Stock buybacks can be just as good for investors as dividends

high dividend Canadian stocks

Stock buybacks can offer investors a number of key advantages over dividends.

We’ve always placed a high value on a sustained record of dividends, mainly because it provides something of a pedigree for stocks we recommend. But stock buybacks are also a great opportunity for investors.

While investors periodically crave cash dividends, they rarely get excited about stock buybacks. But in some ways, stock buybacks are better than dividends.

But first, let’s start with a look at dividend stocks. You can’t fake a record of dividends. It takes a lot of success and high-quality management for a company to have the cash to declare and pay a dividend every year for five, 10 or more years. It’s not something you can create at the spur of the moment.

Many investors are willing to buy dividend stocks, especially as a source of retirement income. However, some take it to extremes. They put too much faith in a history of dividend payments. They think of a stock with a good dividend history as the next best thing to a government bond. But it’s nothing of the kind. It’s a good sign, but not the only sign you need to look for. It takes continuing effort to succeed as a so-called “buy-and-hold” investor. You need to learn how to “buy and watch carefully.”


The difference is dividends

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Many investors buy dividend stocks and sell them too soon

Selling too soon is one mistake that many investors make with dividend stocks. They may sell off good investments in anticipation of a market downturn. Or in times of market pessimism, investors may be tempted to sell all of their dividend stocks, regardless of quality, in hopes of getting back in at lower prices.

Selling to sidestep a market downturn rarely works out as neatly or as profitably as sellers hope. First, some stocks hold steady or rise during a downturn—these are often the strongest stocks in the subsequent upturn. And sometimes the downturn ends much more quickly than you expected, and you wind up buying back in months or even years later, at much higher prices.

Other times, the market moves up, the seller buys back in, and the real downturn begins.

At TSI Network, we encourage investors to find and hold (or buy and watch carefully) shares in well-established companies, especially ones that pay dividends.

Dividend stocks and stock buybacks

In some ways, stock buybacks are better than dividends. In particular, they give you a tax-deferral option that you don’t get with cash dividends.

Stock buybacks raise the value of a given stock holding in two ways:

● First, stock buybacks raise a company’s earnings per share.

● Second, when the company buys back its own stock in the market, it bids up the price of the stock.

When you hold a stock in your personal, taxable account and it pays a cash dividend, you have to pay tax on the dividend in the year in which you receive it. If the company instead devotes the cash to a stock buyback, you have two options:

● If you need cash, you can sell part of your holding in the stock, presumably at a higher price than you’d get in the absence of a buyback. If you do that, you’ll only pay taxes on the sale if the stock has moved up since you bought it. If the stock has moved sideways or down, the proceeds of your sale are tax-free.

● Of course, you’ll always have the option of holding on to your stock until it suits your purposes to sell.

This added opportunity for tax deferral may not seem like much of an advantage in any single year. However, the magic of compound interest applies to that tax deferral. It can add up to a huge advantage over a decade or two.

The advantage expands all the more if you hold off on selling until you need the money. That holding period may last until you retire, when your income tax rate is likely to be lower.

The funny thing is that, just as investors tend to underestimate the value of a buyback, they overestimate the value of a dividend reinvestment program. They put a high value on the fact that they can reinvest their dividends automatically, without paying brokerage commissions. They fail to recognize that brokerage commissions are now at historic lows. They also overlook the fact that they have to pay taxes on the full dividend, even if they reinvest it. That tax hit and the loss of an opportunity for tax-deferred compounding greatly outweigh what they save on brokerage commissions.

Many successful investors like dividend reinvestment plans for the savings in brokerage fees. Is that important to you with today’s lower fees?

Why do you think so many investors ignore the benefits of stock buybacks?

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