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Topic: How To Invest

Investor Toolkit: Why investors should get more excited about share buybacks

Stock Market PicksEvery Wednesday, we publish our “Investor Toolkit” series on TSI Network. Whether you’re a beginning or experienced investor, these weekly updates are designed to give you advice on specific investment topics. Each Investor Toolkit update gives you a fundamental piece of investing strategy, and shows you how you can put it into practice right away.

Today’s tip: “Wise investors always value dividends, but many investors don’t realize that share buybacks can be just as valuable as dividends, and in some cases, more so.”

Dividends are in fashion with investors, and that’s 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.

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 misunderstand—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&#8212Share your investment knowledge and opinions with fellow TSINetwork.ca members

Do many or most of the stocks in your portfolio contain specific “rewards” for investors—dividends, share buybacks or a dividend reinvestment plan? Which of the three has the greatest appeal for you?

Comments

  • Robert 

    I certainly agree that brokerage commissions are very low, so that savings from buying via DRIPs are also low, but some DRIP offerings are also at a discount from the market price on the date purchased – usually only %5, still something.

    I am well past the life-time period for including DRIPs, but I don’t understand the statement that they also represent a loss of time-related compounding. Can someone expand on that?

  • Hugh 

    Stock buy-backs disproportionately reward management with stock options. It’s a place where owners’ and management’s interests may diverge. That’s a worry.

    When a company lowers a dividend, that’s taken as a serious message by the market. So companies don’t like to raise dividends unless they think that they can sustain that level. Stock buy-backs and extraordinary dividends are ways that companies can transfer value without future commitment.

  • Bruce 

    I personally think share buybacks are over-rated. I rather see management increase the dividends. When management increases the dividend they are making a commitment to work harder, make more money to sustain the increased dividends. When they use the excess cash to buy back shares instead, what they are saying is they don’t know what to do with the money and not willing to pay it out to the shareholders. Buying back shares does not require any effort. They even make themselves look good down the road. If next year’s earnings are the same as last year’s, but because of the reduced number of shares outstanding, the per share earnings would be higher. So management makes themselves look good without doing anything or accomplishing any positive result. To add insult to injury, they may even get a bigger bonus based the increased per share earnings. I think in many cases share buybacks are just incompetent management scamming the company and its shareholders.

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