In Support of Buybacks vs. Dividends: Logic and Academia on My Side

I have long been a proponent of stock buybacks as a vehicle for returning cash to shareholders. The RIGHT amount of cash. I think dividends are fine, too, but come along with too much excess baggage. Once dividend policy is established, the payoff to shareholders becomes asymmetric: if dividends are flat or grown a little each year, great, that is expected; if they are dropped because of a bad quarter or a bad year, look out. This leads to “sandbagging,” or the setting a dividend at a level that is so far below a corporation’s ability to return cash to shareholders that it becomes almost meaningless. Let’s face it, dividends are becoming marginalized, especially as institutional investors rule the landscape and retail investors become less of a presence from a funds flow perspective. I’ve argued this several times in the past, getting downright brutal with the New York Times in November of last year and pretty horsey with Barron’s this past May. But now finally a voice of reason has come to save the day, which simply means agreeing with my position on the topic, and it comes from Douglas J. Skinner of the University of Chicago GSB in a study discussed in this weekend’s Barron’s:

 

Skinner finds that stock
buybacks are now being used as substitutes for dividends, even by
companies that continue to make payouts. The reason for that appears to
be the increased volatility of earnings.

In some ways, says Skinner, repurchases are the
superior choice for the issuer because “there’s total flexibility with
stock repurchases, whereas you’re committed forever with a dividend.”
For obvious reasons, companies want to avoid cutting or omitting their
payouts. “With repurchases, you could pay out $3 billion…one period
and zero the next.”

So while corporations that have been paying
dividends for decades continue to do so, their dividend policies are
becoming more conservative, and they’re more frequently rewarding
investors with buybacks. “If a firm has unusually high earnings one
year, they’re not going to increase dividends; instead, they make a
large stock repurchase,” declares Skinner.

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Although it can be argued that dividends
are barometers of earnings quality, he says there’s not much evidence
to support that. “The main contribution of this study is the
substitution hypothesis — determining if stock repurchases are
actually used as substitutes for dividends. If this is the case, stock
repurchases should be linked to earnings.” Skinner notes that the
relationship between dividends and earnings has become weaker in recent
decades, largely because managers now set dividends in a mechanical way
— with small, predictable increases.

 

Two key points are raised here that I believe drive the buybacks vs. dividends decision - flexibility and uncertainty. The setting of a dividend might be theoretically logical for a company with a high level of annuitized revenues that are highly predictable, but this simply doesn’t describe the cash flow characteristics of most companies. Economies go through cycles. Shocks occur. Products obsolesce and aren’t immediately replaced with superior models. The competitive landscape shifts. There are countless reasons why earnings don’t grow in a straight line, and sometimes even fall. And this in and of itself doesn’t mean a company stinks; it means that it’s not impervious to outside influences. Therefore, creating corporate finance policies that are flexible, adaptable and take into account uncertainty seem to fill the bill in an increasingly complex and volatile world. Here are just a few of the things I noted in my earlier discussions of the topic:

From my May 2007 post concerning the market’s perception of share buybacks:

Corporations like buybacks because they are flexible, can be used to
soak up short-term excess cash as well as to facilitate a more optimal
capital structure, and because of the signaling effect they can have on
management’s view of business prospects. I don’t think corporate
managements really believe that institutional investors are as dumb as
Mr. Bary would have you think. Given my knowledge of corporate finance
departments and their decision-making processes, I am pretty confident
that the reasons I raised for why buybacks are used are more on point,
IMHO.

So while we can prattle on about what should and should not be, the
market is saying something: that the current dividend vs. buyback
policy is just fine, thank you. And while we can debate the point on a
theoretical basis, the fact that the two strategies are tax-neutral and
that institutions seem to like the discretionary and signaling aspects
of buybacks means that things are unlikely to change. Until
institutions begin stand up and begin voting with the pocketbooks, that
is. Which means a change in the market. Which is the way things should
be, not the way some people think things should be in the financial
media eco-chamber. Let us always remember: Mr. Market rules, now and
forever.

From my October 2006 post concerning the impact of volatility and financial distress on cash balances:

We essentially ran models that looked at precisely the things mentioned
in the study above - namely, the volatility of a company’s cash flows,
its relationship to economic cycles, potential changes in business mix
and its impact on the characteristics of future cash flows, quantifying
what constituted “financial distress” and arriving at a recommendation
for a base level of cash or near-cash that should be held to cover this
risk. We specifically looked at companies that generated large amounts
of cash - technology companies, telecommunications companies, regulated
utilities, etc. - and advised managements on corporate finance policies
like stock buybacks, dividends, and long-term debt issuance strategies.
I will tell you that this type of analytical framework resonated with
Treasurers and CFOs alike, and had a real impact on how many companies
managed their cash - in some cases, gaining the comfort to increase
their dividends/share buyback programs, while others chose to issue
long-term debt to build the necessary cushion to most efficiently take
the tail risk of financial distress off the table.

In sum, corporations want the flexibility to reward shareholders when it is prudent to do so and in amounts that are consistent with the company’s financial strength and growth plans. Dividends don’t afford managements’ the same levers to operate in a dynamic way, rendering it a far less appealing alternative than buybacks. I am happy that Mr. Skinner’s study made clear what many of us already knew to be intuitively true, that buybacks are simply a better way to optimize capital structure, manage cash and return capital to shareholders. They just are.

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COMMENT:

AUTHOR: Ian

EMAIL: ianysiu@yahoo.com

URL: 

DATE: 09/11/2007 08:10:05 AM

Great article.  Just curious - would your position remain the same if investors did not expect dividends to be consistent?  At that point, both dividends and repurchases could have signaling effects and fluctuate with earnings.  The big advantage of dividends I think would then be that they actually return cash to shareholders whereas repurchases allow cash to remain within management control (subject to share reissues later on - is this likely?).  Thanks for writing - really enjoy your blog!

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COMMENT:

AUTHOR: John

EMAIL: jslack@gmail.com

URL: 

DATE: 09/11/2007 10:18:27 AM

I agree with your (and Prof. Skinner’s) points Roger. Not sure if you knew this but Skinner was a long time accting prof at Michigan—and one of the few who made accting interesting and entertaining IMO. Too bad they let him get away to Chicago. 

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COMMENT:

AUTHOR: Roger

EMAIL: roger@informationarbitrage.com

URL: http://www.informationarbitrage.com

DATE: 09/11/2007 09:18:17 PM

John, that name did ring a bell. Thanks for helping make the connection. Michigan B-School rocks.

Ian, I personally don’t buy the “but management can reissue repurchased shares at a later date” argument. Companies big enough and established enough to pay dividends or do large repurchases seldom do secondary offerings, and if they are done they are certainly not done at the drop of a hat. One could also posit that a company could take on leverage just to pay a dividend or to create the requisite financial flexibility after an excessive payout relative to free cash flows. Bottom line - flexibility and the ability to manage uncertainty rules. Thanks for writing.

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COMMENT:

AUTHOR: NN

EMAIL: abcd@hotmail.com

URL: 

DATE: 09/14/2007 01:24:52 AM

I disagree.  In theory buy backs may be more helpful, but in practice they are not.  Buybacks can be offset by huge stock option grants.  I will take the dividends anyday of the week.  ANYDAY.

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