I am not a big fan of share buybacks or dividends. There I said it. This probably sounds like blasphemy for many in the personal finance community, but bear with me.
These two are technically functionally equivalent. Still one is generally more liked by the personal finance community then the other. Let’s start with the less controversial statement (I guess you could say leave the best for last). Frankly share buybacks are usually a bad deal for investors.
Share Buybacks Happen at the Worst Time
First if we explore when share buybacks are most likely to occur, they are almost never advantageous to the share holder. Simply put a company has the most funds to execute a buyback when profits are the highest. Coincidentally this also tends to be the high point of a stocks price. If the market wasn’t doing so well now we wouldn’t be seeing so many buyouts. In 2008 they were much more rare, yet they would have had way more of an impact as the company could decrease the share count by a higher amount.
When A Buyback is not Really a Buy Back
The second thing to be aware of is many buy backs don’t actually decrease the amount of company stock. In order for a buyback to raise a stock price in theory, it needs to decrease the number of shares compared to its expected future profit. By doing so in theory the shares are thus more valuable. The problem is, people like myself receive sizable stock options as compensation. Furthermore, some companies also use new stock issue as a means of acquiring other companies. This means often times a stock buyback is nothing more than a way to keep the amount of stock stable despite this compensation.
What Does a Buyback Say About a Company
The final thing to be aware of is what all buybacks, and as we’ll later talk about with dividends, say about a company. Frankly the only source of funds a company has for these activities are to sell existing assets or instead of investing profits utilize them for buybacks. That means the only way a buyback might make sense is if the share holders to which it is returned can invest it at a greater rate than the company itself can. In a way it’s an admission that the company has more money then they can use to grow. That is not necessarily a bad thing if it is true, but you are trusting management to have made the right decision. I’m not sure I buy that.
Dividends Not Guaranteed
Which brings me to dividends. Dividends have the same limitations as buybacks in that a dividend paid is money that cannot otherwise be invested. I talked at length about why this means a dividend is not a replacement for bonds during my second month as a blogger, but essentially it boils down to a dividend only being as stable as the profits for the underlying company. Larger companies tend to be the ones that give dividends. They also tend to be more stable. Thus we can assume the only reason dividends seem to be more stable in downturns then other stocks is because larger companies are more stable in general. No other logic really works since a dividend does not appear out of thin air. To be sustainable it depends on company profits.
My Real Issue with Dividends Is…
While the above makes me a bit fearful when I see so many people jumping into dividend stocks as if the risk has somehow disappeared, that is not why I’m not a big fan of them. Nor is it the case like buy backs where I believe the company is just shifting money from one hand to another for compensation purposes. A dividend is a legit pass through of company wealth from my stock holdings back to me. But…
Again a dividend assumes I can reinvest the funds at a higher rate than the company. Otherwise the company should invest in itself. The first problem here is what do most of us do the moment we get a dividend? We buy more of the company. So is the money really growing faster than the companies rate of return? Well, it depends. In theory a company invests in projects above its marginal cost of capital and would pay out anything else. In which case at least by purchasing their stock I am likely to receive a higher portion of the return then if they invested it. But, to what degree? And do I trust their decision? Sure I see value in the company not hoarding money to invest in a savings account or other ludicrously low return investment. But how do I know that’s behind door number 3?
Would You Like Some Dividends with that Tax
Things get more complicated when you start to think about the tax ramifications of dividends. Unlike a buyback where if I don’t sell there is no tax hit, a dividend payment automatically incurs a tax. Now if I were in the retirement phase of my career I probably wouldn’t mind that. My taxes would be optimized for withdrawals from my capital and dividend payments. But in my accrual phase, as I am now, they are not optimized for payouts. As such with each dividend payout I get socked with a new tax bill. I also find myself hunting for new investments or trying to reinvest in the company to buy more with my payout funds(typically but not always with an associated trading fee). In other words in many cases a dividend is an inconvenience and at some points in your life a real tax inefficiency.
Whether Dividends and Buy Backs are Good is Opaque
Now what does this all mean for me personally? Frankly it’s very hard to tell if that company with the dividend is acting in my best interest. Since I don’t truly know their cost of capital and even their expected return is just an estimate, I can’t truly estimate an impact good or bad of a dividend payout. So what do I do about it?
Do Not Consider Dividends or Buy Backs when Purchasing Stock
I long ago decided not to chase dividend bearing stocks. Maybe someday later in life when I need the passive income and am setup with the appropriate tax efficiency. Then at last it saves me the step of selling some stock. But for now I don’t search out dividend bearing stocks.
However, I also don’t avoid dividend bearing stocks any more than I avoid buyback stocks. Frankly both sets of actions are probably less than advantageous to me on the whole at this time. But honestly both sets of actions are favored and frequented by large cap stocks which as I mentioned earlier tend to be the most stable companies. Furthermore, in either case when weighted against the whole value of a large cap index fund both dividends and stock buy backs are a paltry sum. Often when weighted against stock return of these vehicles these are also lower numbers. As such I just kind of put up with them in my index funds.
How do you feel about dividends?