Right Now, I Prefer Buybacks To Dividends

Published in Investing on 22 September 2010

Cash will never go out of fashion, but how best to use it does.

Like many value-orientated investors, I get a warm glow when I see a company with net cash.

Most companies that fail simply run out of money. If nothing else, a company with net cash isn't likely to go bust anytime soon.

On the other hand, we buy equities to grow our money, not just to avoid losing it. And at a time when even the best bank accounts are yielding less than inflation and risk-free bond yields are close to their all-time lows, it's worth asking whether keeping large amounts of cash sloshing about on deposit or in short-term securities -- or even returning it to shareholders via dividends -- is really the best use of company funds.

In fact, with the market seemingly far more interested in buying debt (bonds) than cheaply-rated equities, should companies give traders what they want, and gear up by issuing debt to fund the buy back of their own cheap shares that the market is shunning?

When the ducks quack, feed 'em as the old-time Wall Street brokers used to say.

Bonds attract

I'm obviously not the first to wonder whether cash is a bit trashy right now. Companies retain fleets of accountants to figure out how best to re-jig their balance sheets, and the attractions of cheap debt in today's climate have not gone unnoticed.

For instance, in June the small cap financial services provider Dealogic (LSE: DL) bought back fully a quarter of its share capital via a tender offer that took the company from a net cash position into net debt.

Management said the move was to improve earnings per share -- a share buyback means fewer shares to distribute the profits between, and so higher earnings per share -- as well as to create "a more efficient capital structure".

Sure enough, analysts at JP Morgan duly upgraded their estimate for Dealogic's earnings in 2011 by 25%.

Mega buybacks

At the other end of the scale is Microsoft. It has $36.8 billion in cash and short-term investments, and many vocal shareholders are getting fed up with the company paying it out via a miserly 16 cent per share quarterly dividend.

According to Bloomberg, Microsoft has also spent $76 billion repurchasing its own shares since the 2006 financial year, and it's now partway through a $40 billion buyback that will run until 2013. Yet Microsoft could be far braver in trying to shake its share price out of the doldrums. As a triple-AAA-rated corporation, it could raise billions by issuing ten-year bonds.

I've seen estimates ranging from $6 to $60 billion as to the amount of debt cash-generative Microsoft could take on without losing its top-notch credit rating.

It's already raised money once, securing $3.75 billion via ten-year notes yielding 4.2%. Since then, corporate bond rates have dropped still further -- fellow US blue chip Johnson & Johnson recently issued 10-year notes yielding a puny 2.95%.

If Microsoft can't invest capital internally to generate more than 2.95% per year over the next decade, then Microsoft shareholders should demand that whole cash pile back, pronto.

Indeed, bolder companies than Microsoft did this maths long ago. According to figures from Dealogic quoted in the Financial Times, companies have already issued a record $220 billion in junk bonds this year, and total bond issuance is second only to last year's total.

Yet share buybacks are still only at 2005 levels. The rash of takeover bids we've seen recently might indicate that ambitious managers are keener to use cash or cheap debt to buy the lowly-rated shares of rivals to grow their business, rather than snap up their own.

BLASH and cash

When it comes to returning cash to shareholders, so far I've concentrated on buybacks. These are generally preferred by big City institutions, as they are more tax efficient as far as they are concerned.

Many private investors prefer dividends of course, either in the form of a large special dividend or a higher level of annual payouts going forward.

And in normal times, I'd happily wave the flag for the dividend camp. Dividends make up the major part of the return you can expect from investing over the long-term.

In contrast, buybacks raise the suspicion that managers are trying to elevate a company's earnings per share merely to hit their personal performance targets, or to paper over a lack of organic growth. As for trusting companies to make sensible acquisitions with their cash instead of returning it to shareholders, that too often seems a triumph of hope over experience.

But right now, I do think for many companies there's a stronger case for buybacks than dividends.

Across the board shares seem good value -- the FTSE 100 is on a prospective P/E of less than ten. In contrast, as evidenced by Johnson & Johnson's bargain bond issue, debt is cheap.

Buy low and sell high (BLASH) should be the mantra for companies as well as investors. Yet companies were buying back their own shares in 2006 and 2007 when times were good and their share prices were high -- and when the income available from cash and bonds meant retaining cash actually earned a halfway decent return.

The sad reality is many company boards act like retail investors, turning greedy and fearful at precisely the wrong times.

Hoarding cash today makes little sense. Dividends are all well and good, but they don't take advantage of low share prices. Buybacks have rarely been so appealing.

Hoarding cash is not a sackable offence

Finally, a confession: Despite seeing a clear case for using cash or even debt to boost earnings through buybacks at the moment, I can't look too unkindly on companies who retain a cash safety net.

Cash gives companies the flexibility to react to opportunities, and to ride out a downturn in business. Plenty of people still see economic difficulties ahead, and, equally, low interest rates won't last forever. One day having cash will pay.

But my main point stands -- if a company is ever going to buy back its shares, now is surely the time to do it, when share valuations are in the doldrums and holding cash is barely rewarded.

What's your view? Fire away in the comment section below...

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SystemAddict 23 Sep 2010 , 2:56am

I'm a private investor, I hate buybacks with a passion. They are not 'returning cash to shareholders', they are giving shareholders' cash to people who are baling out; it is, as suggested, a way of cooking the books, does not increase earnings (ie turnover, revenue) one bit.

thebuffoon 23 Sep 2010 , 7:52am

Buybacks used judiciously, i.e. when you can afford to spend the money, and you buyback £1 for less than £1, are my favourite way of using surplus cash. Encore Oil did so recently, but IMHO didn't go far enough. They just bought below net cash per share (14.3p or so). They are now £1.02. Bigger slices of the pie. Hmm, tasty. :^}

SystemAddicts statement is not correct if shares are bought back as described above. It is earnings enhancing for those who remain shareholders.


equitybore 23 Sep 2010 , 8:17am

Surely buybacks are the ultimate criticism of the board of directors - if they can't get a more decent return than their average cost of capital by investing in productive activities they should'nt be there. My reaction to buybacks when I see them is the company does'nt have a clue.

Afrosia 23 Sep 2010 , 1:09pm

Surely if the shares are undervalued then buybacks are an excellent use of capital. Only if they are overvalued are they a poor use of capital, as you are essentially paying off exiting shareholders £1.20 for every £1 of value.

Peter Lynch and Warren Buffett are great believers in buybacks (of undervalued securities) so I'm gonna go with them.

XMFPhila100 23 Sep 2010 , 7:43pm

For anyone who's interested, here' s a great overview of the debate between dividends and share repurchases from Legg Mason Capital's (US) Michael Mauboussin: http://www.lmcm.com/pdf/ClearThinkingAboutShareRepurchase.pdf

Foolish best,

Todd Wenning

FlyingSpur 24 Sep 2010 , 2:20pm

Buybacks are supposed to "increase shareholder value" but this increase has never been quantified. For example I have BP shares - can somebody please tell me what the share price would be if they hadn't done any buybacks.
You can quantify dividends (or you could when they paid them!).

guykguard 24 Sep 2010 , 8:02pm


Todd: right again. That is an excellent article, with first-class references. The standard of stuff at TMF is looking up.

Foolish best, GuyK

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