Investors: You're Being Duped by Share Buybacks

It's a debate almost as old as the stock market itself. What's a better use of capital: paying a dividend or enacting a share buyback? There are valid points to be made for both, which is ultimately the source of the continued debate.

Dividends vs. buybacks ... fight!
Dividends provide corporations a way to share some, or all, of their net profits with their shareholders. The amount of the dividend is subtracted from the share price on the distribution date, and shareholders are taxed at a 15% rate on the payout. Dividends, however, provide almost instant gratification for shareholders.

Share-repurchase programs don't reduce a stock's share price, nor are they subject to the secondary taxation that dividends are (profits are taxed at the corporate level as well). Their purpose, simply, is to reduce the amount of shares outstanding to drive up earnings per share and make the company appear cheaper. Share repurchases often don't have as "instant" of an effect on shareholders pocketbooks as dividend payments do.


While I agree to some extent that both methods reward shareholders, I believe that corporations are purposefully duping investors into believing that share repurchases are an equal reward to dividend payouts, when in fact they aren't.

Don't get me wrong. There is a time a place for share buybacks. In fact, my Foolish cohort Chris Hill, along with Jim Gillies and Jeff Fischer, recently highlighted five companies that are doing a good job of enhancing shareholder value through buybacks. Even Warren Buffett, highly regarded as one the top investing moguls, has turned to share repurchases with his conglomerate, Berkshire Hathaway (NYS: BRK.B) (NYS: BRK.A) , sporting around $38 billion in cash.

However, aside from those few instances where it makes sense, share buybacks have inherent flaws that many investors often overlook.

It demonstrates a lack of growth and innovation
Let's start by looking again at Berkshire Hathaway's decision to repurchase its own shares if they are at 110% of book value, or less. In 2011, when Buffett commented on the decision to enact share buybacks, he also noted that "not a dime of cash has left Berkshire for dividends or cash repurchases during the past 40 years." So why initiate a buyback now? Buffett simply believed that "the underlying businesses of Berkshire are worth considerably more than this."

The logic makes sense, as does Buffett's intent, but I took this buyback to mean something completely different. In the past, Berkshire had kept all of its income for reinvesting in its business. With the enactment of a buyback, that signaled to me that Berkshire is having difficulty finding new paths to growth.

But if it's any consolation, Buffet and Berkshire aren't alone. More than a handful of companies have turned to share buybacks to boost EPS because, frankly, they haven't exactly figured out how to jump-start their business.

For example, take Best Buy (NYS: BBY) , which is currently struggling with the transition to online retailing. Best Buy does pay a dividend that's currently yielding 3.5%, but it's spent the vast majority of its cash in recent memory on share buybacks.

Source: Morningstar. All figures in millions.

In just six years, Best Buy has reduced its share count by 27.5% to 366 million, but net income has gone nowhere despite incremental rises in revenue each and every year. Reducing the outstanding share count had a positive impact on driving EPS growth, but it falsely lured growth investors into a stock that had been suffering through declining margins.

Poor timing
That brings me to my second point: poor timing.

Companies will often inform investors that the reason for enacting a share-repurchase program is that they think their shares are undervalued. If share prices rise after the buyback, no one tends to complain -- but what happens if they get even cheaper?

The fact is, many companies are really bad at timing their stock purchases. Best Buy is a perfect example. It began aggressively repurchasing its shares in 2008, when its share price dipped briefly below $20 per share, but it also repurchased roughly 87 million shares with its share price ranging from $23 to $48. With its share price now slightly above $18, that move isn't looking too hot.

Best Buy isn't alone. Plenty of companies that could probably use the cash right about now have repurchased shares at very inopportune times.

Sears Holdings (NAS: SHLD) began aggressively repurchasing its shares in 2008 and has reduced its share count by 50 million shares since then. The problem with these repurchases is that almost all of them occurred with Sears' stock north of $60. That's more than $3 billion in cash, possibly even more, spent on share buybacks from a company that's closing up to 120 stores to reduce expenses and generate cash.

Sprint Nextel (NYS: S) is another prime offender and may even take the cake for the worst-timed purchase. In 2006, Sprint's board of directors passed a repurchase plan allowing the company the ability to buy up to $6 billion in stock. By the time the plan expired in 2008, Sprint had repurchased 185 million shares at an average price of $18.77 and costing $3.5 billion. Sprint now trades for less than $4 per share.

Dividends are more conducive to shareholder investment -- at least in this environment
The final aspect investors are overlooking is the historically low lending rates. With the Fed Funds rate hovering around 0.25%, companies should be investing heavily in growth and making large strides at boosting their dividend payouts. With most CDs yielding less than 1% and Treasury bonds at historic lows, dividends offer possibly the safest form of inflation-beating growth. If companies really want to spur investment and drive their share price higher, they should be considering dividends instead of share buybacks in this low-rate environment.

But are companies doing this? You guessed it -- nope!

Sources: Robert Shiller's Irrational Exuberance, Standard & Poor's.

Currently, companies in the S&P 500 are paying out what amounts to a few basis points over 2% in yield, which is well below the historical average. Share buybacks, however, are on the rise. In 2011, nearly 2000 companies repurchased $397 billion worth of their own stock -- the third-highest year on record, behind only 2006 and 2007. Buyback totals dropped moderately through the first half of 2012, but dividend increases have remained relatively tame.

If companies were smart in their pursuit of higher share prices, they'd be boosting dividend payments and drawing investors to purchase their stock as opposed to repurchasing their own shares and offering little incentive to shareholders in an already low-rate environment. To put it another way, it's no secret why the high-yielding utility sectors keep heading higher.

Show me the money
With global growth slowing and interest rates in the U.S. at historic lows, I say keep your lousy share buybacks and show me the money.

If you want to be shown the money right now, and you can't find your DVD of Jerry Maguire, then feel free to get your free copy of our report detailing nine rock-solid dividend-paying stocks hand-picked by our analysts at Motley Fool Stock Advisor. Trust me -- it'll complete you!

The article Investors: You're Being Duped by Share Buybacks originally appeared on Fool.com.

Fool contributor Sean Williams owns SPDR puts that mirror the performance of the S&P 500, but he has no material interest in any other companies mentioned in this article. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong.The Motley Fool owns shares of Berkshire Hathaway and Best Buy. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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