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Why Dividends Trump Buybacks

Matthew Coffina, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Many management teams have been focusing on share repurchases versus dividends in recent years. I'm here with Matt Coffina--he's the editor of Morningstar StockInvestor newsletter--to hear how he thinks about the differences between the two. Matt, thanks for joining me.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: So, how should investors think about dividends versus share buybacks? Are they really equivalent? Are they both creating value, or do you prefer one over the other?

Coffina: In theory, there shouldn't be a difference between share repurchases and dividends; but in practice, I don't think the theory really holds up. What we see is that companies tend to be much more aggressive with share repurchases at exactly the wrong time. It's when the business environment is favorable and the companies are feeling flush with cash. They have a lot of excess cash on hand, and they're repurchasing their stocks at relatively high stock prices. And then they tend to cut back on share repurchases at exactly the wrong time--when the market takes a turn for the worse or the economy takes a turn for the worse--and their shares could be acquired at better terms. That's when they tend to be not repurchasing shares.

So, we're seeing a great example of this in the energy sector right now. A lot of energy companies, particularly the larger oil majors, have been aggressively repurchasing stock over the past five years. Now, energy prices have taken a tumble, everyone's trying to preserve cash, and share buybacks are really the first thing to go. You'd really rather see those companies accelerating their share repurchases now, when their share prices are lower; but exactly the opposite is taking place.

For that reason, I tend to prefer dividends. As my colleague Josh Peters over at Morningstar DividendInvestor likes to say, dividends are always worth 100 cents on the dollar. It's not possible for a company to destroy value by returning cash directly to shareholders. And so, that's usually the preferred method in my view.

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Glaser: And how about companies that don't do either dividends or share repurchases--[ones] that are just building cash on their balance sheet? How do you think about those names, and would the fact that they don't return capital to shareholders be something that would keep you from investing?

Coffina: I hate to see a company just accumulating cash on the balance sheet. It's one thing if they have a good use for the cash and they can put it back to work in building a new plant and equipment or investing in high-return growth projects, maybe making strategic acquisitions where there are significant synergies to be realized. But we do see a lot of companies, particularly in the tech sector, just accumulating loads and loads of cash, and it's really against the best interests of shareholders.

I'd hate to think where Google's (GOOG) or Apple's (AAPL) share price would be today if they had been repurchasing stock over the past 10 years, instead of allowing it to accumulate on the balance sheet. Apple, obviously, has become a lot more diligent about returning cash to shareholders now; but it would have been so much better to have repurchased their stock at lower share prices earlier or even to pay dividends that shareholders could then go use to reinvest in those stocks or in other stocks.

So, there is no question about it--companies, in my view, destroy value by holding a lot of cash on the balance sheet. That said, it's usually not important enough that it would deter me from owning an otherwise high-quality company. Often, the kinds of companies that are accumulating this huge amount of cash are doing so because they can--because they're growing at a healthy rate. Investors are satisfied with the performance of the overall business. They're not feeling a lot of pressure to maximize earnings per share in other ways like repurchasing stock. There is not that much pressure on them to pay a dividend. So, if you avoid companies that don't return cash to shareholders, you're going to miss out on a lot of very high-quality businesses like Google or like Priceline (PCLN). And I think those companies would be much better and they'd be much better investments if their management teams were more diligent about returning cash to shareholders. But even so, they are high enough quality businesses that I'm willing to own them, despite the suboptimal capital-allocation policies.

Glaser: Of the businesses that you own in your portfolios, which ones do you think have some of the most shareholder-friendly practices?

Coffina: I would say one company that stands out more than any other to me is CME Group (CME). This is a company that, as of a couple of years ago, initiated a new policy of paying a generous regular dividend. The regular dividend provides a yield of a little over 2%. But then they take whatever cash they have left over at the end of the year and also return that to shareholders. Sometimes, it's cash from operations, but it could [come from other places as well]. A couple of years ago, they sold their NYMEX building in New York and they returned the proceeds of that directly to shareholders through the special dividend.

So, once a year, they pay a special dividend, and the advantage of this policy is that it allows them to avoid making a significant regular dividend commitment that might be hard to continue paying in a downturn. CME Group has a very cyclical business, trading volumes come and go. You can get periods of very aggressive trading volumes and derivatives and then other much slower, lower-volatility periods. So, their earnings can fluctuate wildly with trading activity, and it would be hard to support a very generous regular dividend. But by paying a good-size regular dividend and then these special dividends, they maximize cash returns to shareholders when they have the cash available, but they're also not on the hook and not subject to a dividend cut--at least to the regular dividend--during the downturns.

So, CME's special dividend this year also provided a little more than 2% yield on the current stock price, but the overall yield was north of 4%, and that's basically them returning all of their cash flow--and by the way, they generate a lot of cash flow. This is a business with very low fixed costs, a lot of operating leverage--operating margins are in the neighborhood of 50%. So, it's a very cash-flow-rich business. And instead of using that cash for value-destroying acquisitions or procyclical share repurchases, I'd much rather see them return that cash to shareholders, which is exactly what they do.

Glaser: Matt, thanks for your thoughts on dividends versus buybacks today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching. 

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