With apologies to Sir Mix-a-Lot, I like buybacks and I cannot lie. However, before I dig into my own rap favoring share repurchases over garden-variety dividend distributions, let me tap into the wisdom of great market minds.
In Warren Buffett's 1984 letter to Berkshire Hathaway (NYSE:BRKa) shareowners, the "Oracle of Omaha" praised buybacks. "When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace," Buffett wrote, "no alternative action can benefit shareholders as surely as repurchases."
That was around the time that buybacks began springing into fashion. According to Legg Mason's Michael Mauboussin, in an excellent academic treatise on the importance of buybacks, Congress had passed the 10b-18 rule that granted companies safe harbor two years before. This "legal shield" provided the luxury for companies to engage in significant buying sprees of their own stock. By the late 1990s, buybacks had replaced dividends as the most popular way for companies to return cash to their claimholders.
Buybacks aren't perfect. Companies with sterling ROIC rates may find that their greenbacks are better off reinvested in the company. In a cruel twist, the overvalued high-P/E-multiple stocks often have more to gain from a repurchase to alleviate lofty multiples than more conventional low-P/E companies undertaking a similar pursuit. Repurchases can also often be abused by companies, as they attempt to throw the stink off a bad quarter by managing earnings or offsetting overly generous stock-option grants.
However, this week's bout is simply pitting buybacks against dividends, and on that basis, I can look past buybacks' shortcomings to favor the practice as the ultimate winner.
Giving dividends their due
Dividends are nice. I probably wouldn't have been a buyer of units in regional amusement park operator Cedar Fair (NYSE:FUN) several years ago if the Income Investor newsletter pick didn't tempt me with a juicy yield. However, I am also an investor in Cracker Barrel parent CBRL Group (NASDAQ:CBRL). Earlier this month, the company posted marginal improvement in earnings per share, despite a 31% slide in net income. The trick? A massive buyback that cut diluted shares outstanding from nearly 52 million to just 36 million.
Can your dividend check do that?
I turned to James Fink, the Foolish financial editor who happened to suggest this week's topic, to solicit some thoughts on why buybacks are so popular these days:
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Lower transaction costs
for the company, since it only needs to make a few stock purchases on a single stock exchange, rather than distribute money to thousands of shareholders.
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Potentially lower taxes, since the capital gains tax rate has historically been lower than the dividend tax rate (though that's not the case right now). Furthermore, the tax only applies to selling shareholders, whereas there is no tax consequence for non-selling remaining shareholders.
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The ability to increase the firm's value for remaining shareholders, if the shares are purchased at a price below their intrinsic value.
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An increase in remaining shareholders' percentage of ownership in the firm. They now reap a larger portion of the company's future cash flows, because they own same number of shares amid a smaller outstanding pool.
- Lower transaction costs for shareholders, who receive a larger percentage of ownership in the company automatically, rather than needing to reinvest dividends by purchasing stock on an exchange.
I can do far worse than lean on the great minds of Warren, Michael, and Jim to do my homework. However, I couldn't get any of them to condemn dividends. (Jim is actually a major proponent of James Early's Income Investor newsletter service.) So I'll have to go out on a limb on my own to get even more aggressive in my conclusion.
Aren't dividends a form of surrender? Isn't a company simply shrugging its shoulders and passing the buck when it distributes owned or leveraged greenbacks? If I'm investing in a company, do I really want to see it play hot-potato and send money back to me in the form of a taxable event?
Buybacks are cleaner and more effective. They send the appropriate home-cooking message. Open-market purchases can also have a favorable effect on share price (unlike a stock's price drop when it goes ex-dividend).
I'm not alone in my appreciation for buybacks. Nathan Parmelee has also come up big in their favor. "Here's a statement you won't expect to hear from a dividend guy," he wrote. "If executed properly, share repurchases are likely to be more beneficial to shareholders than dividends are."
He then goes on to show his math. Fancy that! In arguing that buybacks are great tools for companies confident that their stocks will appreciate in value -- and why own a stake in a company that thinks otherwise? -- I now stand on the shoulders of four skilled market-watchers to make my case.
Five, if you count Sir-Mix-a-Lot.
Read Nathan Parmelee's odes to buybacks:
Think you're done with the Duel? Think again! Go back and read the other three parts, then vote for the winner !
Longtime Fool contributor Rick Munarriz is a fan of buybacks, and he does own shares in Cedar Fair and CBRL Group. He is also part of the Rule Breakers newsletter research team, seeking out tomorrow's ultimate growth stocks a day early. Berkshire Hathaway is a Motley Fool Inside Value pick. The Fool has a disclosure policy.
