Why I prefer dividends to share buybacks

It seems that share buybacks are all the rage in the UK’s boardrooms at the moment.

Two of my most recent Income For Life recommendations — Glencore and Barrett Developments — have both announced that they are planning — or at least considering — buying back substantial numbers of their own shares as a way of returning money to their shareholders.

Well, that all sounds very nice, but do you actually know it means?

And, more importantly — as an income seeking shareholder — is it a good thing?

Before we answer those questions, let’s back up the bus a little and take a look at the big picture.

Dividends

I’m assuming that you have a pretty good idea of what a dividend is, and why yield hunters like me, are so keen on them. They are simply a share of the profits that a company makes that are regularly paid out to shareholders.

Dividends are paid out of a company’s after-tax profits and are then subject to further taxation for the shareholders (after their allowances are used up). It’s a straightforward approach and has the advantage that the dividends usually — but not always — increase over time.

However, there is another way that companies can return value to their shareholders. And that is to buy back their own shares.

Mature companies can find themselves in a position where they have excess cash kicking about. They are not expanding like a start-up and their market and business model means that they are consistently spinning off profits. It’s a nice position to be in.

But, what to do with the excess money?

Well, instead of just sitting on it, they can choose to pay it back to shareholders, either as a dividend or by buying back their own shares.

Buybacks

This practice tends to be more prevalent in the US, but in recent years, many UK listed companies such as Lloyds, BP and Aviva have also announced buybacks.

The most common way they do this, is to announce their intention to start a buyback program and then simply buy their own shares in the open market, over a stated period. Once they have bought them back, they usually cancel them and so reduce the total number of shares available in the market.

The remaining shareholders now own a larger slice of the pie, and so — in theory — their shares should increase in value.

An example

A simplified example should help explain.

ABC Plc makes £100 million a year in profit, and it conveniently has 100 million shares in circulation. Therefore, its earnings per share (EPS) is £1 — or 100p to use the usual UK standard.

If the shares are trading at 1,500p each, then they will have a price earnings (PE) ratio of 15 (1,500p/100p).

Now, if ABC Plc decides to buy back and cancel 10 million shares, then the same £100 million profit will be split between the remaining 90 million shares.

Therefore, the earnings per share (EPS) will rise to 111p (£100m profit/90m shares).

And, if investors are still happy to pay fifteen times the earnings — a PE ratio of 15 — the shares will increase in value to 1,665p each (111p x 15).

Phew. I hope you followed that.

So, if the script plays out, the remaining share holders should see the value of their holdings increase and everybody is happy. But of course, the real world is never that clear cut and there are no guarantees that the share price will actually go up.

The real world

Just look at the price of Aviva shares after they made their buyback announcement on May 1st last year. The shares closed at 536p that day, before enjoying a short-term rally. However, just three weeks later they started to drop and continued to fall steadily for the rest of 2018, bottoming out at around 362p each.

As always with markets, there are many competing factors pushing the share price around and any single driver can easily be lost in the mix. So, by no means are buybacks a silver bullet for returning money to shareholders.

There are also a number of other reasons why share buybacks are not necessarily good for shareholders. And, one very good reason, why they are not ideal for income investors like us.

Firstly, managers and directors who are incentivised — via bonuses or stock options — to inflate their own share price, may push buybacks for all the wrong reasons i.e. to line their own pockets.

My investing hero — Warren Buffet — has expressed his liking of buybacks, but only if certain criteria are met.

Firstly, the company must have enough money to pay for its day-to-day operations. And secondly, it should only buy its own shares if they can be bought at a good price. This second point is key.

Like any buyer, the company should be buying their shares when they believe they are cheap, not expensive. Unfortunately, there is precious little evidence that they are any better at timing their purchases than anyone else. And a badly timed purchase just ends up destroying value.

Income Investors

These are important considerations, but have you spotted the key issue with buybacks for income investors?

Yep, they rely on you actually selling your shares to realise any possible uplift in the price.

And — as income investors — we don’t particularly want to be selling our shares to realise the income.

After all, once you’ve sold them, you will not be receiving any more dividends from them.

We want to be able to hold onto our shares long term and collect our income via dividends. We don’t want to have to sell a few of the family jewels every time we have a bill to pay.

And, if we want to sell covered calls — as I advise — we must own a fixed number of shares in order to sell the options. So, lopping a few off to realise a profit, is just not practical.

Of course, with covered calls, we accept that we may have to sell all of them for a profit down the line. But that’s in return for getting extra income upfront in the form of the option premium as well as the dividends.

Long story, short. I’m not going to complain too much about a share buyback, but I’d rather just have the dividend please.

 

3 Comments
  1. Alec Swainey 9 months ago

    Hey, Thank you for taking the time to write this. I have to start blogging again soon ugh.

  2. Fletcher Sequra 9 months ago

    This really answered my problem, thank you!

  3. Benito Difede 9 months ago

    Thank you for this. Very well written. I used to blog alot until work set it but def need to start writing again. Cheers!

Comments are closed.

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