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My Complicated Relationship With Share Buybacks
And why they're ultimately inferior to dividends
Despite my better judgement, I’m going to wade back into the dividend versus buyback debate. Sort of, anyway.
First, a little background for those of you who (mercifully) are unfamiliar with this cluster of a debate. Various academic theories state that dividends and share buybacks are functionally identical. Each takes a percentage of a company’s profits and gives it back to shareholders, just in different ways. Dividends are paid out in cash, while a share buyback simply shrinks the company by the same size as the dividend.
Buybacks, these folks argue, are actually superior to dividends, since a buyback can be done on a tax-free basis (although not for long, at least in Canada) and investors are forced to pay taxes on their dividends.
This argument then goes a step further and says if buybacks increase the value of shares, then it’s more efficient for the average investor to let those shares go up forever and defer tax. If this fictional investor needs income, they can simply sell a portion of the investment and live off that.
This is going to shock(!) you, but this dividend investing publication thinks this ideal world gets shattered once it’s held up to a little scrutiny. First of all, this theory assumes that every share repurchase is accretive, and that just isn’t true. It also assumes that investors will value a company at its fair value at all times, which simply doesn’t happen in the real world.
The TSX alone is full of stories where massive share buybacks went wrong. Take CI Financial (TSX:CIX) as an example. The company slashed its dividend in August, 2018, to free up cash to repurchase what it viewed as undervalued shares. Despite making massive progress on the share buyback — shares outstanding fell from 264M at the end of 2017 to about 178M today — shares are actually down some 30% since the announcement. Whoopsie.
For me, it’s very simple. $1 in dividends is always going to be $1. $1 in buybacks could end up being worth anywhere from $0.01 to $10. But as a dividend receiver, I’ll always have the choice to either take the cash or reinvest it into more shares. I like that optionality.
Other people may have differing opinions, and that’s okay. I’m not really here to try and change anyone’s mind.
For me, the choice is clear when presented with a dividend or a buyback. I’ll take the dividend six days a week and twice on Sundays. But capital allocation is hardly ever that simple. There are companies that have regular dividends and regular share buybacks, and many more companies that have regular dividends and irregular share buybacks.
It can be a lot, so I thought I’d weigh in. Here’s my outlook on share buybacks as a dividend investor, and the certain kind of share buyback I like best.
Like versus insist
My philosophy on capital allocation is pretty simple. I like share buybacks, but I insist on dividends.
I’ve very intentionally narrowed my investing universe to only dividend-paying stocks. Yes, I realize I’ll miss out on the next Amazon or Facebook. I’m quite okay with that. Such stocks don’t align with my investing goals, and besides, they don’t really mesh that well with how I think. I’m much better at identifying value than trying to predict some revolutionary product or idea, so I spend my time on the latter.
Dividends are important to me because they pay my bills. With that safety net, I can engage in various low ROI activities and not have to worry where my next meal is going to come from.
Share buybacks, meanwhile, are in the nice to have bucket. Owning a steady portion of a business while shares continually get reduced can be a very powerful wealth generation tool. But it all depends on the value of the underlying business. If that erodes, then share buybacks are a bad idea.
There are also plenty of companies that have succeeded despite issuing shares regularly. The tech sector is notorious for this, but it exists in plenty of other high growth companies as well. These folks will often give out equity instead of actual cash, which is effective for motivating staff, but isn’t necessarily friendly to shareholders.
Whenever I analyze a company for paid subscribers of this newsletter, I always look at the company’s history of both dividends and share buybacks. Buybacks are in the nice to have bucket, but dividends are much more important. Thus, I almost always spend more time on the latter.
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The best share repurchases
Now that I’ve established I like share buybacks, let me explain the most powerful type.
Essentially, a company’s share repurchase program tends to fall into one of three buckets:
The company repurchases shares when times are good, share prices are high, and they’re flush with cash
The company saves its cash (or will borrow) and repurchases shares when the stock is low
The company consistently repurchases a small percent of the company every year
The problem is the same with the first two — companies are generally bad at predicting when the best time is to repurchase shares. The problem with spending on repurchases at the top is obvious, so we won’t spend much time on it. Spending on repurchases at the bottom is much trickier, but ultimately suffers from the same problem.
Most CEOs are good operators, but a comparative few are good investors. This makes sense; after all, they probably spend 90%+ of their time on operations. So it doesn’t come as much of a surprise that many share repurchases basically follow the logic of shares down = good time to buyback.
Much of the time management doesn’t really understand why shares are lower. For instance, if a company is viewed as having too much debt in a world with rapidly rising interest rates, then perhaps the best course of action is to repay debt, which will be well received in the market. Even if management thinks the balance sheet is fine.
One type of share buyback avoids all these problems. Management teams that commit to steady share repurchases don’t have to worry about whether times are good or not, nor do they have to worry about getting a good price. They simply allocate a certain amount of cash towards buybacks each year and steadily buy — no matter what the underlying stock is going to do.
Such thinking is the equivalent of an investor dollar cost averaging into a stock they believe in. It doesn’t necessarily yield impressive results over a one or three-year period, but it sure looks impressive after five or ten years, and it basically looks like a superpower after a couple of decades. This is exactly what long-term shareholders should want to see, not a buyback program that can be turned on or off on a whim.
The discipline is the most valuable part. Just like a steadily rising dividend, share buybacks really start to be powerful over time, not after a year or two.
A bonus for dividend investors
Finally, dividend investors should appreciate share buybacks because they make the dividend all the easier to grow over time.
A steadily increasing share count will cause the total amount of cash going out the door as dividends to go down over time, even as the payout stays the same. To use a simple example, a company with 10M shares paying out a $1 per share dividend pays $10M in dividends. If that same company buys back 1M shares and pays the same dividend per share, total cash paid out in dividends equals $9M.
Let’s look at a real life example. Canadian Tire has delivered both consistent dividend growth and share repurchases over the last five years. The dividend has increased from $3.74 per share in 2018 to $6.28 per share in 2022, or an increase of 68%. But thanks to a consistently shrinking number of shares, cash going out the door only increased 53%.
Ultimately, this leads to even higher dividend increases for long-term shareholders, especially in those companies where overall earnings are growing, not just earnings per share. Combine steadily growing earnings and a consistent share buyback, and really impressive things start to happen.
Dollarama is a great example of just how much share repurchases can boost earnings on a per share basis. In 2013, Dollarama earned $250M in normalized profit, or $0.58 per share. In 2023 it earned $802M in normalized profit, an increase of 220% compared to 2013. But per share earnings experienced much better growth, with that metric growing a whopping 376%.
One last example. Imperial Oil started repurchasing shares in size in 2016 after the energy market had been struggling for a few years. Normalized earnings increased from $1.2B in 2017 to $7.1B in 2022, for an increase of 491%. Earnings per share, meanwhile, increased from $1.48 to $11.12, an increase of 651%.
This is the power of a consistent share buyback. Imperial Oil’s number of shares outstanding went down approximately 24% between 2017 and 2022, or approximately 5% per year — cash it used to repurchase shares even though it consistently paid its quarterly dividend as well.
The bottom line
I don’t really care what the academics say. Dividends and buybacks are not the same. Not even close. The latter is often poorly executed by management teams trying to galaxy brain a fairly simple thing, and buybacks don’t necessarily deliver $1 in long-term value for every $1 spent on buybacks.
I’ll also point out that there are other capital allocation choices, such as investing in the business, making an acquisition, or paying down debt. The dividends/buybacks debate usually doesn’t factor those in.
Ultimately, I think dividend investors should appreciate a good share buyback. After all, consistent share buybacks make it easier for a company to raise its dividend in the future. A consistent share buyback can also be really powerful if done for a number of years, and the impact will just get bigger over time, especially if overall earnings are growing.
But a good share buyback isn’t as common as one might think, and I don’t think investors should necessarily penalize a stock for not engaging in one. Perhaps it has reinvestment potential beyond the dividend. Maybe it has acquisition potential. That’s okay. I don’t penalize a stock for doing that. In fact, I’m okay with a company issuing stock to pay for acquisitions — providing it creates value on a per share basis.
In closing, capital allocation is complex. A company has numerous paths it can embark down, which is why the consistency of a consistent share buyback is so valuable. There’s no simple right answer here, no matter how emphatic someone might say so on Twitter.