Companies have gotten stingier with dividends in recent decades, but they've grown more generous with share repurchases. There's just one problem for investors. For the stock market as a whole, repurchases might be largely a mirage.
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"Most buybacks are phony," wrote Rob Arnott, former editor of Financial Analysts Journal and founder of investment firm Research Affiliates, in a recent email exchange. "If management redeems stock options and the company then buys back the same amount of shares, this is management compensation, not a buyback."
Arnott constructed an 85-year history of U.S. stock market dilution by comparing the rate at which companies issue shares, including through public offerings and options that are converted to shares, with the rate of repurchases.
His conclusion: Issuance exceeded repurchases over the entire period, save for the Michael Milken era of leveraged buyouts from 1984 to early 1991 and the recent repurchase frenzy from 2004 to 2007. Those two periods combined reduced the supply of shares by just over 11%, but during the period between them, net issuance increased the supply by 25%.
Half of today's supply of shares didn't exist 50 years ago, according to Arnott, who reckons that entrepreneurial capitalism dilutes the stock market by about 2% a year over long time periods through the creation of new enterprises. "People see buybacks, and leap to the conclusion that this is an important phenomenon, but they ignore the [secondary offerings], management stock option redemptions and [initial offerings] that, in most years, swamp all buybacks with room to spare," he wrote.
That finding might dampen the hope among investors that repurchases will boost stock market returns in coming years.
Dividends and repurchases are the two main ways companies can return a portion of their profit to investors. Dividends are usually cash payments. With repurchases, companies spend the cash to buy and retire some of their shares. Theoretically, the benefit to shareholders should be the same, absent taxes, because a lower share count increases earnings per share, thereby making remaining shares more valuable. In other words, dividends reward stockholders with cash, whereas repurchases should reward them with what should become a higher stock price.
Source: Research Affiliates
Why would investors settle for the theoretical benefit of repurchases instead of the cash-in-pocket provided by dividends? Dividends are taxed twice: once when a company earns a profit and again when a shareholder receives the cash (so long as the shares aren't held in a tax-deferred retirement account or the like). Repurchases are taxed only as profits, not again as distributions.
Regulatory changes in the early 1980s made it easier for companies to repurchase shares. From 1980 to 2000, share repurchase spending by U.S. companies grew by more than 26% a year, versus less than 7% for dividends. Thirty years ago S&P 500 companies paid 57% of their profit as dividends. Last year they paid 29% as dividends.
Despite the tax advantages and rising popularity of repurchases, however, dividends have provided a better deal in recent years. Repurchase spending by S&P 500 companies peaked at $172 billion during the third quarter of 2007 and plunged to $24 billion by the second quarter of 2009 -- a decline of more than 85%. U.S. shares lost half their value during that span, meaning companies bought high and froze low. Dividend payments shrank by less during that time -- 22% -- allowing most investors who reinvest their payments to buy low.
Arnott's finding adds to a growing chorus of skepticism regarding repurchases. Several studies have found a strong link between chief executive bonus plans based on earnings-per-share targets and the use of share repurchases to give earnings per share a boost. A 2009 paper found that accelerated share repurchases, whereby companies retire shares today and enter into a contract to pay for them in the future, are particularly popular among companies whose chief executives are paid according to short-term earnings-per-share performance. Another paper reported that accelerated share repurchases tend to foretell poor stock performance.
U.S. companies hold a record $1.9 trillion in cash. Last year, money spent on share repurchases by S&P 500 companies more than doubled, but was still half of what was spent in 2007. Dividend spending increased 5%.
Jack Hough is an associate editor at SmartMoney.com and author of "Your Next Great Stock."
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