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Dividends Over Buybacks?

One of my favorite new podcasts is "Invest Like the Best" (found it a few weeks ago, so I am still catching up). The host, Patrick O'Shaughnessy, does an excellent job finding thought-provoking guests across different fields of interest. Back in February, the podcast featured Joe Mansueto, the founder and longtime CEO of Morningstar ( MORN ).

During the interview,O'Shaughnessy askedMansueto about his thoughts on dividends and share repurchases. His response, posted below, is what I would like to discuss in this article.

O'Shaughnessy followed up with a reasonable question: Given the logic presented for share repurchases, why do you think dividends are so prevalent at public companies? Here wasMansueto 's response:

I think this conclusion is spot on. Simply put, dividends are the safe choice when returning capital to shareholders. Unlike share repurchases, where you may be forced to defend your decision, nobody really questions dividends. For most individual investors, it seems safe to assume their preference is for dividends over share repurchases. Why?

Assuming a company repurchases shares at fair value, the overall value of your investment is identical in each scenario (the per-share value rises by an identical amount as the dividend payment). The only difference, asMansueto noted, is paying a dividend forces the individual investor to incur a taxable event. Why do so many prefer this less attractive option?

I think one of the main reasons is because dividends are "real." It is cash in your bank account that is no longer in the hands of the company. If the stock does not go anywhere - or even worse, down - you still have the dividends. As the saying goes, you are "paid to wait."

Share repurchases, on the other hand, can feel less real. The company does not cut you a check, and you own the same number of shares as you did the day before. The per share value is higher, but here is the problem: intrinsic value is a "fluffy" number. The dollar in your pocket is certain; the incremental increase in intrinsic value, on the other hand, is not necessarily reflected in the stock price. While intrinsic value is what matters over time, short-term swings in the market are a meaningful event for most investors. A small increase in intrinsic value offers little comfort to the individual investor when stock prices are moving lower and they are losing money.

This discomfort with repurchases is exacerbated by a generally poor track record for corporate America. Most companies seem to follow a straightforward approach to buybacks: the funds for repurchases should be based on what you have left over after paying dividends. Importantly, the dividend payout is usually based on a percentage of normalized earnings. In the good years, when earnings power is outsized, that means the capacity to repurchase shares is higher; unsurprisingly, the good years tend to come with higher stock prices. The outcome is outsized repurchases at higher prices with limited funds for buybacks when stock prices are truly depressed. In defense of these managers, the urge to quickly spend any available resources to "increase shareholder value" has likely been exacerbated by the rise of activist investors.

We can see a clear pattern when we look at the repurchase record for S&P 500 companies:

My sense is the average corporate executive views this as an acceptable outcome. In some cases, they have apparently convinced themselves all this activity does not matter anyways. We are talking about major companies like Coca-Cola ( KO ), where the former CFO said the following:

Misunderstandings about share repurchases apparently extend to the C-suite as well.


William Thorndike's book "The Outsiders" discusses how the repurchase strategy of outlier CEOs differ from the average:

I will not hold my breath for meaningful change. The major takeaway is that "suction hose" repurchases are quite rare. When you find a company with a CEO (and board of directors) that understands the importance of capital allocation decisions, keep them in your sights.

Disclosure: None.

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This article first appeared on GuruFocus .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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