Once companies have allocated capital to maintain and grow their business, they should consider paying shareholders. They can do so via either dividends or share buybacks. When implementing our investment process, we tend to favor steadily increasing dividends over share repurchases.
Unfortunately, many companies don’t consider value when they repurchase shares. When businesses are performing their best, they generate more cash and (often) have higher stock prices. If they repurchase shares during this period, then they are buying back shares when prices are highest which can lead to the destruction of shareholder capital.
We view large share buybacks as a form of financial engineering. They lead to fewer shares outstanding, meaning that the growth rate of metrics such as earnings per share can seem to be higher than they really are. For example, over its past nine fiscal years, IBM has bought back $100 billion of stock. This reduced its share count by a third, which helped to boost its average earnings growth rate by 53% to 16%.
On the other hand, dividends are paid directly to shareholders and represent an important element of the total return (dividends plus capital gains) shareholders can earn on their investments. We prefer that companies pay dividends rather than destroy capital by making poor investments or repurchasing overpriced shares. While dividends are particularly valuable for our retiree clients who are taking regular distributions from their portfolios, we believe companies that are good capital allocators can represent good investments for other clients, too.