How Successful Investors Get RICH

Learn everything you need to know in 'The Canadian Guide on How to Invest in Stocks Successfully' for FREE from The Successful Investor.

How to Invest In Stocks Guide: Find 10 factors that make your investments safer and stronger.

 I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

Topic: How To Invest

Why share buybacks deserve more respect

Share buybacks - stock image

Dividends are in fashion with investors right now, and that’s always a good thing. Creative accounting can produce false impressions of prosperity and hide embarrassing financial problems. But accounting can’t create cash for this year’s dividend, let alone conjure up a history of past dividends. If you restrict your stock market picks to dividend payers, you’ll avoid most of the market’s greatest disasters.

It’s odd that while investors periodically crave cash dividends, they rarely get excited about stock buybacks. But 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. Buybacks reduce the number of shares outstanding. To get earnings per share, you divide total earnings by the number of shares outstanding. With fewer shares, the calculation naturally gives you a higher number for earnings per share. On the whole, buyers are willing to pay slightly more for a stock with slightly higher 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. 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.

How Successful Investors Get RICH

Learn everything you need to know in 'The Canadian Guide on How to Invest in Stocks Successfully' for FREE from The Successful Investor.

How to Invest In Stocks Guide: Find 10 factors that make your investments safer and stronger.

 I consent to receiving information from The Successful Investor via email. I understand I can unsubscribe from these updates at any time.

Overestimating the value of dividend reinvestment plans

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 (or DRIP). 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.

Don’t get me wrong—cash dividends are a definite plus. But you still need to follow the three key guidelines in our Successful Investor approach to sound investing:

Invest mainly in well-established companies, since they are the companies most likely to keep making, if not increasing, those dividend payments each year.

Spread your portfolio out across the five main economic sectors: Manufacturing & Industry, Resources & Commodities, the Consumer sector, Finance and Utilities.

You also need to limit your exposure to stocks that are in the broker/media limelight, which bloats investor expectations. When stocks fail to live up to those expectations, big downturns often follow, regardless of a company’s dividend history.

COMMENTS PLEASE

Are you more likely to buy a stock if it offers shareholder “rewards” like dividends, share buybacks or a dividend reinvestment plan? Which of the three has the greatest appeal for you? Let us know what you think in the comments section below. Click here.

Comments

  • Ron 

    Pat first let me say I have been a subscriber to Successful Investor for several years and have profited quite well, thank you.

    In this particular case I prefer the DRIP program notwithstanding the acknowledged low commisions out there. I predicate this comment by stating the DRIP is subject to the the over value of the stock in question & its current trend and the industry, i.e Canadian bank stocks are an automatic DRIP investmen.

  • Leo 

    I love dividends more than any other means of share benefits, as long as they are higher than inflation plus taxes and keep on coming.

  • Joy 

    I bought a basket of Canadian stocks (most recommended by Successful Investor)years ago, and used the DRIP to ‘save’ for retirement outside of my RSP. I have more stocks which are not in a DRIP program. I focus on the desirability of a stock to me over it’s DRIP availability. Share buybacks are appreciated. In my case, the DRIP part of the portfolio has outperformed the others.

  • Tom 

    One point I would like addressed is the fact CEOs can do a buyback so that they may be able to get an extreme bonus if price hits a certain level.
    Maybe all stock options should be available to all shareholders or a prorated basis. then boards and execs would seriously look at their policies. Just some thoughts.

  • Pete 

    With regard to the point about limiting exposure to companies in the media limelight (and how that may ‘artificially’ drive up the share price), I’d like to hear what you have to say about CP and the public clash with Pershing Square. This is your #1 stock pick for the year, so i’d be interested in how it overrides this important rule?

Tell Us What YOU Think

You must be logged in to post a comment.

Please be respectful with your comments and help us keep this an area that everyone can enjoy. If you believe a comment is abusive or otherwise violates our Terms of Use, please click here to report it to the administrator.