As shareholders, and I think this is particularly true in the UK, we tend to instinctively look kindly upon dividends as a source of investment income. After all, most investors are saving for their retirement and look forward to the day when a rising stream of passive income will enable them to sail off into the sunset.
That is all perfectly good and admirable as far as it goes, but I think we are missing out by failing to embrace the share buyback as an effective and often superior form of shareholder return.
Dividends and buybacks both require surplus cash, and so they both demonstrate basic financial strength to execute.
Dividends and buybacks both return cash to shareholders. In the case of dividends, it is simple: every shareholder receives the same amount. Buybacks only pay out to those shareholders who choose to sell their shares, but those shareholders do directly receive cash from the company.
So dividends and buybacks are both the return of free cash from the company to shareholders and are equal in that respect.
What can’t be downplayed with respect to buybacks is their voluntary nature and how they discriminate between shareholders: the shares can only be bought on the open market from willing sellers or through a tender process where shareholders choose how many shares they wish to sell.
So the buyback is essentially a technique to provide a cash exit for those shareholders who don’t wish to hold on for the opportunity of higher future value, while enabling those shareholders who do believe that there is higher value in the future to own a larger stake in the company. It eliminates from the company register those shareholders who think the company is fully valued, and increases the participation in the company’s success for everybody else.
Doesn’t sound very exciting? It is. The problem is that buybacks are often executed badly – haphazardly, when the company cannot afford them, or at times when the shares are overvalued (although this is of course partly the fault of shareholders themselves).
But well-executed buybacks can assist in generating life-changing returns. Look at the track record of Next plc (here and here and here). Look at Berkshire Hathaway (here). And Character Group (here).
Buybacks, when executed intelligently, are consistent with the basic principle that cash should be allocated where it achieves the greatest return…
