Share buybacks and what the dividend yield isn't telling you

Seeing the elephant

Focusing too much on operations and not enough on capital allocation can be dangerous.

In his book, Shareholder Yield: A Better Approach to Dividend Investing, US author and investor Meb Faber tells the Indian parable of the blind men and the elephant. The curious group hears about a strange animal. They seek it out and each one inspects a different part of its body before arguing about what to make of this strange beast. “The creature is some kind of snake.” said the man who felt its trunk.

“No, no.” disagreed the next man, who felt its front leg. “The elephant is straight and sturdy, like a tree trunk.” And on and on they go, each party insisting the elephant is something else entirely. None of them could see the complete picture and all of them made incorrect conclusions.

When it comes to looking at stocks, to see the elephant, it helps to look not just at how a company generates cash, but how productively it deploys capital. A steadily increasing dividend isn’t always in the best interests of a company, for example. In fact, sometimes, it can get in the way of future growth.

Efficient capital allocation is one of the fundamental drivers of future value and the way companies distribute their resources is changing. How do we keep up?

The capital deployment tool kit

• Companies have five main “tools” for deploying capital

• Understanding when to use which tool is vital in creating shareholder value

• Financial records are littered with examples of poor capital allocation

Warren Buffett points us to William Thorndike’s The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success. One passage, in particular, stands out:

“CEOs need to do two things well to be successful: run their operations efficiently and deploy the cash generated from those operations. Most CEOs (and the management books they write or read) focus on managing operations, which is undeniably important…” writes Thorndike.

“Basically, CEOs have five choices for deploying capital --  investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock -- and three alternatives for raising it -- tapping internal cash flow, issuing debt, or raising equity. Think of these options collectively as a tool kit. Over the long term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options.”

Michael Mauboussin, Director of Research at Bluemountain Capital Management, wrote a paper in 2012 while at Legg Mason Capital Management called Share Repurchase from All Angles. It makes the fundamentally important point that the prime responsibility of management is to invest capital - be it physical, financial, or human - at a rate in excess of the opportunity cost of capital.

Alternatively, capital should be allocated to opportunities with the highest returns. This sounds basic but how often do we stop to check that this is what management is actually doing?

In his paper, Mauboussin published the following exhibit of how US companies spent cash between 1985 and 2011:

The data show that for every $1 spent in the period, companies spent $0.55 on capex, $0.27 on mergers and acquisitions, and $0.18 on dividends and buybacks.

Profitable capex is the most desirable use of cash. As for dividends, high yielders have been proven to outperform the market over time (when dividends are reinvested). M&A is a little trickier - studies show that value typically goes to the seller, while the buyer tends to earn about its cost of capital. Reasons for this include:

• Hubristic management underestimating the complexity and cost of extracting synergies

• Eroding value by bidding up the price (the winner’s curse)

• Increasing scale driven by ego, influence, and financial compensation (empire building)

• Buying at the top of the cycle, when the firm has cash to burn, prices are high, and sellers want to sell

When good chances go begging because of dividend commitments...

• Studies identify many winning high-yield investment strategies

• A strong dividend track record can provide a floor to a stock price and reduce volatility

• The risk is that higher-return opportunities are abandoned to satisfy a demand for yield

Dividends are a valuable source of income and can be a signal of strength. Studies also suggest they limit the volatility of stocks during tougher markets. Tweedy, Browne compiled this paper, which is a good (and short) introduction to some of these.

Shareholders seek stable and rising dividends, but it is here that problems can arise. What was once “stable and rising” can become “inflexible and burdensome”. At worst, dividends can prevent optimal capital allocation and affect financial health.

Warren Buffett articulated a wariness of dividends in his 1984 Berkshire Hathaway letter:

“Dividend policy is often reported to shareholders, but seldom explained.  A company will say something like, ‘Our goal is to pay out 40% to 50% of earnings and to increase dividends at
a rate at least equal to the rise in the CPI’.  And that’s it - no analysis will be supplied as to why that particular policy is best for the owners of the business.  Yet, allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed… In our opinion,  management should choose whichever course makes greater sense for the owners of the business.”

It appears that others agree. The documented link between dividends and long-run sustainable earnings appears to be weakening (as found in this paper by Brav, Graham, Harvey, and Michaely). Other, more flexible options are winning favour.

Share buybacks and the changing face of capital allocation

• Share buybacks are growing in popularity around the world

• Their flexibility allows them to complement, or even replace, dividends

• Unfortunately, there is anecdotal evidence of poor execution

Stock buybacks had their “Big Bang” moment in 1982 when the SEC introduced 10b-18. This rule gave companies safe harbour to purchase their own stock. At first in the US, and then at other companies around the world, management began substituting dividends with buybacks. This trend does not look like it will be slowing down anytime soon.

With this tool, management can commit capital to more attractive opportunities as they arise. The problem is buybacks can be executed poorly. They are sometimes switched on when times are good (and shares are expensive) but turned off when the market crashes (and shares are cheap). As Mauboussin notes, this is the exact opposite pattern you would expect from management trying to build value.

If we visualise Michael Mauboussin’s data from the table above, it tells an interesting story:

Similar trends to this are observed in other markets around the world. Two points jump out: 1) M&A and stock buybacks are more volatile than capital expenditure and dividends, and 2) buybacks became more popular than dividends in 2004 and have remained so ever since (except for 2009).

When we calculate the compound annual growth rate of each tool, we see that buybacks increased at more than twice the rate of dividends in the period:

• Buyback CAGR: 12.0%
• M&A CAGR: 7.5%
• Dividend CAGR: 5.4%
• Capex CAGR: 3.6%

Interpreting buybacks

• Good buybacks: high conviction. Meaningful quantities bought back at a discount to expected value. Only if no better investment opportunities exist

• Bad buybacks: low conviction. Expensive stock purchased to offset options or superficially inflate performance

The data point to a long-term trend of increasing share buybacks in multiple markets. Clearly, we need to be able to analyse and interpret this capital allocation tool.

The key question is: does the stock trade at a discount to estimates of its intrinsic value? Some, such as Mauboussin, argue few executives think about buybacks properly. Using an objective measure such as price-to-book or a composite of different measures to identify a premium or discount might help. For overcapitalised companies with expensive shares, a special dividend is a reasonable alternative.

Look at the net amount of shares bought back and account for the dilutive effect of options. A rough and ready way to do this is to keep track of the change in the number of shares outstanding. Mauboussin splits stock repurchase programmes into three distinct classes. In order of preference:

• The intrinsic value school - executives distinguish between under and overvalued. Their buybacks provide a useful signal to investors

• The fair value school - steady and consistent buybacks

• The impure motives school - using buybacks to inflate EPS, offset dilution, or to lift the return on equity

Conclusion

• Capital allocation is changing

• Shareholder yield captures more information than dividend yield

• But it is harder to track

As the saying goes, “When the facts change, I change my mind. What do you do, sir?”

The way in which executives distribute cash to shareholders is evolving. Dividends are less popular and share buybacks are winning ground. This has important implications, such as lowering the comparability of indices on a dividend yield basis over longer time frames.

It might be more instructive to look not just at dividend payments, but at the total amount of capital returned to shareholders. The shareholder yield accounts for dividends and buybacks. The trouble is, we lack visibility and solid data regarding the latter. This makes the shareholder yield more of a pain to calculate.

That aside, the fact remains that stock repurchases are an increasingly popular tool for companies to use. Getting to grips with them can only help.