Don’t Celebrate a Rush Into Stock Buybacks

by Will Ashworth | December 11, 2012 7:00 am

Are you familiar with the special dividend phenomenon[1] taking place in America?

Sure you are. Companies in record numbers are trying to outrun the government by distributing capital to its shareholders before the end of the year in anticipation of the Bush-era tax cuts expiring, thereby taxing dividends as ordinary income in some cases as high as 39.6%.

Chances are[2] you’ve heard about[3] this by now[4].

But what about the share repurchase uprising?

The less-known but equally serious part of this corporate call to arms is a push to increase share repurchases, which will become more attractive in 2013 given the potential tax changes to dividend income. Around $220 billion in share repurchase announcements have been made so far in 2012; more are bound to make the news before New Year’s.

Peter C. Anderson, who manages the All Cap Opportunity Fund (MUTF:CACOX[5]) for Congress Asset Management in Boston, believes dividends are passé[6] when compared with share repurchases, and believes they lift share prices.

The man’s entitled to his opinion, but I have one of my own: Buybacks are a complete waste of shareholder funds.

Buybacks vs. Dividends

After George W. Bush lowered the tax rate (2003) on investment income and capital gains to 15%, companies continued to put a consistent amount of money toward dividends while also increasing share repurchases — between 2004 and 2011, the 500 constituents that make up the S&P 500 bought back $2.7 trillion in stock and made dividend payments totaling $1.8 trillion. They did this because share repurchases are really the deferral of a dividend today for a potentially larger one tomorrow.

With dividend income potentially being taxed as regular income, it looks as though buybacks will become even more popular.

The unfortunate part of this herd-like mentality is that CFOs are terrible at estimating the intrinsic value of their share price and thus tend to overpay. I’m not the only one who thinks so.

The reality is companies don’t know how to buy back their shares at prices significantly lower than the intrinsic value. If they did, the early part of 2009 would have seen the busiest trading in the history of the markets. Of course, we know that didn’t happen.

According to the Credit Suisse report, if you use 7% cost of capital, only 180 of the 500 companies in the index made more than that on an annual basis. Market timers they’re not. For instance …

Bottom Line

The most infuriating aspect of Credit Suisse’s report is the fact that the top 10 purchasers of stock (in terms of dollar value) wasted $67.4 billion that could have been spent on dividends. The report doesn’t speculate whether those funds, if reinvested in the company rather than the stock, would have produced a better return — but it’s clear dividends would.

After all, a bird in the hand is worth two in the bush.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned securities.

  1. special dividend phenomenon:
  2. Chances are:
  3. heard about:
  4. by now:
  5. CACOX:
  6. believes dividends are passé:
  7. dividends are a far better option:
  8. PG:
  9. CS:
  10. INTC:

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