. I think Teva lost something like 50% of its market cap in the month of August when it made this announcement. So, it was a rough month for Teva shareholders. But, on the flip side, at that point, it kind of makes sense, and you want them, I think, to cut that dividend so that they can instead grow shareholder value in other ways.
Frankel: Right. It would almost be irresponsible to keep paying it at that point. But, like you said, because it's the most visible way to return capital, it's taken by shareholders as a sign of the company being unhealthy. Like you've just said, cutting the dividend was probably the healthiest thing they could have done in that situation.
Douglass: Right. Of course, it is kind of a sign of unhealthiness, too. When you can no longer meet all those commitments, it's where you're stuck.
Frankel: Definitely. It works both ways. A dividend record can either be a good thing or a bad thing. Companies need to make sure they can reasonably continue to pay a dividend if they want to implement one.
Douglass: Yeah, so much matters on context, unfortunately. That's one of the things that I think is really frustrating for a lot of investors. There aren't a lot of really simple, hard-and-fast rules. So much depends on the situation. That's why doing your research and really understanding companies is so important.
Let's turn over to actually investing in business growth. There are two primary ways. Mergers and acquisitions -- again, that's inorganic growth; buying growth from someone else -- and organic growth, which is when you invest in your own business. Let's talk about mergers and acquisitions first, because this is the flashy stuff that always ends up in the headlines. So-and-so bought so-and-so for $1 billion, and that's when people really start paying attention to investments.
Frankel: Right. One of the most common questions I get when it comes to M&As is, why are companies willing to pay more than what a stock is worth? Because generally, when a company gets bought out, shareholders get a 20% premium, or something to that effect. And the answer is generally because the business could be worth more to the acquirer than it was as a stand-alone company. A good example is that Amazon-Whole Foods deal, I think Amazon paid about $14 billion and change for that.
Douglass: Something like that.
Frankel: It opens up a new sector for Amazon. Whereas building that organically would have, I bet, cost more than that. So, that's a good reason for M&A, and a reason why companies are willing to pay a premium to acquire another company.
Douglass: And I would say, even dragging it back to financials for a minute, think about when Berkshire Hathaway makes an acquisition. I'm making up numbers here, but let's say there's a company trading for, it has a $1 billion market cap, Berkshire pays $1.5 billion, and then invests another $1 billion into the company. So, total cost if you think about it as this billion-dollar company, it costs $2.5 billion total, in terms of both their immediate financial investment and the money they put in toward capital expenditures. But, what if that billion-dollar company was legitimately worth a billion dollars at the time, but with that additional billion dollars that's been invested in it, it has the ability to really ramp up growth and become worth, let's say $10 billion 10 years down the road. Then, suddenly, that $2.5 billion that Berkshire paid looks like a steal because you've got a quadruple in 10 years. And that looks really darn good. And that's been a lot of Buffett's philosophy in approaching companies. I'm not saying he's necessarily willing to pay 50% above asking or above the market price or anything like that. But, that's why it's been so attractive.
Frankel: Definitely. The point is, that allows the company to achieve growth that it wouldn't be able to achieve as a stand-alone company.
Douglass: Right. And I think one of the key things here is growth. We've been talking about, either doubling down on the same strategy, you're buying out a direct competitor, or you're trying to, like Amazon with Whole Foods, get into a different niche of the market. I'm very skeptical when people are talking about, "This is going to work out with cost synergies." Basically, "We're going to combine our back office operations and save enough money that it's going to be worth it." I tend to find that that is problematic at best.
Frankel: Yeah. Are cost synergies a real thing? Yes. Do they help? Yes. Is it worth paying a 25% premium for a company? Usually not.
Frankel: That's probably the best way I could put it.
Frankel: Yes. New York Community Bancorp is one of the highest dividend bank stocks, and for a reason. It's intentionally paid a high dividend for years to remain under the $50 billion regulatory cap. That allows it to keep its regulatory costs low and avoid becoming what's called a systemically important financial institution, I think that's what the acronym stands for.
Douglass: Right, or SIFI.
Frankel: Right. And they decided to acquire Astoria Financial, which would have put them well over the $50 billion cap. Shareholders immediately resented the acquisition idea. It actually wound up falling apart, which drove to stock down even more, because there's a lot of unanswered questions as to why it fell apart. They weren't very clear on that. But, that's an acquisition that would actually have cost the company more. Not only that Astoria was not nearly as an efficient bank as New York Community. And it would have added to costs, it would have lowered its efficiency, which is its big competitive advantage, and created a lot of problems with shareholders. That's not why they invested in the bank in the first place.
Douglass: Yeah. I think one of the key things to point out here is, New York Community Bancorp was and is in a really attractive niche, specifically rent-controlled apartments in New York.
Frankel: Yeah. That's something like 80% of their loan portfolio, rent-controlled or rent-stabilized buildings in Manhattan.
Douglass: Right, so it's just about all there. Astoria would have diversified it a great deal, but it certainly looked like it could have been diworsification instead of diversification, in terms of putting it into a lot of less attractive market areas. So, I think for a lot of reasons, that merger looked pretty problematic to shareholders.
Frankel: Right. Nobody leaves a rent-controlled apartment building. Well, very few people to, if you ask any friends in New York who have them. But single-family homes go into foreclosure a lot more frequently. Things that are on Astoria's balance sheet that would have diluted the competitive advantage, which is what it's all about at the end of the day.
Douglass: Yeah, absolutely. So, there's a little bit of thinking about when a merger and acquisition can make sense, and when it seems a little bit more problematic. Let's finally turn to organic growth. Now, this one is really tough to get your arms around it, when it's effective to do organic growth. Generally speaking, that's the preference. Because what that usually means is that you know the people who are doing the work, and usually you know the work pretty well. If you're a bank and you're invested in single-family mortgages, and you're basically trying to write more business, you have a pretty good sense of what the trade-offs are there. If you're a bank and you usually do single-family homes since you're trying to move into multifamily, sure, you're moving into a new business, but generally speaking you know what people you're putting on that business, so you therefore can really understand what that risk looks like on an initial basis as you really begin that ramp.
Frankel: Sure. You said, all things being equal, organic growth is a preferred way to grow. And the right way to do organic growth is invest in something that's -- not necessarily immediately -- but going to add to your business, maybe open up a new channel of growth. Goldman Sachs is one of my favorite examples of recent times. They have been pumping money into their new online lending platform. It's kind of like a Lending Club, but without other people lending money. It's Goldman Sachs lending the money. And it's already surpassed a billion dollars in loans, quicker than any of the other online platforms have. That's an example of good organic growth. They saw a market that they felt like they could do a better job of capturing, and have been pumping money into it and are willing to put money into it, because they have it, first of all, and because they want to grow it the right way to be a new permanent channel of growth for them.
Douglass: Right. I think that's really crucial. You can organically grow in businesses you're already doing, you can organically grow in businesses that are, let's say, pretty close to what you're already doing. Again, Goldman Sachs is a bank, so lending money is theoretically something they should be reasonably good at. I think the third thing is when you can find ways to invest money to make what you currently do better, more efficient, more customer-friendly. A great example of this is the Starbucks (SBUX -4.21%) app. If you don't have it, personally, I think it's fantastic. Essentially, Starbucks recognized that they could make transactions go faster, they could really personalize offers for customers, they could drive more transactions and drive more business and drive more foot traffic if they really invested in their technology portfolio. So they did, and it's gone really well. While a lot of other food and drink establishments have struggled, Starbucks has been doing really well, and as a shareholder, I'm thrilled.
Frankel: Right. I don't know the numbers, but Starbucks invested millions into developing their mobile platform.
Douglass: Oh, I'm sure, and it's so slick.
Frankel: They capture people like me who, if I see 28 people in line in front of me, I'll keep driving. But I can order before I leave my house, my coffee is there. That's a $5 sale they wouldn't have gotten.
Douglass: Right. It's interesting, because it's not something that on the surface on day one looked like it would drive a lot of money. Sure, it might make things a little bit faster, a little bit more efficient. Maybe it would capture a few people. But it's really making a big difference, even though it's not investing in a new business line, or investing in a different part of a current business line. It's really just something that, across the board, is making the entire business stickier.
Frankel: Yeah, it's just doing their business better, is how I would put it.
Douglass: Right, that sounds good to me. With all that in mind, there's a lot here about thinking about capital allocation. But the key thing here is that you want a management team that is good at capital allocation, because if they know what they're doing, they will make the right mergers and acquisitions, they will invest in organic growth when it makes sense, and they won't just be slavishly devoted to the dividend and the buyback. Those are important tools, but they are not nearly as important as investing in the business and making sure the business, long-term, has a moat and is really successfully growing.
Frankel: Right. If I can throw in one more example, Warren Buffett's Berkshire Hathaway is a great example of everything. That's why we keep bringing them up. But, he's publicly prioritized the way that he will use Berkshire's cash, and No. 1 is always make sure the current business needs are met first. Be that growth, capital requirements, whatever. No. 2 is to acquire new companies that will add value to Berkshire, kind of how Michael described buying a $1 billion company for $1.5 billion and sinking money into it. That's No. 2. A distant third and fourth are dividends and buybacks. So, it kind of tells you that Warren Buffett doesn't feel that Berkshire is an overly mature company yet, even though it's worth about $400 billion.
Douglass: Right. And it's hard to argue with one of the world's best money managers, and frankly, business managers. But that is a long conversation, and I'm sure we can devote whole episodes just to that. In fact, we have in the past. Again, folks, if you want that list of Dividend Aristocrats, just send us an email, firstname.lastname@example.org. That's it for this week's Financials show. Questions, comments, again, you can reach us at email@example.com, or on Twitter @MFIndustryFocus. As always, people on the program may have interests in the stocks they talk about, I own a couple that we've talked about --
Frankel: I do as well.
Douglass: -- and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Matt Frankel, I'm Michael Douglass. Thanks for listening and Fool on!