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Share buybacks shine, but dividends still look better

canadian money

Feng Yu/Getty Images/iStockphoto

Share buybacks have become a popular way for companies to return cash to shareholders. According to Savita Subramanian, equity and quantitative strategist at Bank of America, 56 per cent of companies in the S&P 500 have reduced their share counts over the past year.

That's close to the peak of 66 per cent in 2008, which of course raises concerns over whether rising share buybacks is a sign of impending market turbulence.

But Ms. Subramanian has noticed that buybacks have coincided with anything but doom and gloom recently. When she looks at the 50 companies that have reduced their share counts the most, they have outperformed the S&P 500 by a dazzling 16.5 percentage points this year.

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Despite these impressive numbers, though, she doesn't recommend a stampede into companies that initiate buybacks. Between 2003 and 2010, the companies that were most active with share buybacks produced hardly any excess return, suggesting that investors need to be selective.

"Companies with serial share repurchase programs began to be regarded cynically by investors as selfserving, in that buybacks improved many of the 'per-share' metrics on which management was compensated," she said in a note. "Moreover, buybacks were seen as a signal that a company had a waning set of growth opportunities but lacked the confidence to initiate a dividend."

Good buybacks, she argues, come when stocks are inexpensive, companies initiate them to reduce the share count (as opposed to offsetting dilution that follows stock compensation), management takes advantage of the low cost of debt and companies are sitting on piles of cash.

That said, she still prefers dividends over buybacks: They impose capital discipline and offer downside protection to the share price, among other reasons.

"But in an environment in which the equity risk premium remains elevated and companies have hoarded excess cash, which is earning paltry returns, we think that selective share buybacks continue to make sense," she said.

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