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The Downside of Share Buybacks

Josh Peters, CFA
Jeremy Glaser

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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Glaser: If you are a dividend-focused investor then, should you see buybacks as a red flag at a company that maybe the dividend isn't going to rise as much as you expected or that they are not as committed to it as you might hope?

Peters: What you hope for with share buybacks is that you will get more dividend growth on a per-share basis. For example, you take a company like General Mills. This year they'll probably pay out enough dividends to provide the stock with about a 3% yield, and they'll also in all likelihood buyback enough shares that they'll reduce the share count by at least another 2%.

Next year, when they get around to setting the dividend they should have the benefit of both the internal growth of the business itself at the bottom line as well as a smaller number of shares with which to distribute those dividends over. So you wind up with maybe a 2% bigger dividend increase than you would have gotten otherwise, call that maybe 7% instead of 5% or 8% instead of 6%.

Where I have a problem is when you see companies devote overwhelmingly larger resources to the buybacks than the dividends. In fact, earlier this year, I sold a bank that frankly I like, U.S. Bancorp, because buybacks have taken precedence. The dividend is providing only about a 2% yield. They only raised it 6.5% this year. They want to stay apparently below regulators' 30% cap on payout ratios even though some other banks like Wells Fargo have pushed now beyond that in order to provide larger dividends. Instead U.S. Bank is going to buyback that much more stock. Maybe that appeals to some shareholders, but I am not going to confuse it for an actual dividend payment that puts cash in my account.

At the end of this whole process, you have to remember that's essentially an identity. If a company has spent enough money to buy back 1% of its total number of shares outstanding, it also had enough money that it could have provided shareholders with exactly a 1% higher dividend yield.

Some people get real bent out of shape about taxes and the fact that only people who sell into a buyback are taxed. Then they only claim capital gains, so there is a cost basis involved, and it is more tax-efficient. That's really the only justification I can come up with buybacks, and it's a pretty poor one. It's not the job of a company to minimize its shareholders' tax liabilities.

Shareholders have plenty of choices, plenty of options to try to manage their own taxes, and it is really none of a company's business. I mean, who did a better job minimizing the shareholders tax liabilities than the crooks who ran WorldCom and Enron? Maximize and optimize the flow of earnings and dividends back to the shareholders; let everybody else take care of taxes from there.

Glaser: The buyback trend you think could continue, but not necessarily to the benefit of many investors?

Peters: What I'd like to think is that over time, we are going to see a shift. Right now, data from the first quarter this year, companies spent almost double the amount on buybacks that they spent on dividends.

That's consistent actually with where we've been for a while. However, going forward as more people retire and retiring baby boomers are leaning more heavily on income in their portfolios to fund withdrawals so that they can support their lifestyles in retirement, I think the math is going to change. I think that companies that pay good dividends are going to be rewarded by shareholders, and companies that continue to emphasize buybacks at the expense of dividends or to the exclusion of dividends might actually suffer in that kind of comparison. This will play out perhaps over the next 10-20 years.

The good news is that there are enough companies--maybe we're only talking about a few dozen that would have worked for our portfolios--but there are enough companies that have high-quality businesses and good balance in their dividend policies. Buybacks may play a role, but putting that good dividend out there and then growing it, keeping it safe, those are the first priorities for a company's cash, and fair prices, that you can build a good portfolio even today, even as much as the stock market's gone up, and even as much as buybacks themselves might be driving stock prices higher.

Glaser: Josh, I appreciate your thoughts on this today.

Peters: Thank you too, Jeremy.

Glaser: For Morningstar, I am Jeremy Glaser. Thanks for watching.

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