Why stock buybacks are better than dividends

Little wonder, then, that just as the Fed was raising rates and everyone was rushing to sell down stocks, companies that bought back their own shares did relatively better than those that did not buy back any of their own shares or only paid out dividends. In 2021, the world’s biggest purchasers of their own stocks were iPhone maker Apple, software behemoth Microsoft, social media supremo Facebook’s owner Meta Platforms, search giant Google’s parent Alphabet, and another large software firm Oracle. Those five firms accounted for 28% of buybacks in the US. In 2022, the order of the top five companies buying back their own shares changed slightly, with the oil giant ExxonMobil replacing Oracle.

Buybacks and dividends

Here is a simple primer on dividends and buybacks. When a company is hoarding a ton of profit, it can spend it on expansion like a new plant or buying out another company, on hiring more workers, or on R&D. Or it can pay the profit out as dividends or buy back its own shares. Dividends and stock buybacks are just different ways to distribute income to shareholders.

To understand why so many people love dividends but hate buybacks, look no further than the history of dividends. Bond markets existed long before stock markets and some bonds, like those issued by American railroad operators, paid a regular annual interest coupon. To win bond investors over to the stock market, the early listed companies offered regular dividend payouts. So, an investor could invest in a stock or a bond and still get regular “income” or a coupon. Stocks were sold as something with the possibility of price appreciation as well.

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These days, fewer than 400 of the biggest 500 US companies pay a dividend, although about 120 pay so little that they might not even bother paying it. And — about a third of them borrow money to pay dividends.

Paying dividends does not necessarily indicate that a firm is profitable or has a lot of spare cash lying around. Many pay dividends just because they are desperate to attract investors. Without dividends, their stock would probably tank — and they might not be able to raise more money in the bond market. Look at the big telecom companies like AT&T, mid-sized banks like Citizens Financial Group, or commercial real estate firms like SL Green, the largest owner of office space in New York’s Manhattan. All have huge dividend yields and stocks that are selling at five times next-12-month earnings. Yet, no value investor in their right mind would touch them with a 10-foot pole.

The problem is not just that most firms do not have profits to pay dividends and are leveraging up to keep paying them every quarter, but that even their long-term prospects are not good, notes Aswath Damodaran, professor of finance at New York University. “Dividends, because they are sticky, require some degree of confidence about future earnings,” he said in a recent podcast. These days, he added, because just about every business is being disrupted, it is difficult to say who has reliable and predictable earnings.

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Twenty years ago, General Electric was the world’s biggest company which grew dividends every year even though it could barely afford to pay them. It has since collapsed and been broken up. “If earnings become less predictable, what company in its right mind wants to increase dividends by 20% and then face the problem two years later of saying, ‘we’ve been disrupted, we have to cut dividends’?”

Damodaran sees buybacks as “flexible dividends”. There is a perception that when a firm cuts dividends, it’s because there is a disaster on the horizon, he notes. Companies are stuck with paying dividends even when they know it is not in their best interest to do so. They do not want to send the wrong signal. The way Damodaran sees it, the world has changed since 1934 when Ben Graham wrote of stocks with bond-like coupons and price appreciation in his seminal tome, Security Analysis. Moreover, there were no Amazon.coms or the threat of disruptive technology back then.

Stock buybacks were illegal in America until 1982, when the Securities and Exchange Commission (SEC), under president Ronald Reagan, allowed companies to legally repurchase their own shares. Buybacks grew rapidly in the 1990s. By 1998, buybacks and dividends for the S&P 500 firms were around US$150 billion each. Buybacks grew substantially in 2018 after the passage of the US Tax Cuts and Jobs Act under president Donald Trump, from US$519 billion in 2017 to US$806 billion in 2018, declining slightly in 2019 and then exploding in the aftermath of the pandemic in 2020. Last year, stock buybacks in the US were over US$1.26 trillion ($1.67 trillion), compared to just US$550 billion for dividends.

Clearly, listed firms are waking up to the reality that share buybacks make a lot more sense than old-fashioned dividends. If you compare two similar-sized US companies that were returning similar amounts of money, and one only paid dividends while the other only did buybacks, you would find that buybacks trump dividends when it comes to stock prices. Shareholders love buybacks. Corporate boards, which were until a few years ago were lukewarm, are now embracing buybacks.

Increasingly, companies are allocating less of their spare cash towards dividends and more towards buybacks. For example, in recent quarters, Apple has repurchased around US$20 billion of its own shares and paid out US$3.7 billion in dividends. Over the years, it has been accelerating its buybacks and decelerating dividend payout. Oil giant Chevron recently announced a 6% increase in its quarterly dividend to US$1.51 per share as well as a new buyback authorisation of US$75 billion.

Firms buy back shares for a number of reasons, including to purchase shares when they are undervalued and that can subsequently be sold at a higher price; or to increase their earnings per share by reducing the number of shares; or to offset the increase in outstanding shares through exercises of employee stock options, particularly at tech companies where options, not basic salary, is used to lure staffers.

Buybacks have been criticised by left-wing politicians like Bernie Sanders, who say firms should use their cash to boost long-term growth by ploughing more money into employee benefits or capital expenditures that create jobs. They also argue that buybacks are somehow linked to management compensation because CEOs get more bang-for-their-buck stock options if their stock price can be pumped up.

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Here is the problem with that argument. If you look at the companies with the biggest stock buybacks in the US, you might find that in about half of those the CEOs or the top managers did not get the kind of boost they allegedly get. The CEO who has gotten the most bang for his buck in history is Elon Musk, who made US$56 billion from EV maker Tesla’s 2018 stock option plan. Tesla unfortunately has never bought back any shares.

Other politicians have criticised companies for wasting their retained cash on buybacks then asking for government handouts as soon things soured. From 2014 through 2019, US airlines spent US$45 billion on stock buybacks even as they cut costs and laid off workers. At the start of Covid-19 pandemic, the airline industry asked the US government for a US$50 billion bailout. Yet, the pandemic was a black swan event and it was Washington that forced a nationwide lockdown, which forced airlines to shut down their operations.

Earlier this year, a freight train carrying toxic chemicals derailed along the Norfolk Southern Railway in a small town in Ohio, spurring an environmental cleanup. In the aftermath of the disaster, Norfolk Southern was accused of prioritising US$10 billion in stock buybacks over maintenance which might have prevented derailment.

Berkshire Hathaway CEO Warren Buffett, in his recent annual letter to shareholders, weighed in on the buyback controversy. Buffett, a disciple of Ben Graham, was once himself a critic of buybacks and preferred collecting dividends from invested companies. Now, he is a big defender of buybacks. “When you are told that all repurchases are harmful to shareholders or to the country, particularly beneficial to CEOs, you are listening to either an economic illiterate or a silver-tongued demagogue,” the Oracle of Omaha intoned. “The math isn’t complicated,” Buffett wrote. “When the share count goes down, your interest in the businesses goes up. Every small bit helps if repurchases are made at value-accretive prices.”

Berkshire itself has never paid a cent in dividend. The Nebraska-based conglomerate initiated a buyback programme in 2011. Berkshire spent US$27 billion in share buybacks in 2021. However, buybacks plunged to just US$8 billion last year when Berkshire went on a shopping spree as stocks sold off, acquiring insurer Alleghany for US$11.6 billion and building stakes in firms like Occidental Petroleum.

Because buybacks are gaining popularity and companies are ditching dividends, governments want to use them to squeeze out more tax revenues to pay for huge pandemic-era budget deficits. President Joe Biden’s Inflation Reduction Act of last year includes a 1% tax on stock repurchases by listed firms. The Congressional Budget Office estimates that a 1% tax on all US share buybacks could raise up to $74 billion over the next decade. In early February, during his State of Union address to the US Congress, Biden proposed increasing the tax rate on buybacks to 4%. But buybacks have such an advantage over dividends that taxes are unlikely to turn the tide.

Time for Asia to embrace buybacks

While buybacks have caught on in Europe, Japan, South Korea and Australia to varying degrees, they are rare in much of the rest of Asia, which is home to some of the fastest-growing economies in the world.

The argument against buybacks is that Asia has many high-growth companies which need a lot of cash to grow. Stock buybacks tend to drain the corporate cash hoard. Yet, the world’s fastest-growing companies are US-based tech players, which also tend to be biggest purchasers of their own stocks. Buybacks enhance stock performance, which in the end help those companies grow even faster, which in turn allows them to further innovate and build even better platforms to keep growing.

Over a 10-year period, Singapore’s Straits Times Index is flat and FTSE Bursa Malaysia KLCI is down 16% in local currencies. In comparison, S&P 500 is up 158% over the same period, while the tech-focused Nasdaq 100 and Technology Sector Select SPDR are up 263% and 384% respectively in US dollar terms. Growth companies and growth markets probably are better suited for buybacks than dividends invented to mimic bond coupons. Is it time for Asia to ditch dividends too and embrace buybacks? I believe it is.

Assif Shameen is a technology and business writer based in North America