Summary
- Since the Great Recession, share buybacks have surpassed dividends in their contribution to shareholder return but they remain surprisingly controversial.
- In discussion of the new 1% buyback tax, Mark Cuban criticized buybacks as favoring departing shareholders who get a one-time cash pop, which is taxed partially as cap gains.
- The big winners are continuing shareholders, who through a math quirk end up owning more than the buyback percentage.
- Companies also enjoy a quirk allowing them to raise dividends by the same percentage of market cap without more cash going out the door.
- Travelers, Apple, and McDonald's exemplify different strategies using buybacks to improve returns and achieve corporate goals.
There's an ongoing debate about buybacks vs. dividends, and it was heightened recently in the course of the August debate over the Inflation Reduction Act, one provision of which was a 1% tax on buybacks. It doesn't sound like much, and it actually isn't much in the grand scheme of things, but buybacks were an easy target for Congressional leaders including Joe Manchin who surrendered his position as no-sayer and supported the bill. Once the bill passed, the camel's nose was under the tent and raising the 1% rate will likely have to be beaten down repeatedly in the future.
What is it that makes buybacks such a good target? Whenever I do an article touching upon the subject I brace myself for comments mostly from investors who feel all shareholder returns should come in the form of cold hard cash. Sometimes the comments are written by people I know as sophisticated investors but who are resistant to the idea that buybacks used properly do everything dividends do and other things dividends can't do. Buybacks contribute greatly in building value in a portfolio, and for those in need of immediate cash return, they enable a simple course of action that will provide it. They're much more tax efficient than dividends - one of the reasons lawmakers see an opportunity in taxing them - and a math quirk enables them to provide a little extra in value creation for the shareholders who continue to hold on to their shares. No wonder that an increasing number of managements use them to reward shareholders. Buybacks have grown in popularity over the past 15 years and now make up a larger percentage of shareholder return than dividends.
The behavior of politicians never surprises me, but the point of view of capitalists like Mark Cuban, who has a past history of interest in the philosophy of Ayn Rand, came as a bit of a shock. Rida Morwa, who writes copiously about dividends on this site, brought Cuban's views to my attention in a recent article entitled "Billionaire Mark Cuban Says Dividends Are Better Than Buybacks." In several interviews during the August debate over the Inflation Reduction Act, Cuban jumped into the argument with an attack on the basic principles of buybacks. His premise was that buybacks favor the departing shareholders over those who stay.
If anything, Cuban's argument has it exactly backwards. Shareholders who sell up to the average percentage of shares a company buys back benefit from a one-time payment in cash. Its major advantage is that the sale of shares is taxable only on the basis of embedded capital gains while the entirety of a dividend is taxed less favorably, as income. The shareholder who does nothing finds that his/her percentage ownership, by a math quirk, actually increases. Not only that, the benefit deriving from an increased percentage of ownership continues indefinitely as long as the shares are owned. (For those who get a kick out of mathy things, it's the same principle that makes it necessary to rally more than the loss percentage from a stock decline to get back to even.)There's another little bit of quirky math from the company's point of view. Buybacks make it possible to return more cash as a dividend. Bear in mind that most companies which repurchase shares also pay dividends.
Though Warren Buffett has often presented the reasons that dividends do not work well for the majority of his shareholders, he has often said that buybacks are a good choice when better uses of cash are not available at the right price. In recent years he has backed this view with action, twice buying back shares with a price of $25 billion or so in a year and meaningfully reducing the Berkshire Hathaway ( BRK.A ) ( BRK.B ) shares outstanding. Buffett has also applauded the share buybacks of Tim Cook at Apple ( AAPL ).
Buffett has maintained that there's a price limit above which shares repurchases destroy value, but has added that fair value is not easy to define. In his 2021 Shareholder Letter, he noted the fact that both Berkshire and Apple reduced the share count by over 5% through share repurchases and called it to the attention of Berkshire shareholders that buybacks by the companies left them owning over 10% more of Apple than they otherwise would have. He also revels in the small math quirk that enhances value for continuing shareholders. A closer look at the two math quirks is in order, with special focus on the second one, which from a company's point of view improves all per share results and makes it easier to increase dividends.
Math Quirk #1 From A Shareholder Point Of View
Buybacks are, in fact, tantamount to dividends because they allow shareholders to convert the percentage of repurchased shares into cash. They can do this by selling that same percentage of the shares they own on the open market. Let's posit a company with $100 billion market cap which decides to buy back $5 billion of its shares. That's a straightforward 5%. Let's say then that an investor with a $100,000 stake in the company wants to give herself/himself a 5% dividend. She simply sells 5% of her shares, receiving $5000 dollars. Her stake in the company is now $95,000. The overall market cap of the company is now $95 billion. The percentage of the company owned remains exactly the same. Her tax bill is certain to be much lower than it would have been if she had received a $5000 dividend. That's almost the end of the story.
You can think of the buyback as an extra dividend of the sort European companies often pay (and which were once more popular here in the US). You can make this special manufactured "dividend" more regular by simply doing it in a way that averages out over time. In his 2012 Shareholder Letter Buffett provided a fictive example of business partners who operate this way and end up with much more wealth in the long run.
It's the shareholders simply hold onto their shares they benefit from that little math quirk which sweetens the deal. The $5 billion buyback reduces the market cap of the company to $95 billion. The $5 billion buyback is actually 5.26% of the new market cap, so that the shareholder who continues to hold his owns 5.26% of all assets, revenues, cash flows, earnings, and dividends. For shareholders of companies that regularly repurchase shares that extra .26% compounds perpetually. In short, for both shareholders who sell a few shares in order to manufacture a dividend and shareholders who hold it's a win-win situation - cash with lower taxes or a larger percentage of ownership.
Math Quirk #2: The Company Point Of View
This quirk came to my attention a few years ago as a shareholder in Bank of America ( BAC ). In the brief window when the Fed felt comfortable with bank capital and allowed some major banks to return 100% of their earnings to shareholders, BAC returned capital in the form of a 3% dividend yield accompanied by 7% in the form of share repurchases. I looked at this carefully and wrote about it in several articles which you can look up. What that 7% share reduction did - in perpetuity - was reduce the denominator for assets, revenues, cash flows, earnings and dividends. The 7% of share repurchases in effect manufactured 7% in earnings growth. It also made possible a dividend raise of 7% the following year which would not require more cash going out the door. Dividend investors take note. Buybacks actually made it easier to increase dividends which were paid out to a reduced number of shares.
Mark Cuban described buybacks as "financial engineering," but if that 7% growth and "freebie" dividend increase is "financial engineering" I'm fine with it. Alas, BAC was among the banks which dropped the ball on this year's stress tests and as a punishment has had to show restraint this year on buybacks. You can look up my two most recent Bank of America articles in which I expressed my displeasure. Many other financial companies have been able to use a combined dividend/buyback approach, in particular, insurance companies which suffered from the past decade of suppressed rates. Quite a few other companies have benefited similarly. The following three show slightly different philosophies.
1. Travelers: A Steady, Safe, Slow-Growth Company
Insurance companies are the model of slow-growth companies with limited opportunities to increase their growth rates. For the more conservative insurance companies, the investment policy usually involved a portfolio largely made up of bonds to offset potential future claims. With interest rates suppressed over the past 15 years (until recently) the approach taken was to be very careful in underwriting. Rather than taking on the risks in less desirable business, it became an unstated policy to use surplus cash to reduce the share count. The results at Travelers ( TRV ) tell a compelling story.
In the 9.5 years starting in 2012 TRV increased revenues by 49%, with steady annual compounding at 4.3%. Net Income increased by 35% over the 9.5 years as underwriting expenses increased. That's an annual compounding rate of 2.9%. That was the natural growth rate for TRV in an environment of low-interest rates which greatly limited the growth of an insurance company required to own a lot of bonds. Interest rate revenues declined irregularly throughout the period, sliding from $2,889M to $2,227M in 2020 before bouncing back to $2680M TTM. In sum, Travelers was a dull conservative low-growth company - before buybacks.
Between 2012 and the most recent quarterly report Travelers has used more than $22 billion of cash to repurchase shares. It has done meaningful buybacks every year, fewer in years with insurance events and the pandemic year of 2020 and more in years with large cash returns. The effect of this is visible in share reduction of 37% over the period. As a result revenues, earnings, cash flow, and dividends were spread over 37% fewer shares. This number fits almost perfectly with the fact that earnings per share more than doubled as opposed to the 35% aggregate increase. That's an annualized compounding rate of 8.5% compared to the growth rate before buybacks of 2.9%. The numbers are even more powerful for dividends per share, which tripled without an increase in the payout ratio. Cash flow also more than tripled.
Thanks to buybacks, dividend yield of 2% plus earnings growth around 8% add up to a very solid 10.5%, supporting TRV's current 14 P/E. It should be mentioned that TRV achieved this with very little increase of its quite modest debt. Travelers is the prototype of a disciplined company which has used buybacks properly to benefit shareholders. Here's what it looks like on a stock chart for the 9.5 years. Note that the 210.8% is the increase in price alone, not including the dividend yield which over much of the period was higher than the current 2%.
2. Apple: Strong Growth Enhanced By Retiring Shares
Apple ( AAPL ) is the No. 1 US stock by market cap and got there by being the premier consumer products company supported by technology. It's a mature company with its largest rate of growth behind it, but CEO Tim Cook has used share repurchases with disciplined persistence to keep growth in its per share numbers high. Its aggregate growth in revenues over 9.5 years has been 220% for an annualized rate of 8.7% while its growth in net income over 9.5 years has been 271% for an annualized rate of 14.8%. The fact that NI grows faster than revenues shows that Apple's growth did not require an increase in capital. A 37% reduction in shares through buybacks increased the growth over 9.5 years to roughly 400%. Cash flow per share increased at about the same rate.
An interesting side note with Apple is that its dividend increased every year but much more slowly than revenues, earnings, and cash flow per share. During the interview cited above when comparing buybacks to dividends Buffett casually cited Apple as an example of the fact that once you pay a dividend you are not going to eliminate it. Reading between the lines Buffett may have implied that Tim Cook regretted ever having paid a dividend and may have seen the light and decided to keep Apple's dividend nominal in scale. In any case, Apple returned money to shareholders in a 2/1 ratio of buybacks to dividends in 2012 which grew to a 7/1 ratio in 2022.
Buffett and Cook may have influenced each other. In that same interview, Buffett acknowledged that fair value for buybacks was hard to estimate and might differ from company to company. Cook may have evolved to a yet more liberal view. The timing of Apple's buybacks strongly suggests that his criterion for buybacks may not involve a stringent valuation limit. His criterion seems instead to be having more cash than needed for internal investment. In short, buybacks at Apple are opportunistic. Once again in the Sept. 1 interview cited above Buffett noted that it would be hard for Apple to find an acquisition of fifty or one hundred billion which fit sensibly and was available at a sensible price. Here's Apple's chart over the 9.5-year period showing that it was a growth stock on buyback steroids, a ten-bagger.
3. McDonald's: Decline Masked By Share Repurchases
Once a great growth company, McDonald's ( MCD ) has run out of game-changing product innovation and expansion into new markets. Now, its per share growth numbers come a lot closer to Mark Cuban's likely definition of "financial engineering." From the topline perspective, McDonald's appears to be a company in gradual decline. Its revenues declined 17% in the 9.5 years since 2012. Thanks to vigorous cost-cutting net income has actually increased by 13%. That's evidence of strong management, but by itself, it would not come close to permitting the increases in MCD's dividend, which almost doubled over the period. Its dividend grew at a rate a little larger than 7%. And make no mistake: for McDonald's it's all about dividends. McDonald's is the model of the TINA stock, bought for the dividend in the absence of safe fixed income alternatives. Never mind that they tripled the level of long-term debt to achieve it and the payout ratio rose from 53% to 66% over the 9.5-year period.
One might reasonably ask if this overall approach will continue to work smoothly if higher interest rates stick around for a while. Debt would gradually become more costly. The amount of cash returned in the form of buybacks broadly tracks the amount paid out in dividends, but the amount paid in dividends has recently been pulling away. The cost of dividends may in the future not be helped as much by the declining share count. McDonald's may also prove in the long run to be one of those companies which bought back shares at a high price. Its P/E ratio is about double that of the much more conservative Travelers, which has almost the same yield and much less significant debt. MCD's P/E is in fact somewhat higher than that of Apple. I can't come up with any good explanation of that except MCD's now imperiled TINA status. I must acknowledge, however, that MCD management has been resourceful and may have a plan in place. Shareholders should hope so. Here's the 9.5-year chard:
Strategies And Risks
With the three companies discussed above, there are three distinct strategies all using the same basic effects from combining buybacks and dividends. The approach used by Travelers is the most measured and conservative, doubling total shareholder return, enough to add up to a respectable 10.5%. That helped lift its P/E ratio, which had spent much of the past decade under 10, to a modest but appropriate 14. More than the other companies TRV seems to have in place a long-term plan to produce solid shareholder return even in an environment that is unfriendly to underwriting profits and fixed income returns.
Apple's approach might be best described as opportunistic. It has clearly become more decisive about buybacks over the past decade. Benefiting from outstanding growth it was able to push the per share numbers into higher gear by aggressive spending on share repurchases. At the same time, it felt able to maintain lower increases in dividends to suit the needs of the majority of its holders. The use of cash in buybacks amounted to a policy which invested in the company Tim Cook knew best rather than making forays into acquisitions with higher cost and higher risk. This approach has so far solved the problem which has beleaguered many aging tech companies.
McDonald's has the narrowest focus in the use to buybacks, which has helped to maintain the dividend growth which is its core goal. It must develop ways to continue dividend increases without radically increasing its payout ratio. It may also need to deal with the potential of persistent high rates to impact its cost of debt and P/E ratio. It clearly has the highest risk of the three. I would stay away from McDonald's until those problems are fully solved.
Conclusion
Dividends and buybacks aren't an either/or choice. They work well together as a both/and although the optimal ratio of the two varies with the circumstances. Travelers is an outstanding stock for conservative investors happy with a solid shareholder return likely to continue for the long haul. Apple provides an opportunity for higher per share growth enhanced by persistent buybacks. The buybacks fit perfectly in its goal to age gracefully as a tech company with slowing growth. Both TRV and AAPL have a place in most portfolios. McDonald's has been resourceful in maintaining 7% annual dividend growth so far. That appeals to its shareholders but management must continue to be resourceful and find creative ways to avoid a shortening runway. I do not own it and don't expect to in the near future.
For further details see:
Dislike Buybacks? Buffett Begs To Differ And So Do Shareholders Of Travelers, Apple And McDonald's