Dividends make up a large part of many investors’ portfolios as regular returns offset the growing need for yield. In my case, I rely heavily on dividends to augment my retirement-based income.
History: Dividends date back to the early days of joint-stock companies in the 17th and 18th centuries. The “joint-stock” company came about as a way to distribute the risk of a business activity, such as shipping, among numerous investors rather than one or a few. To reward the investors for their participation, the joint-stock company would pay a dividend to each one out of the profits of the business enterprise. The payouts were also designed to bring in new investors.
The pace and popularity of dividends grew during the 19the century as railways grew rapidly both in Europe and North America. During the 1920’s payouts became so egregious (Ponzi schemes), they contributed to the severity of the 1929 Wall Street crash. As industrialized economies began to recover in the 1930’s, dividends were considered one of the best ways to restore investor faith. To this day, certain marine shipping companies still pay some of the best dividends available.
Buybacks versus dividends: In recent times in corporate America, dividends have been giving way to stock buybacks as a method of creating returns to shareholders. Buybacks and dividends have different risks attached, especially for smaller private investors. If the company has a setback year, the management would likely decide to postpone stock buybacks to preserve cash. This would take away any stimulus to the stock price that generates the shareholders’ returns.
Dividends could also be postponed or reduced for the same reasons. But the difference comes in that a buyback return is earned by the shareholders over a stretch of time when the company’s stock price rises. At some point the shareholder must sell at least a portion of his/her stock to receive any of the return. The dividend becomes a return on the day the stock trades ex-dividend regardless of the stock price or the financial future of the company. When dividends are cut, it is a future return that is taken away. Whereas, if buybacks are discontinued, it is an already earned return that is lost when the price of the stock falls. The exact timing of the dividend is announced, but the exact time the buybacks take place is not announced – only that a certain dollar amount of buybacks has approved by the Board of Directors and will take place intermittently over the future.
Dividends are deducted from the company’s retained earnings account when paid. Buybacks remain on the company’s balance sheet until they are either sold back into the open market or retired. By selling them back in the open market, the management would likely cause the stock price to fall defeating the purpose of the buyback. Retiring the stock could force the company into a deficit position when it is offset with the company’s capital and retained earnings accounts.
Strategy Abuses: Some managements have overused the buyback strategy and placed unnecessary burdens on the firm’s financial picture. They might claim to the shareholders that they are “making an investment in the company.” But under no circumstances does a stock buyback result in a company investing in itself. To be an investment, a stock buyback must be considered an asset, which it is not.
Conclusion: In building a returns strategy, each private investor must plan on whether to seek dividends or stock growth supported by share buybacks, as the strategies call for different actions. Both have their values and risks, but the often-overlooked attribute of buybacks is that to realize the gains, the shareholder must sell his/her shares.
Sources: The New Dividend Royalty, Schumpeter, The Economist, August 15, 2020