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Thursday, May 8, 2014 - 15:30
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Dividend Hikes Or Stock Buybacks: Which Benefit You More?

Thursday, May 8, 2014 - 3:30pm

We are truly in the golden age of cash flow.

Corporate profit margins have been so strong in recent years that companies have been pulling in large sums of cash every quarter. In the first few years after the economic crisis of 2008, companies sought to hoard their cash, but starting around 2010, growing share buybacks and rising dividends became the name of the game.

Companies now dole out almost as much as they take in, leaving cash balances fairly static. That's fine: Companies are well-cushioned against the next (and inevitable) economic downturn. And with cash flow continuing to pour in as margins remain near peak levels, look for more dividend hikes and fresh buyback announcements.

About the only thing that could derail the buyback-and-dividend freight train would be an increase in acquisitions -- but most companies are continuing to eschew acquisitions and the risks they entail.

In the context of solid dividends and buybacks, it's fair to ask: Is it better to own a company that produces solid and predictable dividends, or one that plans on buying back stock? Let's take a look at the pros and cons of each scenario, starting with dividends.

Scenario 1: The Company Begins Issuing Dividends​

The appeal of dividends lies in the production of income that investors receive. In a world of certificates of deposit (CDs) and government bonds that yield just 1% or 2%, dividend-paying stocks that can pay a 3%, 5% or even 7% yield are highly appreciated.

And many investors think that a robust dividend forces discipline on a company, making management focus on maintaining a steady cash flow that's returned to shareholders rather than using that cash for riskier moves -- like acquisitions -- that may not pay off.

The downside of dividends: double taxation. Unless you own the stock in a tax-favored retirement account, you'll pay the capital gains tax rate on those dividends. That's after companies have already paid their share of taxes on profits (unless they are real estate investment trusts (REITs) of master limited partnerships (MLPs) which allow for a "pass-through" of profits).​

Scenario 2: The Company Buys Back Its Own Stock​

Because dividend payouts can trigger unwanted taxes for an investor, many prefer to see the company announce share buybacks. When a company buys back stock, it reduces the number of shares outstanding, which boosts earnings per share (earnings divided by shares outstanding).

For example, company ABC earns $100. If there are 10 shares outstanding, the company's earnings per share is $10 ($100/10 shares = $10/share). But if company ABC buys back six shares, leaving only four shares outstanding, earnings per share suddenly increases to $25 ($100/4 shares = $25/share).

Even though the amount of money company ABC earned is still the same, the earnings per share (EPS) more than doubled, just from reducing the number of shares outstanding. As you can see, when companies buy back stock, it increases each share's value. Sometimes the increased share value attracts new investors, further driving up prices.​

Yet stock buybacks have one glaring flaw: Companies sometimes buy back their stock at the wrong time -- usually when they thought their share prices were undervalued. Telecom equipment company Nokia (NYSE: NOK) surely regrets spending more than $2.5 billion in 2007 to acquire more than 100 million shares of its stock, only to find that its stock would go on to plunge in value. Spending the same amount today would have retired more than 300 million shares.

But there's another potential risk that shareholders should know about company buybacks: Many buybacks are really just covering up overly generous stock option grants to executives and don't actually boost EPS.

As I noted back in December in a look at which buyback programs had real teeth, regional bank KeyCorp (NYSE: KEY), announced buybacks that equated nearly 5% of shares outstanding. But the share count barely budged, meaning most of that $800 million went toward enriching executives, not shareholders.

Such companies counter that their share counts would have swelled far higher if the buybacks hadn't been enacted, but that's a pretty lame excuse.

So Are Buybacks Or Dividends Better?
In recent years, the buyback approach has been more profitable. Companies buying back stock tend to see a share price appreciation that is greater than yield delivered by dividends. As an example, PowerShares Buyback Achievers ETF (NYSE: PKW), which focused on companies in the midst of buybacks, has outperformed the S&P 500 by 50 percentage points over the past five years. You would have had to garner an 8.5% annual dividend from your portfolio to attain a similar return.

Still, it's fair wonder if buybacks still hold appeal, now that the stock market (and most stocks) are far higher than they were five years ago. Higher share prices suggest that companies are getting less bang for their buck, and a pivot towards dividends would be prudent. We're likely to see such a shift when interest rates rise and companies feel pressure to deliver yields that stay ahead of fixed-income instruments such as bonds and CDs.

And as noted earlier, not all buyback programs hold equal appeal. You should be sure to monitor whether the share count is truly falling from quarter to quarter once buybacks are announced. Not only might these buyback programs be in place merely to offset stock option grants, but they may not even be pursued at all. Some companies say they "may buy up to" a certain amount of stock but never actually bother.

Risks to Consider: Buybacks and dividends can mask the fact that management lacks creative uses for its cash that can expand sales and profits.

Action to Take --> The charm of dividends is that they can't be fudged. Unlike buybacks, a dividend promised is a dividend delivered. Still, in this low interest-rate environment, shareholders will glean better rewards from buyback plans. For a look at my current favorite buyback plays, check out this recent article.

P.S. Hands down, it's the single best way to beat the market with dividend stocks. After months of research, my colleague Nathan Slaughter has proven that investing in a special group of dividend stocks that pay two hidden, "extra" payments to their shareholders is key to maximizing returns and minimizing risk. Since 1982, these dividend payers returned an average of 15% per year. Last year, this group of stocks more than doubled the S&P 500's return. For 2014, he's targeted a handful of these dividend stocks that he expects to do well in his latest report, "The Top 5 Total Yield Stocks For 2014." You can get all the details in this free presentation. 

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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