Dividends Vs Share Buybacks

Scope And Purpose Of This Post

This post is a work-in-progress and right now is mostly a collection of pertinent snippets/summaries of articles on the matter of dividends vs share buybacks vs other.  Some basic points:

• Many arguments in favor of dividends are fatally flawed.
• Many arguments made in favor of dividends are actually arguments in favor of dividends and share buybacks.
• For individual investors, with their tax-normal investments, share buybacks are superior to dividends due to how they're taxed differently.
• For corporate investors, dividends can be superior to share buybacks due to taxation differences.
• For tax-advantaged accounts (401k, IRA), "share buyback vs dividend" doesn't matter.
• The more a company is undervalued, the better share buybacks are, and the more a company is overvalued, the worse share buyback are, but it is foolish to think you know better than the market about the proper value of a company.
• Even if a company is undervalued, a share buyback may be inappropriate if there are good investment/growth opportunities available to the company.

Some more points:

•  A share buyback financed by debt can be thought of as a shift from equity-based financing to debt-based financing.  Interest rates are currently low and interest payments are tax-deductible (while dividends and share buyback payments are not), so this shift to debt-based financing can make a lot of sense.

Notes Useful To The Author While Drafting

Miscellaneous

TODO: re-find paper about equilibrium of all companies offering some dividend even when some investors hate dividends and some love them; the equilibrium is not for companies to chose only one investor type to appeal to; they try to moderately appeal to both types

TODO: re-find data about the amount of dividends and share buybacks in the S&P500; there was some interesting stuff about share buybacks being bigger than dividends before the 2007-2009 unpleasantness, and about how much dividends were cut too (25%, I think).  The Boglehead thread at the bottom gets at this some, but it would be nice to get something that shows all the numbers we want.

Sidenote: http://www.etf.com/sections/features/432.html?nopaging=1 is an article that talks about how qualified dividends for ETFs work.  One of the criteria for qualified dividends is the 61 day holding requirement.  That requirement applies to the ETF holding the underlying stock, AND that requirement is also applied to you holding the ETF.  If you buy an ETF just before the ex-dividend date, all dividends will be non-qualified for you.  If you've held an ETF forever and the ETF buys some stocks just before the ex-dividend date, the dividends from the new stocks will be non-qualified for you (and all other holders of the ETF).

Wiki: share buybacks

Wiki: Share Buybacks

An intro to share buybacks:

Share repurchase (or stock buyback) is the re-acquisition by a company of its own stock. It represents a more flexible way (relative to dividends) of returning money to shareholders.

In most countries, a corporation can repurchase its own stock by distributing cash to existing shareholders in exchange for a fraction of the company's outstanding equity; that is, cash is exchanged for a reduction in the number of shares outstanding. The company either retires the repurchased shares or keeps them as treasury stock, available for re-issuance.

Under US corporate law there are five primary methods of stock repurchase: open market, private negotiations, repurchase 'put' rights and two variants of self-tender repurchase: a fixed price tender offer and a Dutch auction. More than 95% of the buyback programs worldwide are through an open-market method, whereby the company announces the buyback program, and then repurchases shares in the open market (stock exchange).

...When a company repurchases its own shares, it reduces the number of shares held by the public. The reduction of the float or publicly traded shares, means that even if profits remain the same, the earnings per share increase.

 There are some more interesting comments in the Purpose section.

"Investors' Odd Affection For Dividends", Larry Swedroe

Larry Swedroe's article discussing how investors (individual and institutional) seem to treat dividends irrationally:
http://www.etf.com/sections/index-investor-corner/swedroe-investors-odd-affection-dividends?nopaging=1

• "before frictions like trading costs and taxes, investors should be indifferent to $1 in the form of a dividend (causing the stock price to drop by $1) and $1 received by selling shares. This must be true, unless you believe that $1 isn’t worth $1."
• "stocks with the same exposure to common factors ... have the same returns whether they pay a dividend or not. Yet many investors ignore this information and express a preference for dividend-paying stocks."
• 'One frequently expressed explanation for the preference is that dividends offer a safe hedge against the large fluctuations in price that stocks experience. But this ignores that the dividend is offset by the fall in the stock price. It’s what can be called the "fallacy of the free dividend"  '
• "What is particularly puzzling about the preference for dividends is that taxable investors should favor the self-dividend (by selling shares) if cash flow is required. Unlike with dividends, where taxes are paid on the distribution amount, when shares are sold, taxes are due only on the portion of the sale representing a gain. And specific lots can be designated to minimize taxes."
• "First, the authors [of a study] found that investor-trading behavior is driven by past price changes rather than past returns. In other words, they treat two stocks whose prices rose from $5 to $6 the same, even though one first went to $7 and then paid a $1 dividend, which lowered the price to $6."
• "A fourth important finding [of the same study] was that investors’ demand for dividends is higher when interest rates are low and recent equity returns have been poor. They also found that investors’ demand for dividends is higher when dividends are more stable. Once again, this demonstrates that investors have separate mental accounts for the two components of return, treating dividends more like interest payments while ignoring the source of the dividend and its impact on the stock price."
• "Additionally, the authors found that the demand for dividends is lower when recent stock returns have been higher—the dividend component appears less attractive than capital gains despite both contributing to the total return".
• [multi-paragraph quote about dividend reinvestment]
• "the authors found that dividends tend not to be reinvested in the same company. This was true of retail investors (who may find it difficult to reinvest dividends unless the company has a DRIP program), and more sophisticated institutional investors (who don’t have the same consumption motivation that retail investors have)."
• "Specifically, they found that, for individual investors, dividend reinvestment is only about 2% as common as no change in the number of shares held. For institutional investors, it was only about 10% as common."
• "In other words, investors seem to be expressing that they have a desire to reduce their holdings by the exact amount of the dividend paid! It seems far more likely that there is separate mental accounting and that investors ignore the equivalency theory behind the actions."
• "it has been well-documented that some mutual funds "juice" their dividends by buying stocks just before the ex-dividend date"
• [more wonderful quotes remain]

"The Dividend Puzzle", Fischer Black

wiki stub on the concept
legible pdf
less legible pdf

"The Dividend Puzzle" was written by Fischer Black, who was an economist that seems would have gotten a Nobel memorial prize in economics if he had lived until 1997.  So, he's probably not an idiot.

• "There are many ways for the stockholders of a firm to cash out without receiving dividends.  The most obvious is that the firm can buy back some of its shares.  This has the advantage that most investors are not taxed as heavily on shares sold as they are on dividends received."
• "In a world where dividends are taxed more heavily (for most investors) than capital gains, and where capital gains are not taxed until realized, a corporation that pays no dividends will be more attractive to taxable individual investors than a similar corporation that pays dividends."
• "Of course, corporate investors are taxed more heavily on realized capital gains than on dividends.  And tax-exempt investors are taxed on neither.  But it is hard to believe that these groups have enough impact on the market to outweigh the effects of taxable individuals."
• "An investor who holds a non-dividend-paying stock will generally sell some of his shares if he needs to raise cash....these transactions can be costly, especially if small amounts of money are involved...But...if investors are concerned about transactions costs, the corporation that pays no dividends can arrange for automatic share repurchase plans, much like the automatic dividend reinvestment plans that now exist."
• "...dividend changes, or the fact that the dividend doesn't change, may tell investors more about what the managers really think than they can find out from other sources."
• "[dividends allow a company's assets to escape the claims of creditors]...alas, this explanation doesn't go very far.  In many cases, the changes in values of stocks and bonds caused by a change in dividend policy would be so small they would not be detectable.  And if the effects are large, the company can negotiate with the creditors.  If the company agrees not to pay any dividends at all, the creditors would presumably agree to give better terms on the company's credit.  This would eliminate the negative effects of cutting the dividend..."
• "Cutting the dividend, if there are no special reasons for paying dividends, has to be one of the lowest cost sources of funds available to the company [for reinvesting and growing the company].  The underwriting cost of a new debt or equity issue is normally several precent of the amount of money raised.  There are no comparable costs for money raised by cutting the dividend."
• "If the dividend is cut, the managers may lose the money through unwise investment projects...but surely these cases are relatively rare."
• "It is possible that many, many individual investors believe that stocks that don't pay dividends should not be held, or should be held only at prices lower than the prices of similar stocks that do pay dividends.  This belief is not rational, so far as I can tell.  But it may be there nonetheless."
• "On the other hand, investors also seem acutely aware of the tax consequences of dividends.  Investors in high tax brackets seem to hold low dividend stocks, and investors in low tax brackets seem to hold high dividend stocks."

 Note that when the article was written, dividends were taxed like ordinary income.  Now, qualified dividends are taxed at the same rate as long-term capital gains for individuals, however, dividends are still more tax inefficient due to the timing of taxation and that dividends are fully taxed while sales of assets are only taxed on gains.

So, Black's points about dividends being worse tax-wise for individual investors remain valid.  To summarize the paper:

• Lots of arguments for dividends don't hold up to scrutiny.
• Dividends are less tax efficient than share buybacks for individual investors.
• Dividends can be more tax efficient than share buybacks for corporate investors.
• Tax-exempt investors shouldn't really care about dividends versus buybacks.
• Dividends may be valuable to investors as an additional source of information about the company (though I would argue buybacks could serve that same purpose).
• Lots of individual investors seem to be irrational about dividends.

 The only part I would quibble with Black is when he says company "managers may lose..money through unwise investment projects...but surely these cases are relatively rare".  I would say a slightly weaker assertion.  On one hand, Black is a respected economist that has more experience than me, but on the other hand, I can dig up some respected people who are more pessimistic about corporate governance and principal-agent problems than Black.

Anyway, it seems Black's paper is pretty consistent with my thinking on dividends:

• Individual investors are irrationally over-fond of dividends.  Rationally, they should prefer buybacks for stocks in their taxable accounts.
• Corporate investors are rational to prefer dividends over share buybacks.  If corporate investor dollars outnumber taxable individual investor dollars, then it makes sense for companies to do dividends.

Bogleheads Forum Thread: Stock Dividend Yields and Share Buybacks, A Surprise

https://www.bogleheads.org/forum/viewtopic.php?t=147933
which links to this pdf with a blank first page: http://www.valuewalk.com/wp-content/uploads/2014/05/document-1032855431.pdf

Allan Roth's "The Contrarian Case For Stock Buybacks"

http://www.etf.com/sections/index-investor-corner/contrarian-case-stock-buybacks?nopaging=1

Larry Swedroe's "Dividend Policy And Stock Returns"

http://www.etf.com/sections/index-investor-corner/swedroe-dividend-policy-stock-returns
Larry's bullet list summarizing this study:

• The change in the country-level dividend payout rate is negatively correlated with returns.
• In some countries, there is no significant relationship between changes in dividend payout rates and returns.
• There are no countries in which the change in dividend payout rates is significantly positively correlated with returns.
• The cross-country relationship between changes in dividend payout rates and returns is significantly negative.
• Although the signaling story might hold for individual companies, it does not hold for countries as a whole. Rather, at the country level, an increase in dividend payout rate represents a decrease in the country’s investment opportunity set and accordingly is interpreted by investors as bad news, and vice versa.
• Change in a country’s dividend payout rate is negatively connected to changes in analysts’ long-term earnings growth expectations for that country, supporting the bad news story.
• The change in a country’s dividend payout rate is positively correlated with that country’s change in its equity risk premium.
• Countries with lower dividend payout rates have had higher real long-term equity returns.

Larry Swedroe's "Exploring Buybacks' Impacts"

https://www.etf.com/sections/index-investor-corner/swedroe-exploring-buybacks-impacts?nopaging=1

The article covers a December 2017 paper that shows that recently, an increase in share buybacks is mostly fueled by a shift to debt-based financing (due to tax-subsidization and low interest rates) and does not seems to have decreased companies' re-investments in growth opportunities.  Also, net equity issuance has recently been positive, so share buybacks are outnumbered by equity issuance.

• "In a December 2017 paper, 'The Premature Demonization of Stock Repurchases,' ... They show that:"
• "While total dollars now spent to repurchase shares is high relative to history, companies are not “self-liquidating” as some claim. Instead, repurchases have been largely financed by debt issuance. In fact, when scaled by market capitalization, the upward trend in share repurchases over the last five years disappears."
• "There is no obvious link between aggregate share repurchase activity and a decline in aggregate investment activity. First, net equity issuance over the last five years has been positive. Second, share buybacks have been funded by an increase in historically cheap (and tax-subsidized) debt, not a decrease in investment. In other words, share buybacks have been a form of recapitalization and a shift from equity to debt financing (which is logical in light of today’s historically low real interest rates). Third, there’s no apparent negative relationship between normalized investment and share repurchase activity. In fact, the two variables have been positively correlated of late, as both investment and share repurchases have increased since the end of the global financial crisis."
• "Aggregate repurchase activity is not associated with mechanical or automatic earnings-per-share (EPS) growth as is often claimed. Specifically, the claim is that by repurchasing shares a company decreases its share count and so mechanically increases its earnings per share. But this ignores the fact that decreased cash can mean lower earnings, due either to less interest earned on that cash (or greater interest expense if debt is used to finance repurchases) or the loss of returns from other uses for it. In addition, the assertion that any increase in EPS leads to a commensurate increase in share price reflects a naïve understanding of basic corporate finance (e.g., Modigliani/Miller). Any increase in leverage that increases EPS increases risk at the same time, with the net effect being a wash on firm equity value. Empirically, no clear link exists between share repurchases and EPS growth. EPS growth rates for firms that do not repurchase shares are approximately 1% higher than EPS growth rates for firms that do repurchase shares."
• Conclusion from same paper: “Aggregate share repurchase activity has not been at historical highs when measured properly, and when netted against debt issuance is almost a non-event, does not mechanically create earnings (EPS) growth, does not stifle aggregate investment activity, and has not been the primary cause for recent stock market strength. These myths should be discarded.”
• "What’s more, because interest payments are tax-deductible, debt-financed repurchases can be viewed as good news due to the resulting lower tax burden. Another benefit is that share buybacks reduce agency risk—that is, management engaging in “empire-building” acquisitions (the same argument made by those who have a preference for dividends)."
•  "For those interested in understanding the math of how buybacks can impact metrics such as price-to-earnings, price-to-dividend and enterprise value-to EBITDA (earnings before interest, taxes, depreciation and amortization), I recommend this article by Jon Seed at AlphaArchitect.com: Buybacks: Why They Don’t Matter, Why They Do, and Why You Should Care Yet Still Relax."