Buybacks Aren't Doing Much For Shareholders Right Now

"If everyone is doing (buybacks), there must be something wrong with them." 

- Henry Singleton, former Teledyne CEO (profiled in The Outsiders)

With the exception of 2009, gross buybacks have outpaced dividends paid by U.S. companies each year since 1997. As such, it's absolutely critical that investors -- even dividend investors -- take buybacks into consideration when evaluating companies.

But as Michael Mauboussin points out in a recent study on capital allocation, unlike dividends, which treat all shareholders equally:

In a buyback, selling shareholders benefit at the expense of ongoing shareholders if the stock is overvalued, and ongoing shareholders benefit at the expense of selling shareholders if the stock is undervalued. All shareholders are treated uniformly only if the stock price is at fair value.

In other words, when a company repurchases its shares at a discount to fair value, it's a good use of shareholder capital and ongoing shareholders make out quite well. However, relatively few management teams consistently buyback stock at opportunistic prices.

Indeed, the number of S&P 500 companies repurchasing shares and the amount spent on buybacks tends to follow the market.

While there are undoubtedly some companies making smart and opportunistic buyback decisions today, when the majority of companies are also buying back stock, it's not likely that companies on average are adding much long-term shareholder value with share repurchases.

Jim Chanos, in an interview with Barry Ritholtz, echoed these sentiments:

And when corporations embarked on massive buybacks across all industries and all companies, in effect these CEOs are buying the stock market. So what they’re telling you then, is unequivocally that they think that either they’re happy to earn the stock market rate of return or maybe something hopefully better. Or their rate of return on the margin of any new capital project is much much lower, in fact half or less of what is stated. And that does not bode well for the future of profits, or for the quality of earnings reported as current profits.

Any investor can earn the market rate of return on their own using low-cost index funds. We certainly don't need companies doing it on our behalf. If companies can't find projects (including their own stocks) that generate long-term value, that cash should be returned to shareholders via dividends. Let the shareholders decide how to reinvest the cash as they see fit.

Let me know what you think in the comments below or on Twitter @toddwenning

Stay patient, stay focused.

Best,

Todd

Where to Find Differentiated Dividend Ideas

Most dividend strategies focus on larger firms with good balance sheets and a long track record of making uninterrupted and rising dividend payouts.

Assuming you pay good-to-fair prices for stocks that fit these criteria, you can most certainly build a solid income-producing portfolio. The problem is that such companies -- the “aristocrats” or “achievers” as they’re often called -- are a relatively scarce asset.

Think about it -- a teenager might be able to build the next great app or social media platform, but it will likely take decades of success before that company is able to generate consistent free cash flow. The Pfizers, Kimberly-Clarks, and Diageos of the world were not built overnight. 

Thousands of companies are listed on the U.S. market, but only 54 companies are included in the S&P 500 Dividend Aristocrats (25+ years of consecutive dividend increases), 85 companies are held in the broader SPDR S&P Dividend ETF (25+ years of consecutive dividend increases), and 212 are held in the PowerShares Dividend Achievers ETF (10+ years of consecutive dividend increases).

A scarce asset indeed.

Given the limited supply of such companies and the added interest in higher-yielding stocks over the last three years, finding values in this space has been understandably difficult.

So if you’re looking for new dividend ideas in today’s market, or in any market for that matter, don’t forget to search for companies in these four areas, which typically don’t show up in common dividend screens.

1. Firms that have cut their dividend

I realize this is borderline heresy in the income investing world and I’ve generally guided against investing in firms that have cut their dividend payout within the last five years, but it’s worth investigating each cut on a case-by-case basis.

Why did the company cut its payout? If it was one of the 1,000+ U.S.-listed companies that cut their dividend during the financial crisis, for example, there may have been a genuine concern for liquidity following an ill-timed acquisition or investment made in 2007 or 2008 that leveraged the balance sheet at the wrong time. In other words, the decision may not have been based on the board’s long-term outlook but on a short-term concern.

Dow Chemical and General Electric, for example, have more than doubled their payouts post-dividend cut, and though they have yet to fully rebound to pre-cut levels, investors who bought after the cut certainly aren't complaining today.

While most dividend cuts come after a sustained period of poor operating performance, some firms slash their payouts ahead of poor operating performance or if there's a need to retain cash for reinvestment needs. 

In fact, a 2007 study by Bulan, Subramanian, and Tanlu found:

A significant number of dividend omissions are actually good news, signaling a turnaround in the fortunes of the omitting firms after a period of poor performance...we find that good omitters have stronger fundamentals at the time of omission - they have higher profitability and lower levels of debt overhang.

Of course you want to avoid owning a stock prior to a dividend cut, but once the deed is done, there's no harm in having a look. The key is to determine whether or not the underlying business remains solid (i.e. does it have a moat?) and if the lower dividend payouts can actually improve the business's fortunes.

2. Firms that are in the final stages of a deleveraging process

An indebted company that’s currently in a deleveraging process may not pass dividend screens that have low-debt requirements. If the company is generating large amounts of free cash flow, however, it may reallocate that free cash toward dividend growth once the deleveraging process is complete. 

When considering a dividend-paying stock with above-average debt, have a look through the company’s recent filings, conference call transcripts, and presentations to determine if it’s aggressively reducing debt at the moment. If the company is struggling to pay down debt, pass on the idea, but if it is paying down debt and approaching its target leverage ratios, it may be primed for dividend growth in the near future.

3. Small caps

A good number of dividend strategies prefer larger stocks due to their perceived safety (i.e. more financial resources and lower chance of going bust) and avoid smaller cap firms when searching for ideas. While I wouldn’t advocate a dividend portfolio consisting solely of small caps, there are plenty of smaller firms with good competitive positions, solid balance sheets, and a distinguished dividend track record that I would consider just as steady as large firms. Plus, small caps often have longer growth runways than their larger peers. As such, they shouldn’t be overlooked.

4. Spin-offs

Screens that require a long dividend history won’t pick up recent spin-offs, yet these can be great opportunities -- not just on a dividend basis, but also on a value basis as they tend to have less initial analyst coverage and institutional interest. 

These firms also tend to be in good financial health. As Peter Lynch wrote in One Up on Wall Street:

“Large parent companies do not want to spin off divisions and then see those spinoffs get in trouble, because that would bring embarrassing publicity that would reflect back on the parents. Therefore, the spinoffs normally have strong balance sheets and are well prepared to succeed as independent entities.”  

Lists of upcoming and recent spin-offs are easily found online (here’s one). Not all spin-offs make for good dividend holdings, so I suggest focusing on the parent’s dividend record and philosophy, the composition of the new board (are they from the parent company?), and the new company’s recent free cash flow history.

To illustrate, when Philip Morris International was spun-off of Altria in early 2008, it began trading with a dividend yield near 4% and has since more than doubled its payout. With hindsight it's easy to see that PMI was an attractive idea, of course, but it didn’t take a great leap in logic at the time of the spin-off to conclude that despite the new company’s lack of dividend history that it would likely follow its parent’s philosophy about raising dividends (Altria has increased its dividend 47 times in the last 44 years).

Bottom line

The secret is out about high quality large caps with long dividend track records and there simply aren't enough of them to buy at good prices today. If you want differentiated dividend ideas and want to achieve differentiated results, don't forget to comb these four areas of the market.

Good reads this week

• Building an Effective Team - Michael Mauboussin & Dan Callahan
• Lake Wobegon Investing - Total Return Investor
• It's Time for a New Dividend Strategy - WSJ
• Getting Lucky - Howard Marks
• Beat Fund Managers by Cloning Their Best Ideas - Stockopedia

Quote of the week

"We aim above the mark to hit the mark." - Emerson

Best,

Todd
@toddwenning on Twitter

10 Investing Lessons Learned

Ten years ago this week, I started my first job in the investment industry and it seemed a fairly decent occasion to reflect upon some of the key principles I've learned thus far in my career. 

1. Patience is paramount. Having worked with a number of ultra-high net worth individuals, I learned that the common theme in their portfolios was patience. Not a single one was on the phone with us multiple times a day placing trades. Sure, the clients had questions about their holdings now and then, but they stuck to the agreed-upon strategies and were letting time do the work. In some cases, they still held onto shares of companies that their grandparents had bought half a century earlier and were simply letting the dividends roll in year after year.
   
   
2. Always consider incentives. Investors typically spend the majority of their research time investigating the company's income statement, balance sheet, and cash flow statement. While the information on these statements is obviously important, I've found that far less time is spent researching executive incentives and pay packages, which can be found in the annual proxy statement (14A) in the U.S. (In some markets, this information can be found in the annual report.) Unlike the historical financial statements tell you what's already happened, reviewing management's incentives can help you understand how management will steer the company going forward.
   
   
3. You need to have a good information filter. With so much financial information available today, it's essential to know what's important and what isn't. This comes with experience, but a good rule-of-thumb is to focus on information pertinent to a company's competitive positioning within the industry.
   
   
4. The best investments you make are usually the ones where your get the most criticism. With investing, it rarely pays to be on the side of the cheerleaders. Indeed, some of the best investments I've made received initial criticism -- and the more passionate the criticism, the better; conversely, when I hear someone say "good call" about a recent investment, I start to wonder if I missed something important. Being able to stand alone in your convictions is a key ingredient to successful long-term investing.
   
   
5. There’s no substitute for dividends. Despite the recent enthusiasm for "total yield" and similar measures that lump in buybacks and debt repayments with dividends, the bottom line is that only dividends put cash in shareholders' pockets today. None of the aforementioned successful investors that I worked with talked about how they were "living off their buybacks" and none of them manufactured their own dividends by selling partial stakes every quarter. That works in theory, but less so in practice.
   
   
6. Process matters more than short-term results. Whether you're evaluating a mutual fund manager or reviewing your own strategies, short-term returns are largely a matter of luck rather than skill. Instead, focus on the investment selection process, as over time the process will have a more meaningful impact on returns. If you're going to review performance, pay closer attention to five-year returns as that's typically enough time to reveal the success of an investment strategy. Legendary investor Philip Fisher asked his clients for three years before they judged his results. Whichever time frame you prefer, the point is to not focus on quarter-to-quarter or even year-to-year results as a measure of investor skill.
   

   
   
7. Keep costs to a minimum. The more capital you have to compound, the better. Some trading costs are unavoidable, but the key is to keep them to a minimum. A good rule-of-thumb is to keep commissions below 2% of each investment (e.g. invest more than $500 at a time if commissions are $10) -- and ideally much less. It's also smart to practice good capital location to keep a lid on tax costs -- i.e. to the extent possible, keep dividend paying stocks in tax-advantaged accounts like IRAs and your non-dividend paying stocks in taxable accounts.
   
   
8. Actively seek feedback. Investing without feedback can slow your learning process, create or enable biases, and increase the odds of permanent losses as you're more likely to commit avoidable mistakes. If you can, find a trusted investing partner to run your ideas by -- and ideally one that isn't afraid to be critical and provide feedback. Even if you're confident in your abilities as an investor and think you can go it alone, consider the Warren Buffett/Charlie Munger partnership -- even the most capable investors of our time value the benefits of an investing partnership.
   
   
9. Keep good records. A common denominator among the investors I admire is they meticulously keep track of each investment's thesis and their progress using spreadsheets and/or notebooks. The purpose of this exercise is to reduce biases that may skew your memory of why you bought the stock in the first place. Similarly, it can help you understand when the time is right to sell the stock.
   
   
10. Read, think, and teach. Another common denominator among great investors is that they're bookworms. Sure, devour as many annual reports, investing books, and shareholder letters as you can, but you can also get valuable perspective from non-finance books. The Tao Te Ching, for example, provides some great insight about the value of patience. As you improve your knowledge base, don't forget that investing isn't an easy topic and there are many people seeking reliable answers. When its prudent -- and you know the answer -- don't shy away from opportunities to teach and help others become better investors. As the Roman philosopher Seneca said, "Welcome those whom you yourself can improve. The process is mutual; for men learn while they teach."

If you have any lessons to share from your investing experience, I'd like to hear them! Please share them in the comments section below or on Twitter @toddwenning. 

Best,

Todd

@toddwenning on Twitter

Is Total Yield a Contrarian Indicator?

A high dividend yield has long been a useful metric for value-minded investors. Since stock prices and dividend yields have an inverse relationship, all else equal, a high dividend yield can mean a depressed share price and represent a good buying opportunity. 

The following chart showing the S&P 500's quarterly value and dividend yield illustrates this relationship:

Source: Standard & Poors (through 3/31/2013)

Indeed, the correlation between the two data sets is -53.3%. Even with the significant dividend cuts during the financial crisis, dividend yield has remained a useful buying metric over this period.

What about buybacks?

Given the rise in buyback activity in recent decades, however, some in the investing community have suggested that we reduce the emphasis on dividend yield and focus more on a "total" or "adjusted" yield that also considers buybacks.

Using the same S&P data, here's how quarterly buyback yield alone compares to the S&P 500 quarterly market value:

Source: Standard & Poors

As you can see, buyback yield has a much more positive correlation with equity values -- +60.4% by my calculation for this period. In other words, as stock prices have gone up, buyback yields have generally risen, too.

Even when we combine dividends and buybacks to come up with a "total" or "adjusted" yield, the relationship is still positive:

Source: Standard & Poors

The correlation in this case was 45.8% -- reduced a bit by the dividend yield, but still very much a positive relationship.

If anything, then, a higher total yield tends to suggest an over-valued market rather than the other way around.

Granted, this is a relatively small sample size of a few dozen quarters. Perhaps over the course of a few decades companies will begin to repurchase more of their stock when prices are depressed and make total yield more of a helpful indicator. Well...here's to hoping at least.

Bottom line

Though I'm certainly not against buybacks and think they should be included in any equity research process, investors should be skeptical about using a high total or adjusted yield as a buying signal.

Other good reads this week

• From the vault: Michael Mauboussin on measuring moats. (Very helpful tools for your research process)
• Abnormal Returns: There is No Such Thing as Emotionless Investing
• Reformed Broker: The World According to Investors

Quote of the week

It is our belief that shareholders should demand of their managements either a normal payout of earnings -- on the order of, say, two-thirds -- or else a clear-cut demonstration that the reinvested profits have produced a satisfactory increase in per-share earnings. ~Benjamin Graham, The Intelligent Investor (ch. 19)

Have a great weekend!

Best,

Todd
@toddwenning on Twitter

Can a Total Shareholder Yield ETF Work?

A rare mid-week post, but earlier today I read an interesting article on Forbes about the Cambria Shareholder Yield ETF (SYLD), which was based on an interview with the Cambria CIO. So I decided to dig into the story a little this evening.

The SYLD ETF is slightly different from the growing number of dividend ETFs on the market today in that it doesn't focus solely on dividends, but also includes buybacks and debt reduction in its algorithm. From the Cambria site:

The Cambria Shareholder Yield ETF is an actively managed fund that employs the manager's quantitative algorithm to select U.S. listed companies that show strong characteristics in returning free cash flow to their shareholders. Specifically, SYLD invests in 100 stocks with market caps greater than $200 million that rank among the highest in (a) paying cash dividends, (b) engaging in net share repurchases, and (c) paying down debt on their balance sheets.

It's a novel approach for sure and investors should certainly pay attention to buybacks and debt when analyzing individual companies. (I particularly liked the CIO's mention in the Forbes article about watching out for high-yielding stocks that are also increasing their share count. A good tip!)

Though I give Cambria credit for trying something different, after reading the SYLD ETF's prospectus, I'm not sure it will work as an ETF or formula-based strategy.

As we discussed in an earlier post, though buybacks are becoming a larger part of corporate distributions, I don't think a "total yield" measure can replace dividend yield.

Source: Birinyi Associates and FRB Z.1.

The obvious reason is that buybacks remain a choice rather than a commitment. In a given year or two, a company could dramatically pull back on buybacks and the "total yield" shrivels up. (It's true that a company could also cut its dividend, but this would be much harder to do given different shareholder expectations.)

To Cambria's credit, they are looking to invest in companies with a systematic approach to buybacks, but this puts enormous faith in management's ability to have a good buyback process. How Cambria measures this in its security selection algorithm is not disclosed, but it seems to be a challenging task using a strictly quantitative process.

As we've seen, many companies end up buying back stock when they have excess cash...which also tends to be when their share price is higher. In my experience, I've come across very few companies with a rational and disciplined approach to buybacks.

I'm also not clear on why debt reduction should be considered part of "shareholder yield." At face value, less debt on a balance sheet seems desirable, but it's also possible for companies to be underlevered. In this case, companies should take on more debt to reduce their overall cost of capital. Further, and more to the point, the cash return is to bondholders and not shareholders.

Perhaps the answer to the net debt reduction question lies in the prospectus, which notes that the measure of dividends, net buybacks, and net debt reduction cash flows:

"in isolation, is inadequate to determine the attractiveness of its equity securities, considered together these measures have the potential to result in the construction of a portfolio of companies with better cash flows, stronger growth potential and higher yield characteristics. Considering these measures together, which comprise shareholder yield, may result in a more attractive investment portfolio." (My emphasis)

If I were considering SYLD I would ask whether or not net debt reduction was simply a "plug" figure in the formula that made the algorithm look more predictive than dividends and net buybacks alone. Best case is the ETF is looking for firms that can return cash via dividends and buybacks without borrowing, but if that's the case, it should be more explicit in the prospectus.

I realize I've been critical of most of the new ETFs out there, but I also think it's important to look behind the alluring stories in the ETF launch material. Ultimately, I remain convinced that investors are best served building their own dividend-focused portfolio one stock at a time with thorough research.

I'm interested to hear what you think, so please let me know in the comments below or on Twitter @toddwenning.

Best,

Todd

Should We Do Away With Dividend Yield?

We may not like it, but buybacks are here to stay. Management teams prefer buybacks for a number of reasons, even though those reasons may not always be in the best interests of their shareholders.

So ingrained are buybacks in today's market that some have called for an end to the classic definition of dividend yield (dividends per share / share price) to be replaced with a "modified" or "total" yield that includes buybacks ( (dividends + buybacks per share) / share price). 

Indeed, Standard & Poors now includes a "dividend & buyback yield" column in its quarterly update on S&P 500 distributions. Ready or not, it's becoming a more commonly-used metric.

The game has changed...

The total yield approach is somewhat instructive as it helps explain a number of things that we've seen in the 30 years since Congress (via rule 10b-18) allowed companies to make greater use of buybacks. 

The major thing total yield helps explain is why dividend yields over the past 30 years remain well-off historical averages. The chart below shows the dividend yield of the S&P 500 between 1960 and 2011 and compares it with the total yield of all U.S. companies since 1985 when buybacks started becoming a meaningful way of returning shareholder cash. 

Source: S&P (via Aswath Damodaran) and Birinyi Associates and FRB Z.1. (via Michael Mauboussin) 

Recognizing there's only a slight difference between the 1960-2011 and 1985-2011 data, the major difference between the red and blue lines is buyback yield. Put in this perspective, the decline in dividend yield can be rationalized as a paradigm shift toward alternative ways of returning shareholder cash.

In fact, it shows that companies have become even more generous with distributions than in the past. 

(Don't break out the party hats just yet...)

The next chart provides more granularity for the total yield period and shows the rise of buybacks as the primary means of returning shareholder cash between 1985 and 2011.

Source: Birinyi Associates and FRB Z.1.  

As you can see from these two charts, buybacks have only recently become a truly driving force in the total yield equation. Until 2004, dividends had accounted for the majority of distributions -- even during the dotcom boom.

Predictably, the buyback trend since 2004 has largely followed the market. When the market has been good and companies feel flush, buybacks have increased, and vice versa. Curiously -- and sadly -- as Michael Mauboussin points out here, M&A activity has generally followed this path, as well:

Indeed, M&A and buybacks follow the economic cycle: Activity increases when the stock market is up and decreases when the market is down. This is the exact opposite pattern you’d expect if management’s primary goal is to build value.  (His emphasis)

One shining example of this principle in action has been Hewlett-Packard, which repurchased $36 billion of its stock between 2008 and 2011.

Its current market cap is $28 billion.

Long-term HPQ shareholders certainly don't feel any richer despite the $36 billion buybacks that should have been used to enhance shareholder value -- or in part distributed to shareholders as special cash dividends. Worse, most of the buybacks were fueled by borrowings and HPQ's debt/equity ratio increased from 13% in 2007 to 76% in the most recent quarter.

...but common sense remains common sense

There are companies that make prudent use of buybacks and no, I'm not completely opposed to them; however, general market data shows that, on average, buybacks are value destructive.

For this reason alone, I cannot accept the idea that we should do away with dividend yield and replace it with a total yield metric that includes buybacks. The two types of returning shareholder cash are simply not apples-to-apples. 

The total yield metric is certainly instructive, but given the differences between dividends and buybacks and the track record of companies destroying value using buybacks, it's critical to keep dividend yield and buyback yield separate.

Hope you're having a great weekend! Thanks for reading.

Best,

Todd

Should More Companies Adopt Flexible Dividend Policies?

In the U.S. and U.K. markets, the most common form of dividend policy is one that aims to pay at least the same amount year after year, regardless of the company's performance that year. I'll call this the "consistent" dividend policy.

In such a system, a dividend increase is typically seen as a positive thing -- a sign that the company expects profitability to improve in coming years. Conversely, a dividend cut is usually a negative -- a sign that the company has run into trouble and needs to shore up cash.

Indeed, a number of companies have run into trouble desperately trying to maintain the historical dividend level -- borrowing, selling assets, etc. -- when the logical thing to do would have been to reduce the dividend payout until things got better.

An alternative approach is the "flexible" payout policy in which a company establishes that it will pay a certain percentage of earnings or free cash flow each year. The payout amount could fluctuate up and down, but it relieves the company of having to worry about maintaining a certain payout each year.

I see benefits and drawbacks to both approaches. In the end, I think it depends on the nature of the company's business and the precedent that it has set with shareholders.

U.K.-based Rotork, for example, operates in a cyclical industry and smartly implements a flexible dividend policy that incorporates a "core" dividend that grows in line with earnings plus an "additional" dividend in particularly good years. If the company runs into a bad year, the total payout may be lower than the previous year, but shareholders will likely be more accepting of that since the policy has been clearly communicated and consistent.

On the other hand, Procter & Gamble (a stock I own) operates in a more defensive industry and has paid an increasing dividend for 56 years. As such, its shareholders expect a consistent (and rising!) payout each year. A lower dividend would be disastrous signal.

All that said, many large companies with consistent dividend policies also practice flexible distribution policies -- it's just that they substitute buybacks for cash dividends to bridge the gap. In other words, they maintain a consistent dividend policy and adjust to the business climate using buybacks.

As the chart below shows, since 1999 the modified payout (dividends + buybacks) has fluctuated quite a bit, but the median modified payout has been about 82%.

Source: Standard & Poors

U.S. companies are paying out most of their earnings over the business cycle, just not with dividends -- the median dividend payout ratio over the period is 35% with the balance going to buybacks.

If anything, then, investors who prefer a flexible dividend policy should be demanding that companies use a greater percentage of actual dividends in their distribution policies (i.e. a normal + special dividend policy). I think there's a good case for that.

What's your take? Have a suggestion for future posts? Please post your comments below.

Have a great weekend.

Best,

Todd
@toddwenning on Twitter