Share buybacks superior to dividends, if done right

Apple, the largest listed company in the world by market cap, has spent more than any other on share buybacks over the past decade, totalling more than US$550 billion, according to a Bloomberg report in November 2022, and another US$20 billion or so since then. So much so that the buybacks have become an integral part of the investment thesis for the stock. Investors have come to expect its consistent buybacks — the company does not try to time the market — to reduce stock price volatility, especially in times of heightened market uncertainties and economic slowdown, thus, bolstering the stock’s perceived safe haven status and premium valuations. Many also view it as a sign of management confidence in its prospects.

Mathematically, buybacks reduce the number of outstanding shares (whether they are held as treasury shares or cancelled outright) and as such, each remaining shareholder will now own a slightly higher percentage stake in the company. Chart 1 shows the material impact buybacks had on Apple’s shares outstanding, which have shrunk by almost 40% from the peak in 2012, the year the company authorised its first buyback programme.

If shareholders wish to have an income stream, they can “cash out” by selling some of their shares, while retaining their original ownership percentage. The sale proceeds would be equivalent to “dividends”. If they choose to hold on to all their existing shares (that is, do nothing), this would be akin to them “reinvesting dividends” in the company. In this case, they would now own more of the company, at no additional cost. In a way, a share buyback is a more efficient and effective way to grow wealth, given that most will probably spend away their dividend incomes.

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Since a share buyback reduces the number of shares outstanding, it will correspondingly increase the earnings per share (which is calculated as net profits divided by number of shares). A higher EPS translates to higher share prices, all else being equal. We mentioned earlier that stock prices usually get an immediate boost when the company announces a huge share buyback programme — but are the gains sustainable?

Positive correlation between share buybacks, growth and stock prices

We analysed the total amount spent on share buybacks and dividends data over the last five years, as well as revenue growth and share price changes over the period, for the largest 100 companies in the S&P 500. First, we separated the stocks into five baskets, based on their revenue growth over the five-year period, and determined whether each of these companies spent more on buybacks or dividends. We then calculated their median share price change (over the same five-year period). (See Chart 2).

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The results show a strong positive correlation between buybacks, growth and share price appreciation. A significantly higher number of fast-growing companies spent more on buybacks than dividends while the opposite is true for lower-growth companies. We think this is due, at least in part, to the discretionary nature of share buybacks — they are more flexible than dividends. Companies with high growth tend to have higher volatility, in terms of sales and profits. Therefore, they can more easily reduce or stop buybacks, if necessary — with fewer risks of incurring investor backlash. Dividends are generally perceived to carry a high degree of commitment from management, that they will be regular and sustainable, if not increased, going forward. The last thing management wants to do is cut dividends as it sends a negative message to the market that something is amiss.

Unsurprisingly, stock prices for higher-growth companies outperformed lower-growth companies. But it is notable that stock prices for companies that spent more on share buybacks than dividends performed better over the same period across all five baskets, low and high growth (see Chart 2). This suggests that share buybacks do provide sustainable boosts to stock prices — as long as the buyback programmes themselves are sustainable. Why?

The stock market is a market for stocks. And share prices are determined by marginal demand and marginal supply. When a company purchases its own shares, it reduces the supply in the market. If its business also does well, demand from buybacks will add to market demand for its shares, thereby boosting share prices. For example, Apple’s market cap — price multiplied by number of shares outstanding — has grown strongly over the years, as its share price gains far outweighed the shrinking number of shares. In other words, buybacks quite likely give a bigger bang for the buck, compared with paying the same amount in dividends, which just reduces the company’s cash.

We think there is another factor that is compounding this positive effect for big cap stocks that are components of major market benchmark indices — funds, especially passive exchange-traded funds (ETFs) that mirror the indices. As the market cap for, say, Apple grows relative to the S&P 500 index — from less than 4% to more than 7% over the last five years (see Chart 3) — these ETFs will also have to increase their holdings. The shares held by these funds are effectively “locked up”, further reducing the tradeable number of Apple shares in the market. Like we said, price is driven by marginal demand and supply. This is why share prices for companies tend to jump when they are added into the major indices, and why component stocks typically trade at premium valuations.

Why then are Malaysia and Singapore listed companies leery of buybacks?

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The question then is this: Why are share buybacks not more popular in Malaysia and Singapore, given the positive correlation between stock prices and buybacks that we see in the US? Companies listed on Bursa Malaysia and Singapore Exchange (SGX) do regularly seek shareholder approval for share buybacks, but few actually perform more than token purchases, and mostly on an ad hoc basis.

Warren Buffett, one of the most successful investors in our lifetime, is a vocal proponent for buybacks. Berkshire Hathaway has famously never paid dividends in the 58 years since Buffett took the helm — because he is confident that he can best reinvest the company’s cash, and generate higher returns for his shareholders, than they could. This is proven by the phenomenal performance of Berkshire shares over the decades. Yet, the company has spent more than US$62 billion over the past five years to buy back its own shares.

In his latest annual letter to shareholders, Buffett wrote, “Gains from value-accretive repurchases, it should be emphasized, benefit all owners — in every respect.” Therein lies the rub. Buybacks are positive for shareholders — only when the repurchases are made at prices below the stock’s intrinsic value. Determining the intrinsic value, however, is far easier said than done. Indeed, Buffett goes on to say, “Just as surely, when a company overpays for repurchases, the continuing shareholders lose. At such times, gains flow only to the selling shareholders and to the friendly, but expensive, investment banker who recommended the foolish purchases.”

We think this is one of the key reasons why buybacks have not taken off in this part of the world — because our investors are a much more sceptical lot. Market perception of any share buyback, whether it is to be viewed positively or negatively, is heavily dependent on the integrity of its management, who more often than not are also the controlling shareholders. These shareholders may have vested interests in making the buybacks just so that they can then sell their shares at higher prices. This is unlike companies in the West, which are mostly professionally managed, and whose management has little pre-existing stakes in the company (aside from stock options). No doubt, share buybacks can be — and have been — used as a tool for market manipulation by self-serving shareholders. In fact, buybacks were illegal in the US prior to 1982, precisely for this reason.

Many companies themselves, we suspect, are wary on the market’s perception — and perhaps also that of the regulators — of any buyback. Paying dividends is far less likely to attract controversy. Regular dividends too send a positive message to the market — that the company is generating strong cash flows, which typically results in less volatile stock prices during periods of market turbulence. And since management also tends to be the controlling shareholders, with big existing stakes in the company, rewarding themselves with dividend income is a no-brainer.

Again, the situation is different in the US — not only are most companies managed professionally, the bulk of top management’s remuneration is made up of stock options. Case in point, Sundar Pichai, CEO of Alphabet, received US$226 million in total compensation in 2022, of which US$218 million was in the form of a triennial stock grant. His annual salary was US$2 million from 2020 to 2022. Hence, management clearly had strong vested interests in ensuring rising share prices — with higher stock prices, the value of their options rises. And buybacks have proven to do just that.

So, buybacks or dividends? Anecdotal evidence strongly suggests buybacks have a positive effect on stock prices. On the other hand, paying reliable dividends regularly also has its virtues. Companies that pay consistent dividends are attractive to certain types of investors — those seeking reliable income streams such as retirees, to meet expenses. Indeed, there are dedicated dividend funds that only invest in high-yield companies. And as we mentioned, these stocks general ly outperform in a “risk-off” market. In the same letter to shareholders last year, Buffett also expounded the virtues of his “winners” in companies that pay regular, and growing, dividends, such as Coca-Cola and American Express. We think the answer is not one or the other, but companies — and investors — will choose the option that best fits their circumstances.

Why are we writing this article, and that a couple of weeks ago (“Why some companies trade at below net cash? Opportunity or value trap?”, published on April 24, 2023)? The SGX has underperformed in the last decade, and Bursa Malaysia’s performance is even more dismal (negative 16% over the 10-year period). Unless reversed, it will self-perpetuate — no one invests in markets that do not perform and owners do not list their companies in “undervalued” markets. In our article two weeks back, we wrote that “activist investors” are necessary for price discovery of companies where trading is illiquid or where major shareholders do not care to monetise undervalued assets. We showed this week that share buybacks are effective to realise better valuations.

Both these suggestions require major execution efforts and clarity on legislative and regulatory hurdles, whether real, perceived or simply a matter of fear.

Yes, scepticism is valid as many buybacks were executed with the aim of taking out substantial shareholders at a premium. How do we stop this, akin to “insider dealing”?

But the reverse is also true. The lack of clarity means potential risks of selective prosecution and those with high integrity do not wish to be caught out. For example, when is a sale by a controlling shareholder to a buyback totally legitimate? In the US, the Securities and Exchange Commission has a “safe harbour” rule that protects companies from stock manipulation charges, as long as they meet a set of conditions, including purchasing from open market and limits on timing, daily volume and price for the shares bought.

There is no space in this article to fully articulate all these but The Edge as a business media in Singapore and Malaysia is prepared to initiate engagement with all stakeholders, shareholders, management and regulators to arrive at a facilitative and practical framework.

The Global Portfolio fell 5.2% for the week ended May 3. All stocks fell for the week, with the top losers being Star Media Group (-13.8%), LONGi Green Energy Technology Co (-3.6%) and Alibaba Group Holding (-3.5%). Total portfolio returns since inception now stand at 30.1%, trailing the MSCI World Net Return Index’s 45.6% returns over the same period.

Meanwhile, the Malaysian Portfolio fell 6.8% last week, underperforming the FBM KLCI, which gained 0.8%. All three stocks in the portfolio, Star Media Group (-13.8%), KUB Malaysia (-8.0%) and Insas (-2.9%) succumbed to profit-taking after surging in the previous week. Nevertheless, this portfolio is outperforming the benchmark index, by a long, long way. Total portfolio returns now stand at 174.7% since inception, while the FBM KLCI is down 22.1%, over the same period.

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.