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Would You Prefer Your Favorite Company To Buy Back Stock or Pay A Dividend?

12 January 2009 3 Comments

The companies you invest in generate profits (hopefully).  What management and the board of directors of these companies do with the excess cash after reinvesting in operations should be a large determining factor when choosing companies to invest in.  In this article, I will contrast two strategies: the share buyback and paying dividends.  Which is better for the company and which is better for the investor?

Many investors consider both options of paying dividends and buying back shares of the stock as two ways to return value to shareholders.  After all dividends are straight cash payments to investors and buying back shares reduces the number of outstanding shares which should allow shares to go up in value, right?

The Problems With Buying Back Shares

First the main problem with buying back shares of stock is the potential of a badly timed buyback.  For the last year or two, “experts” have been hounding Apple to buy back shares with all the cash they have been sitting on.  If they had done this, it would have undoubtedly been a terrible investment as Apple’s share price is now below $100.  Apple did not buy back any stock, the stock price fell and they were left with a tremendous amount of cash which is very nice during a credit crunch.  More on Apple later.

Even more concerning are the companies that actually borrowed money to buy back stock.  There are several companies that borrowed money to buy back shares of their stock when the business was doing great.  Now, when the businesses are doing poorly, the shares they bought back are much lower and they still have the debt loads from the transaction.  Terrible decisions.  Macy’s and Home Depot are two companies that borrowed to buy back stock at a higher price than current levels.

Another interesting argument regarding share buyback programs are the connection with executive compensation.  Many argue that boards of directors often buy back stock to balance out stock options that are exercised by executives.  By buying back shares, they prevent the stock from becoming diluted.  If true, this would fall under the category of executive pay and not shareholder value.

You Can’t Go Wrong With Dividends

After going through the problems with buyback programs, you can see that I clearly favor dividends over buying back shares.  Cash returned to me is mine.  I can decide how to invest it.  High dividend yields are crucial in a good portion of your investments.  Even if the market is flat in coming years, you will earn a return from dividends.

Back to Apple… With approximately $25 billion in cash and generating a billion or so in cash each quarter, I wish Apple would start a dividend program.  Returning cash to shareholders would be a fantastic announcement that would truly provide some encouragement and confidence in Apple’s management that the shareholders are their priority.  Even a small yield would be encouraging.

Like many tech stocks, Apple pays no dividend.  Because of this, I would recommend not buying tech stocks like Apple during bull markets.  Bull markets tend to expand P/E multiples of stocks especially hyped, tech stocks.  Shooting for only capital appreciation is risky and especially risky during bull markets.  If you want some tech exposure, perhaps Apple exposure, buy the stock during bear markets.  Perhaps, now is a good time to consider.

Apple’s shares are way down from peaking over $200.  Even more interesting is the fact that the business is arguably more healthy now than it was when the stock was over $200.  Sure the consumer concerns are valid, but I wonder how priced in these concerns are?  Especially as Apple continues to innovate and generate tons of cash.  Look for a coming article on Apple and my 2009 outlook for them.

My Recommendations

Build a portfolio of high yielding dividend stocks that will generate returns for you during bear and bull markets.  Stick to non-dividend paying stocks like tech stocks only during bear markets and sell them during bull markets.  Because they don’t pay a dividend, the only way for you to profit is to sell the stock.  Think about it.  To make money this way, you have no choice but to sell the stock during a bull market.  Good luck.

3 Comments »

  • The weakonomist said:

    I want my divs at a standard rate and surplus profits can be used to buy back stock.

  • doctor S said:

    I will take the dividends as well, especially during these times. Let me decide what I want to do with MY money would definitely be the way to go.