Dividends are psychologically more robust than buybacks

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Lucky C
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Dividends are psychologically more robust than buybacks

Post by Lucky C » Thu Apr 04, 2019 12:51 pm

Some people prefer buybacks to dividends, especially if they would have been taxed by dividends that they would have used to buy more of the same stock. Meb Faber for example argues that a buyback yield of X% is just as good (if not better) than a dividend yield of X%.

On the other hand, dividends are seen as entitlements whereas buybacks may be seen as more of a windfall. If a company that has paid a steady dividend suddenly slashes it, it causes investors more pain than when a company has bought back shares previously but then decides to cut back on buybacks. See the Loss Aversion chapters from Thinking Fast and Slow. Our loss averse nature makes us feel the pain of lost income more strongly than missing out on an expected bonus, even if the dollar amounts are the same in each scenario. So a company that wants to keep its investors happy would want to avoid cutting dividends as much as possible whereas a company buying back shares should feel more free to stop buying them back.

Then when it comes to price movements, big movements downward generate more pain than the joy generated by big movements upward. The negative feedback loop of loss aversion brings prices down more rapidly than when they're going up. Although prices may tank once in a while, if the dividend-yielding company is doing alright in the long term, your entitled dividends should hold steady, if not increase. You don't have to worry about selling the right amount of shares at the right time like you do with a stock that has only buyback yield.

So while I used to think buybacks could be preferable to dividends due to tax treatment, now I'd much prefer the robustness of dividends for early retirement.

George the original one
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Re: Dividends are psychologically more robust than buybacks

Post by George the original one » Thu Apr 04, 2019 1:00 pm

You've skipped the studies that show buybacks usually occur when the stock is priced high, thus the company is intentionally burning capital only when the company is flush with cash. Rarely do companies engage in a buyback when it would beneficially prop up a sagging share price.

With a dividend, shareholders have more control of how that excess cash is used.

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Re: Dividends are psychologically more robust than buybacks

Post by jacob » Thu Apr 04, 2019 1:01 pm

With the exception of BRK, what annoys me most about buybacks is that corporations always do them at the wrong time when the price is at its highest and expected ROIs are at their lowest. What seems to happen is an unintended consequence of credit-cycle lag. Debt remains cheap for too long after companies run out of capital investment projects. This leaves buybacks and mergers (e.g. trying to grow financially instead of economically) which are almost always bad (zero-sum) investments as they simply play with leverage. Then the house of cards eventually collapses.

Psychologically, I prefer dividends because it's cash in hand I and I can choose not to participate it in the stupidity. OTOH, the concept(*) of total return is part and parcel of MPT so I can see what price-insensitive investors would prefer buybacks for tax reasons. Insofar qualified dividends were taxed higher, I would likely change my opinion/preference as well.

(*) Simplifying premise.

Add: Another pernicious effect of buybacks is in gaming the EPS count. This leverages the [naive] games market cheerleaders like to play with forward earnings, i.e. not only does the buyback increase demand for the shares, they also increase EPS even as NOTHING has physically changed with the business itself.

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Dream of Freedom
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Re: Dividends are psychologically more robust than buybacks

Post by Dream of Freedom » Thu Apr 04, 2019 1:13 pm

I get a little dopamine hit each time I see a dividend rolling in. It might not be as tax efficient but it keeps me interested in investing.

IlliniDave
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Re: Dividends are psychologically more robust than buybacks

Post by IlliniDave » Thu Apr 04, 2019 2:42 pm

I'm a little skeptical of buybacks as I see them as just another trick of financial engineering. Despite buybacks overall I think the trend is still a share dilution market-wide, making me think not all the buyback goes into retiring shares but ultimately many wind up effectively passed out to corporate officers. Dividends can cause a bit of a drag in a non-retirement account, but as has been pointed out, the cash is real.

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Lillailler
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Re: Dividends are psychologically more robust than buybacks

Post by Lillailler » Fri Apr 05, 2019 8:14 am

There is an argument that a buyback shows that the management has no good ideas. In that case it is a 'sell' indicator.

Seppia
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Re: Dividends are psychologically more robust than buybacks

Post by Seppia » Fri Apr 05, 2019 9:36 am

Buybacks are obviously more tax efficient and it's not debatable, but I like dividends better because as Jacob mentions, buybacks have this weird tendency to be often deployed at the worst times, in which case I'd prefer to get some cash I can spend elsewhere
Lillailler wrote:
Fri Apr 05, 2019 8:14 am
There is an argument that a buyback shows that the management has no good ideas.
You could say the same about a dividend.

Toska2
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Re: Dividends are psychologically more robust than buybacks

Post by Toska2 » Fri Apr 05, 2019 8:00 pm

I could. I would if it was at the whim of the management. I havent heard of a stock switching dividend payout to some, zero, some on a frequent basis.

Sclass
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Re: Dividends are psychologically more robust than buybacks

Post by Sclass » Fri Apr 05, 2019 9:29 pm

I like the one that makes me more money.

Dave
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Re: Dividends are psychologically more robust than buybacks

Post by Dave » Sat Apr 06, 2019 1:13 am

Regarding dividends being psychologically robust than dividends, this is more relevant to price insensitive investors and/or investors who are investing in style-box buckets like “High Dividend Yield” that are maximizing a variable like reliability of dividend cash flow over total value maximization.

I say it’s more relevant to these sorts of investors, because a price sensitive investor’s view on share buybacks is more nuanced: if the company has excess capital and the current share price represents a discount to its intrinsic value such that the buyback offers 1) the best rate of return of available projects/uses of capital and 2) a sufficiently high absolute rate of return, i.e. over their internal hurdle rate, then buybacks make lots of sense over dividends.

In other words, you simply cannot ignore the price at which a buyback occurs (or a company’s other available uses of capital) in evaluating their efficacy. Buybacks below intrinsic value add value to remaining shareholders, and buybacks above intrinsic value destroy value to remaining shareholders. Additionally, buybacks add value to exiting shareholders, too, since the firm is providing demand/liquidity for the shares.

Now, as others said above, corporations as a group have a poor record of executing buybacks at value-adding prices. Many companies appear to be price insensitive (or worse as the folks above mentioned, price counter-sensitive, hah) and just routinely buy back shares in set amounts, at times as an offset to the stock comp dilution. However, this is not the case for all companies. Some companies do not just go out and buy back shares evenly, all the time, but they actually wait until their shares are cheap and do massive repurchases. See Alliance Data Systems (ADS), Autozone (AZO), and Autonation (AN) as examples of companies that have successfully done this over the last decade to varying degrees of success. For these companies, I don’t think it’s a “trick” of financial engineering, but simply an efficient use of capital. To ground this in an example, why would a company pay out a $1 of dividends to a shareholder that will be taxed when they could take that dollar and buy something (their stock) worth $1.50?

That’s why I don’t even think about buybacks as a company “propping up” its stock in all cases. This idea doesn’t hold water when you take a long-term perspective, which admittedly a lot of management teams lack. If you believe fundamentals drive stock prices, then a company doing such a thing as buying its stock above intrinsic value will actually lower the share price in time. A management team that believes buybacks will prop up their stock this shows a poor understanding of financial theory, which is troubling, and I agree this does happen quite a bit. At best it increases demand for the stock in the short-term, but this won’t result in long-term elevated share prices. So the relevant question is whether the company is allocating capital to attractive investment situations. If their stock is worth $100 and they buy back shares at $75, that is a great use of capital assuming that is better than available internal projects. The fact that this props up the share price in the short-term is not meaningful to long-term investors.

I’d argue that for price-sensitive investors who hold shares in companies such as AZO and who view buybacks done at rational prices as a component of the investment thesis that buybacks are actually more psychologically robust, because a company with such a policy can take a “negative” (a share price decline) and turn it into a positive (being able to buy more shares back below intrinsic value).

For myself, I have owned shares in such companies and look at share price declines with a smile as I know the company is out there buying more shares than it would otherwise be able to pre-decline. In such a situation, I much prefer them buying back shares than paying out dividends, and it is more robust.

But, to be fair I must admit that most companies are not all-stars at repurchasing their own shares when they are cheap. But, these companies do exist, and I personally seek that trait out in management as a key attribute, as it adds another tool in the capital allocation toolkit.

I’m with Sclass – I like the one that makes me more money. And depending on the company’s internal projects available and the relationship of their share price to its intrinsic value, it could be one or the other. But I don’t think assuming that all sharebacks are bad is an accurate viewpoint. It may be accurate in the aggregate, but not all investors invest in the aggregate i.e. indexes. Some investors pick individual securities, and focus on certain types of stocks. “Cannibals” – i.e. companies that eat up their own shares outstanding – can be excellent long-term investments when the price paid for those repurchases makes sense. It basically allows companies that may not have internal need for the cash to grow per-share value at high rates of return, well beyond what the business can grow at internally and what most outside investors will earn on their own investments.

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Dream of Freedom
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Re: Dividends are psychologically more robust than buybacks

Post by Dream of Freedom » Sat Apr 06, 2019 10:27 am

Lillailler wrote:
Fri Apr 05, 2019 8:14 am
There is an argument that a buyback shows that the management has no good ideas. In that case it is a 'sell' indicator.
One can always find a way to be cynical. For instance you could say a company can't afford to pay a dividend or do a buyback because their position is precarious and they are afraid that they can't compete with less. Or in the case of an Amazon/Google because the billionaire founder wants the money for his pet sci-fi projects.
Last edited by Dream of Freedom on Sat Apr 06, 2019 11:07 am, edited 1 time in total.

Sclass
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Re: Dividends are psychologically more robust than buybacks

Post by Sclass » Sat Apr 06, 2019 10:43 am

Dave wrote:
Sat Apr 06, 2019 1:13 am
Regarding dividends being psychologically robust than dividends, this is more relevant to price insensitive...,

I’d argue that for price-sensitive investors who hold shares in companies such as AZO and who view buybacks done at rational prices as a component of the investment thesis that buybacks are actually more psychologically robust, because a company with such a policy can take a “negative” (a share price decline) and turn it into a positive (being able to buy more shares back below intrinsic value).
Hey good insightful post. Funny, I own some AZO. Bought back in 2004. Yes, they have been a bit buyback crazy but I’ll take the equity any day. This is the stock that jumped into my mind when people said buybacks don’t work. Average double digit return for fifteen years. I was a little worried a year ago with their earnings slump. I thought the buybacks were masking the erosion of their sales but I guess I don’t understand how their business works even though I shop there a couple times a week. A good example of not panicking and staying the course working out for good. They’re management did seem to make a lot of flimsy excuses about earnings shortfalls while dancing to a buyback drumbeat.

Having worked in big tech (HP) I got to see up close and personal how a company can set fire to R&D money internally. They can make it really sound good but at the end of the day, billions get vaporized with absolutely 0 return. Probably negative returns because they strengthen the programs of the internal sinks of capital and divert money away from promising programs that might threaten the existing power structure. Yes, I’ve seen good programs torpedoed by bad powerful players who didn’t want to lose influence. I suspect all big companies have this, it’s just a question of what degree is permitted. Just sayin’ a buyback can be way better than spending on R&D.

Access to capital also changes when the business strengthens their numbers. It isn’t always dumb to buy back stock.

Dividends can be deceiving in some circumstances. A few years ago in invested in a small Chinese firm that kept cutting special 15% one time annual dividends for years. I got cued into it by a Chinese friend who said they Family was using the dividend to pipeline cash out of China’s strict currency control system. Probably for relatives living overseas. When I sat down and analyzed the ownership it indeed was mostly family owned. This worked out very well up to the moment it did not. There are plenty of anecdotes out there about juicy dividends paving the road to disaster.

So it really depends on the situation. If it were just as simple as drawing a quarterly dividend check that would make for any easy stock screen. And sadly like everything in the world, it depends.

Edit - I’d like to add that the same complaint can be made about dividends vs. reinvestment of profits. I recall some idiot coworkers at HP telling me that they don’t like buying dividend stocks because the business doesn’t know what to do with their money and they will not grow if they do not reinvest. Again, I think my reply was roughly the same. “I like to buy stocks that go up.” Not, “I like to buy stocks that reinvest their money so they’ll grow and the share price will rise accordingly.”

My example at the time was Phillip-Morris. They had a juicy dividend. They also had gone up a lot from where I’d bought it in the depths of their class action suit for killing ignorant smokers. Then they went on to split into Mondelez food, PM international, Altria...duh, Kraft Heinz I think... Again, a situation where a high div yield told you nothing about how the business was going to grow. If you tore the books apart you’d figure out that they were investing in R&D. A lot. Like how much antifreeze and fiberglass to add to menthol cigs to make the second pack more attractive. Or proving “More lab rats smoke Camels than any other cigarette.” That costs money. After they did that, and a whole bunch of other experiments like how to make Oreos more addictive, there was still money left over to give back to shareholders. So it really depends on a what a particular business is going to do with the earnings.

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Re: Dividends are psychologically more robust than buybacks

Post by Dave » Fri Apr 12, 2019 5:29 pm

@Sclass

Nice hold on AZO. I looked at it mid 2017 when it briefly touched $500, but it didn't stay long and I didn't research it quick enough to reach a decision. 2x in 18 months, for a great business.

That's interesting with the Chinese firm. I've historically stayed away from Chinese firms for reasons of fraud. Funny side note, the first "value" stock I ever found was a fraud. I didn't invest as this became clear after some digging, but these things pop up with regularity. On the other hand, the very fact that there is so much fraud means that there are probably a ton of great businesses trading at too-low prices, but it's not something I think is easy to analyze.

Good story of wasteful R&D. That's exactly what I'm talking about. From a financial perspective, it's incomplete to assess some category of action without looking at the prices paid. R&D, buybacks, IPOs...whatever. There can be a trend of good or bad, but generalizing will led you to be wrong in certain cases because ultimately what matters is the ROI on a given allocation, which is a function of price and value.

Tying back in to the OP, I think it may be generally true, but in several of the investments I hold it's actually the total opposite as these companies have a record of value-accretive buybacks at bargain prices. I'd be genuinely upset if they stopped their buyback policy and paid dividends when the stock is undervalued.

Sclass
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Re: Dividends are psychologically more robust than buybacks

Post by Sclass » Fri Apr 12, 2019 10:38 pm

Dave wrote:
Fri Apr 12, 2019 5:29 pm
@Sclass

Nice hold on AZO. I looked at it mid 2017 when it briefly touched $500, but it didn't stay long and I didn't research it quick enough to reach a decision. 2x in 18 months, for a great business.
I almost sold it right there. Luckily I didn’t think too much about it. I’m an auto repair junkie and I spend a lot of time at AZO stores. I noticed the prices going up and the profits going down. They sell pretty junky replacement parts but the price is quite low. I was alarmed to pay 15% more for the same junky parts in 2017. Some kind of new corporate agenda.

My friends in the OEM parts biz also told me parts sales were just down across the board. Auto leasing went mad in 2017 and people had service contracts through their dealers. A lot of suppliers and small time repairmen felt the pinch. I’m not sure what the future holds with AZO though. I must say it has been quite a run.

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