Are you familiar with the special dividend phenomenon 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%.
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) for Congress Asset Management in Boston, believes dividends are passé 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.
- Eddy Elfenbein, editor of the hugely popular blog Crossing Wall Street, isn’t a fan of buybacks. He believes, as do I, that dividends are a far better option for investors than share repurchases ever could be. Elfenbein sees share repurchases as simply hiding the stock option grants given to the top management.
- Greg Milano, CEO of Fortuna Advisors, says, “When you buy back stock with money you could have reinvested, you not only deliver worse returns, you wind up employing less people.” A classic case: Procter & Gamble (NYSE:PG) is laying off as many as 5,000 employees, yet it has the audacity to increase its share repurchase program from $4 billion to $6 billion. It might mean something if buybacks actually worked, but alas … they don’t.
- The New York Times article mentioning Anderson’s love of repurchases, as well as Eddie’s post, are the result of a Credit Suisse (NYSE:CS) study that concludes as follows: “It looks like most of the buybacks for the S&P 500 over the past eight years have not yet added much value for the remaining shareholders.”
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 …
- Intel (NASDAQ:INTC) announced Dec. 4 that it was selling $6 billion in bonds to fund share repurchases and other corporate activities. Intel bought back 2.18 billion INTC shares between 2004 and 2011 at a cost of $49.9 billion. That was $5.7 billion that could have been returned as dividends to shareholders. Overall, Intel achieved an annualized return of 5.1% on those repurchases — 190 basis points lower than the 7% cost of capital mentioned earlier. Put another way, Intel spent $4 to make $1. Now it’s borrowing to do the same thing. And in my book, borrowing for share repurchases is just plain wrong, no matter the cost of the debt.
- Previously, I mentioned how Procter & Gamble increased its share repurchase program to $6 billion. In the eight years from 2004 through 2011, it was the fourth-largest purchaser of its own shares in the S&P 500. P&G bought back slightly more than a billion shares for $61.9 billion. All of that for a 3.6% annualized return. For every dollar earned through share repurchases, Procter & Gamble had to spend almost $6 to make it work … which makes you wonder why P&G is a part of Bill Ackman’s stock list.
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.