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By Josh Peters, CFA and Jeremy Glaser | 06-25-2014 12:00 AM

The Downside of Share Buybacks

Companies are buying back shares at near-record levels, but Morningstar's Josh Peters says firms can serve shareholders much better with dividends rather than stock repurchases.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I am here today with Josh Peters, editor of Morningstar DividendInvestor and also our director of equity-income strategy. He is going to talk to us about how share buybacks and their ever-increasing numbers are impacting dividend investors.

Josh, thanks for joining me today.

Josh Peters: Good to be here, Jeremy.

Glaser: Put some context around how share buybacks look today versus historically. Are companies buying back a lot more shares?

Peters: They are buying back more shares than they have at any time in this economic expansion, in this bull market cycle. We haven't quite hit the peak of $172 billion in a quarter; that's $172 billion worth of shares in just three months for just the S&P 500 companies. That record was set back in the third quarter of 2007. It just happens to coincide with the all-time peak in the stock market prior to the crash. How interesting. Buybacks then declined dramatically as corporate earnings fell. Stock prices were getting cheaper, but companies stopped buying back their shares by and large.

Now, buybacks have moved up quite swiftly, hitting, according to S&P's latest data, $159 billion in the first quarter of 2014.

Glaser: You mentioned that management teams often do these buybacks at inopportune times. Is this happening again? Do you think management is putting all this money to work at possibly a pretty bad time and toward the market peak?

Peters: I think that's a real risk. I can't look at this data and call a peak for the stock market. I think that would be premature and also insufficient evidence to make a case like that.

However, you do see this pattern, companies tend to buy back their shares en masse, in very large quantities when prices are high, and they are not buying their shares back when prices are low. And it makes perfect sense; when companies are flushed with cash or generating more cash than they know what to do with, that probably means stock price is up quite a bit, as well. So, you have this sort of automatic problem that's built into the buyback issue.

Companies don't have the money to buy back their shares when they are cheap. And in fact, what we saw in the last cycle is that banks, which very heavily repurchased shares in the years leading up to the crash, were reissuing those shares often at a fraction of the price that the banks had paid in order to shore up their balance sheets. And shareholders got massively diluted by that.

I frankly would much prefer that if companies have excess cash, they payout special dividends. I understand you don't want to raise your regular dividends so high that it becomes unsustainable in the next downturn. But if we are just here and now, you've got more cash than you need, payout a dividend to everybody. Why do you only want to give the cash that's being returned by the company to shareholders to the former shareholders? Why not reward all shareholders equally with the dividend?

A mutual fund manager of T. Rowe Price, named Tom Huber, I sat with him on a panel at our investment conference recently. He put it this way, "Why do we want to reward the companies that paid people to go away?" I think that's a brilliant way of distilling how people should look at buybacks. They should be fairly skeptical.

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