Yesterday I posted an “Astounding Chart” that explains the entire 7 year bull market. Basically, it shows that stock buybacks have been the biggest demand source for equities over the last few years. My conclusion is that investors better hope they continue. They could continue, provided return on equity remains high, growth remains low, excess cash continues to pile up and interest rates remain accommodative.
The post generated an interesting discussion about buybacks versus dividends and then my pal Cullen Roche pointed us toward a gem of a paper from Michael Mauboussin on the topic. Mauboussin goes into a Q&A format to explain some of the important nuances of the topic. In particular, I really liked the way he framed the choice companies make when deciding whether to do a buyback, raise the dividend or do both concurrently.
Mauboussin puts it in terms of strategic decisions versus tactical ones.
In the below, he explains that dividends payouts represent more of a longer-term commitment and, as such, exhibit less volatility (emphasis mine):
The most fundamental difference between buybacks and dividends may be the attitude of executives. Executives believe that maintaining the dividend is on par with investment decisions such as capital spending, whereas they view buybacks as something to do with residual cash flow after the company has made all investments that are appropriate.
There are a couple consequences of this difference in attitude. The first is that dividend payments are inherently less volatile than buybacks. Exhibit 6 shows the annual amount of buybacks and dividends by companies in the S&P 500 as well as the price level and market value of the index from 1982 through 2013. The average arithmetic growth rate of dividends from 1982 to 2013 was 6.7 percent with a standard deviation of 9 percent. The average arithmetic growth rate of buybacks was 23.7 percent with a standard deviation of 56 percent. The average growth rate of dividends and buybacks combined was 10.9 percent with a standard deviation of 20 percent.
Dividends are remarkably resilient compared to buybacks. This was in full evidence through the recent financial crisis, as dividends declined only 20 percent from 2007 to 2009. Buybacks tend to follow the level of the S&P 500 more closely, which is consistent with the view that residual cash flows should fund them. Buybacks dropped more than 75 percent from 2007 to 2009. Companies tend to buy back stock when the market is up and refrain when the market is down.
Probably the best way to think about dividends vs buybacks is not to think of them as facing off against each other, but as working in concert to return capital to shareholders when there is no better use for it. Meb Faber calls this combination “shareholder yield”. But still, it’s also worth thinking about buybacks as being market-following and mercurial, versus dividends as being steadier and, often times, more responsible.
Disbursing Cash to Shareholders
Credit Suisse – May 6th, 2014