An Effort That Pays Dividends (and More!)
April 4, 2018
Image used with permission: iStock/martince2
An Effort That Pays Dividends (and More!)
Times are tough for investors looking for income. In today’s low interest rate environment, finding a reasonable source of investment income is about as easy as finding hen’s teeth.
According to the latest data from J.P. Morgan, an American who invested $100,000 in a typical certificate of deposit in 2017 would have earned a paltry $400, or 0.4%. (1) Compare that to the roughly $8,000 that same investment would have generated in the late 1980s and you’ll get a sense of just how far we’ve fallen. For Canadian investors, the trend has been pretty much the same: down.
Is it even worth the effort to look for income these days?
Dividends offer some relief
Fortunately, there is some good news. For those who own stocks, some respite can be found in the cash that companies often pay out to shareholders in the form of dividends. The level of dividend payments varies from company to company, with some paying a high dividend yield, some paying a low yield, and some paying none at all. However, you can get a sense for the average by looking at the dividend yield of a broad index of stocks. Today, for example, the S&P 500 index has a dividend yield of about 2%. This is obviously a big leg up from the paltry 0.4% available on a certificate of deposit. And that’s not all, since stocks also offer the prospect of returns in the form of rising share prices (capital gains). But if we leave aside capital gains and just focus on dividends, a 2% dividend yield is nothing to write home about, particularly with inflation running at about the same pace.
Buybacks can add to the relief
Thankfully, dividends are not the only source of returns available to equity investors. Recent research published in the Financial Analysts Journal shines a light on another method of paying out cash to shareholders: stock repurchases, or “buybacks”. (2) Simply put, a share buyback is a company using its cash to buy its own shares. Buybacks can be a big benefit for buy-and-hold investors because as the number of shares outstanding is reduced, the remaining shareholders end up owning a larger share of the corporate profits. This helps increase your profit per share which is a valuable way to return money to shareholders, even though it takes a different form than a dividend.
The research, which uses data stretching back to the 1870s, shows that, as the dividend yield has faded in recent decades, the so-called buyback yield has risen to take its place. Surprisingly, today the buyback yield is higher than the dividend yield, as illustrated in the charts below.
An important conclusion from this research is that from an equity investor’s perspective, the total cash returned to shareholders is higher than it might appear on the basis of dividend payouts alone. How much higher? Well, if you add the two (dividend yield + buyback yield) to create a “total yield” then, as the next chart shows, your annual yield is more than double what you receive from dividends alone. (3)
However, as with all things in investing, there is also risk. The challenge is that buybacks are not universally positive, and can even be negative if a company’s management team makes poor decisions in executing its buyback program. Here are four considerations:
- The price paid: It’s far better for a company to buy its own shares when the price is low, not high. Just like any investor, if a company pays too much for its shares this will lead to bad outcomes.
- Manufacturing earnings per share growth: It’s also possible that buybacks can be misused if management has the wrong incentive scheme. Buybacks can create the appearance of earnings per share growth, a metric that is often important in determining executive bonuses. If buybacks are done without regard to the price paid – and only to boost the optics of growth in earnings per share – this can be a problem.
- Capital allocation choices: The main job of management is to decide how to spend a company’s money. The choices are many and can include acquisitions, research and development, internal projects, dividends and buybacks. The key is to make choices that generate the best returns. One benefit of buybacks is that they make capital scarcer (money leaves the company), which imposes a degree of discipline on how management spends the remaining capital. In fact, there is evidence that companies that buy back their shares outperform those that don’t, precisely because the capital is taken out of the hands of management teams that might otherwise misspend it. In a nutshell, sometimes buybacks are the optimal choice, but sometimes money is best allocated elsewhere.
- What’s the signal? When management announces a buyback program it sends a mixed signal. They could be buying because they think the shares are cheap, which is encouraging. On the other hand, the return of cash could mean that the company doesn’t have any good internal investment opportunities. As with any mixed signal, it’s tough to interpret.
The big picture
Although dividends have been the dominant method of paying out cash to shareholders in the past, buybacks have become more prevalent and are now a key driver of long-run stock market returns. And while there are a few considerations to bear in mind with buybacks, it’s clear that they have become an important part of the total payout that investors receive for investing in equities. Under the right circumstances, both dividends and buybacks can be important tools for investors coping with today’s low interest rate environment. DMC
(1) J.P. Morgan Asset Management, Guide to the Markets, 2Q 2018.
(2) Straehl, Philip U., and Roger G. Ibbotson (2017). “The Long-Run Drivers of Stock Returns: Total Payouts and the Real Economy.” Financial Analysts Journal, Third Quarter 2017, Vol. 73, No. 3: 32-52.
(3) For simplicity we have not included the impact of new shares issued in this data. However, there is a strong case to be made to amend this formula to be (dividends + buybacks – shares issued) in order to arrive at a yield figure that properly accounts for the offsetting forces of share issues and share buybacks. Straehl and Ibbotson do go through this exercise to create a model they call the dividend less net issuance model.