- Buybacks and dividends continuously exceed earnings creating a financialized corporate environment and leaving less money for innovation and investments.
- Such a situation isn’t sustainable in the long term.
- We’ll close with an example of somebody willing to spend $21.5 billion of shareholders’ money to increase his salary by a few million.
The end of each quarter is an excellent time to analyze what’s going on with buybacks and dividends. FactSet’s comprehensive analysis of quarterly buybacks and dividends for the S&P 500 is a great place to start.
It’s of extreme importance to know what it is that management is doing with your money and if they are increasing or decreasing shareholder value. Today, we’ll analyze the situation and give you a few hints to enable you to easily analyze if the managers of the stocks you own add or subtract value with dividends and buybacks.
Dividends Aren’t In Danger, But The Environment Around Them Is About To Change
Dividends on aggregate increased 1.2% in Q3 2016 marking the sixth consecutive year of dividend increases. However, the dividend growth rate has been slowing down for four consecutive periods.
Figure 1: S&P 500 dividend trends. Source: FactSet.
In total, dividends have doubled since 2010 and so has the S&P 500. This has been keeping the dividend yield constant and around 2%.
Figure 2: S&P 500 dividend yield. Source: Multpl.
From an historic perspective, dividend yields have never been so low except for the short period around the peak of the dot.com bubble. The reason dividend yields are so low now is related to the fact that interest rates are also at historical lows.
Figure 3: Effective federal funds rate. Source: FRED.
The two trends marked with the red line on the above figures clearly identify the correlation.
As interest rates can’t go much lower than where they are now, the main danger for dividend investors is a shift in the secular trend of low interest rates.
Another smaller danger worth mentioning is that 44 corporations of the S&P 500 have payout ratios exceeding 100% of earnings which is the second highest count in the past 10 years, after Q1 2016. The aggregate payout ratio is 40% of earnings. The 40% payout ratio seems healthy and sustainable but it isn’t when buybacks are taken into account.
Buybacks have several advantages compared to dividends. The main advantage of buybacks is that they lower the number of shares outstanding and immediately increase future earnings per share even if net income is flat. The second is that you don’t pay additional taxes on them as your benefit is indirect through higher earnings per share. Higher earnings per share should push the value of the shares higher. Thirdly, buybacks support the price of a share and increase the float.
However, there is also a very important negative side to buybacks. Management will always tell you that they don’t see a better investment than in themselves. Unfortunately, this is rarely true.
It isn’t always that shareholder value is maximized through buying back shares. Something that I find very strange is that companies prefer to invest in themselves through the stock market rather than by directly investing in their business. If the company is the best business to invest in, then the way to increase shareholder value is to invest in new branches, factories, marketing, etc., in order to replicate what has been done well.
Buying back shares is three times more expensive than investing in businesses because the average S&P 500 price to book value is 2.96.
Figure 4: S&P 500 price to book value. Source: Multpl.
Price to book values were much lower in the period between 2009 and 2013. However, corporations usually increase buybacks when prices are high and vice versa. I wouldn’t call this creating shareholder value.
Figure 5: Buybacks are the highest when prices are high. Source: FactSet.
You should check to see if the corporations in your portfolio add value when they do buybacks. Even if it seems like a smart idea and a good use of extra cash, it might not be a good idea in the long term as eventually the economic cycle will turn and shares will be much cheaper.
On top of overpaying, companies like to overspend on buybacks and dividends. In the last two years, S&P 500 dividends and buybacks have been bigger than corporate earnings. This means companies are borrowing, and also not investing in their businesses, to increase buybacks. Such a situation is unsustainable and similar to what was going on in 2007.
Figure 6: Total shareholder distributions are above earnings. Source: FactSet.
On aggregate, companies are borrowing to repurchase more shares and push stock prices higher. This certainly increases short term shareholder value through higher stock prices but when the cycle turns and debt costs increase, the chickens will eventually come home to roost. Therefore, if you are a long-term investor, pick companies that increase your long-term value by consistently reinvesting in their business and that aren’t interested in short term stock price pumping schemes through buybacks.
A great example is set by Buffett and Berkshire Hathaway. In his 2011 letter to shareholders, he discussed how Berkshire would repurchase its shares at a price of up to 110% of book value. He also said that repurchases should be favored when two conditions are met:
“First, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.”
Another condition to be met is that repurchases significantly lower the number of shares outstanding and aren’t just a cover for dilution through management options schemes.
Buffett summarizes buybacks by quoting the first law of capital allocation:
“The first law of capital allocation, whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another.”
The message is clearly not heard by the majority of corporate managers as they buyback no matter the price. Therefore, we can conclude that most of them are dumb. Be careful not to own stocks that have dumb managers who are overpaying for their buybacks and taking on more debt to do so.
This is unfortunately easier said than done as the majority of companies on the S&P 500 don’t even come close to Buffett’s buyback criteria. The two companies with the biggest buyback activities are Apple (Nasdaq: AAPL) and General Electric (NYSE: GE). Neither of the two meet Buffet’s criteria. AAPL’s price to book value is 4.8, while GE’s is 3.4. However, APPL’s $31 billion of buybacks in the last 12 months still looks ok seeing as it had profits of $45 billion, while GE’s buyback activity can be easily questioned as they spent $21.5 billion on buybacks while their trailing earnings are just $11.4 billion and they recorded a loss in 2015.
What’s interesting is that the destruction of shareholder value at GE isn’t a recent thing. An older Forbes article shows how GE usually repurchases lots of its stock when the price is high and practically none of it when the price is low.
Figure 7: GE historical stock repurchases in relation to book value. Source: Forbes.
Of course, I’m just a financial analyst. The CEO of GE is paid $26 million a year, of which 34% is in stocks which he is so eagerly repurchasing in order to push the price higher and increase the value of his options.
Today we’ll conclude with a question. What would you do if you were the CEO of GE where your salary depends on GE’s stock price and you have a $21.5 billion cannon that can be recharged yearly?
Would you invest in the real business, or just buyback as much stock as you can in order to push the price up in the current bull market and increase the value of your stock options? Worst case scenario, you’re forced to retire and get a multi-million dollar check to go with it.
It’s extremely important to understand the real reasons behind buybacks and invest accordingly, especially if you are a long-term investor.