I've Always Been Pro-Buyback - Stock Buybacks Versus Dividends - An Analysis Of The Arguments

This piece was originally published on November 30th, 2023.

Overview

For many years, I’ve seen prominent investors criticize stock buybacks. In the worst examples, they’ve said buybacks provide only a one-time lift to earnings with no long-term benefit. Recently, investor Harris Kupperman, wrote about the subject of dividends vs buybacks and came out strongly in favor of buybacks. I agree with his conclusion, and think it’s valuable to examine the reasons I prefer to see one versus the other.

The “One-Time” Benefit

The most dishonest criticism I’ve ever seen about stock buybacks is they only provide a one-time benefit. This isn’t true. When a company buys back its own shares, it retires those shares permanently. Earnings per share (EPS) go up permanently because the denominator (in this case the share count) is reduced.

It’s actually dividends that are one-time in nature. People often assume that dividends are stable, and there are indeed a few companies with long unbroken streaks of paying dividends complete with regular raises. However, as we saw when entire economies shut down in 2020, many companies were quick to cut the dividend to preserve cash. It was the right move at the time, but one that illustrates that dividends are one-time in nature and can be stopped without warning.

Some will claim that buybacks have little value when performed by companies that issue a lot of stock options. It’s true that some companies buy back shares to offset executive stock options. In doing so, they turn these non-cash stock grants into a drain on company finances. However, it’s not the buyback that’s the problem in this example; but rather, the potentially excessive stock issuance. If it weren’t for the buyback, the share count would grow each year further diluting the shareholder base.

Alignment Of Interests And Agreement On Value

I’ve also seen investors complain that management only buys back stock to enrich themselves. This is also untrue. When a company buys back stock and retires those shares, the benefits flow equally to all shareholders in proportion to their ownership. Management can’t benefit themselves at the expense of shareholders with a stock buyback. The lower share count is a benefit for all shareholders who now own a larger percentage of the same company.

A buyback also shows that management and investors share the same view of the value of a company. If you own a stock, presumably, you do so because you think the stock is cheap relative to its intrinsic value. Management should be buying back stock if they share the same view. It’s true that management can destroy shareholder value by repurchasing shares at a premium to the intrinsic value of the company. However, if you think the stock is too expensive, there’s no need or reason to own it. Management repurchasing stock in a company you own is confirmation that they have the same view on value as you do.

Buybacks Versus Acquisitions

Some claim that management should be buying other companies instead of repurchasing their own shares. I’ve never agreed with that argument. Most mergers and acquisitions (M&A) fail and destroy value. It’s hard to acquire a different company, fire duplicative management and staff, and complete a complex integration. Further, buying another company almost always means paying a premium price.

When companies buy back their own stock, they are acquiring assets they already, know and operate. They don’t need to figure out which staff to fire, or worry that the remaining people won’t know what to do. They don’t need to pay an acquisition premium, and can just pay the market price. It’s a lot safer to buy your own assets than it is to buy someone else’s at a premium.

Buybacks Are Tax Efficient

Due to quirks in US tax law, dividends are taxed twice. When money is earned by a company, the corporation pays income taxes. Then, when dividends are distributed to shareholders, those shareholders pay a second set of taxes on the exact same funds.

In contrast, buybacks don’t require shareholders to recognize gains unless they choose to do so. You could choose to hold onto those shares for years and only pay capital gains taxes when you sell. Depending on your personal tax situation and how long you’ve been invested in a particular company, long-term capital gains are probably less than paying income taxes on dividends. And buybacks allow you to choose when to recognize those gains. Dividends require recognizing that income in the year they are distributed. In the case of a stock buyback, you have the option to choose the year you realize those gains because you have control over when you sell.

Leverage Is An Optional Problem

The one valid criticism I’ve seen on buybacks is related to leverage. Buybacks are best when companies use internally-generated cash flow to retire shares at a discount to intrinsic value. In the last couple of decades, there have been examples of companies that took on leverage to buy back stock. If they took on too much debt and later had a problem paying the interest expense, that would lead to an expensive refinancing, bankruptcy speculation, and a much lower stock price. In these situations, a company could potentially crash the stock price by financing a repurchase leaving the company with both too much leverage and a stock trading at distressed levels.

This is a problem. However, it’s an optional one. In this example, the problem isn’t buying back stock; but rather, financing the buyback unwisely. When companies with large and stable cash flow repurchase stock without taking on crippling debt, the outcome tends to be much better. I’m not saying everyone should be buying back stock, but the fact that some do so unwisely doesn’t mean the concept is flawed.

Conclusion

Stock buybacks tend to be contentious. While I respect that good investors will frequently have differences of opinion, most of the arguments I’ve seen against stock buybacks don’t stand up to detailed scrutiny. If I own a company because I think its stock is inexpensive, and that company has stable financials, I like to see them buy back stock and retire those shares. Many companies, like Las Vegas Sands LVS use a combination of dividends and buybacks, but if I had to choose only one, I prefer buybacks.

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