Analysts who are the most bearish on the U.S. equity markets point to expensive valuation ratios on the S&P 500, notably the dividend yield,2 which is considerably below its long-term average. John P. Hussman, Ph.D., president and principal shareholder of Hussman Econometrics Advisors, the investment advisory firm that manages the Hussman Funds, is well known for being in this bearish camp. Summarizing his case for the U.S. equity market, Hussman wrote last year:
"Over the past 13 years, the total return for the S&P 500 [Index] has averaged just 3.23%. Why have stocks performed so poorly? One word. Valuation… It is not a theory, but simple algebra, that the total return on the S&P 500 [Index] over any period of time can be accurately written in terms of its original [dividend] yield, its terminal [dividend] yield, and the growth rate of dividends."3
Hussman then points out that the current dividend yield on the S&P 500 Index is just around 2 percent, when the average across time was considerably higher. Similarly, Robert Shiller's research on the equity markets shows that from 1871-1982, the average dividend yield for the S&P 500 Index was above 5 percent.4 Given that current dividend yields on the S&P 500 Index are well below that historical average, at face value, the bearish arguments may unwittingly scare investors out of the equity markets.
While the idea of the market being driven by yield is compelling in its simplicity, I believe Hussman's analysis fails to account for a critical market dynamic: share buybacks. Firms generally have three strategic ways they can utilize excess cash: Firms can either pay dividends; engage in share buybacks; or use the cash for other investments, such as acquiring other companies or expanding operations. An increasing number of companies, perhaps driven by a belief that modern equity investors have more appetite for capital appreciation than income, have opted to supplement their traditional dividend payments with share buybacks. In a share buyback, a company invests in itself by using cash to repurchase its shares from investors; this share buyback results in the company reducing its float, thus causing share prices to rise, all else being equal. When one accounts for the combined cash that is being returned to shareholders both from share buybacks and dividends, the market's valuation levels look more enticing.
Dividends Or Buybacks: What's The Difference?
Firms have engaged in increased share buyback activity over recent years. While theoretically buybacks function in very similar ways as dividends as a method of returning cash to shareholders, there are some key differences between dividends and buybacks. The key differences include:
1) Distribution of Cash
- Dividends: All shareholders of a firm receive dividends when they are distributed.
- Buybacks: A select group of investors sells shares back to the company either in the open market or during a period in which investors receive the option to sell all or a portion of their shares back to the company within a certain time frame known as a "tender offer" period. Only those who elect to sell their shares back to the company during the buyback program receive cash, and there is risk that if investors defer selling to the future that stock prices will move lower.
2) Timing of Benefit
- Dividends: The benefit, or the cash received, from dividends occurs at the time the dividends are paid, and therefore reflect a historical measure.
- Buybacks: The benefit from share buybacks—a reduction in shares outstanding—is a benefit that applies to future distributions. Even though only a portion of shareholders sell their shares back to the company, the reduction in shares benefits all the remaining shareholders; the total future cash distributions by the firm are divided in the future among a smaller shareholder base. The concomitant rise in share price associated with the reduction in float benefits all investors on paper at the time of the buyback, and at the time of some future sale in cash terms.
- Dividends: Once firms state their intention to pay a regular dividend, the vast majority in the United States follow through with that commitment unless there is an extraordinary downturn in business prospects.
- Buybacks: Firms announce plans to buy back stock that often are not carried through to execution.
In pure finance theory, when it comes to weighing the pros and cons of the features of dividends and buybacks outlined above, share repurchases are often a preferred method for returning cash to shareholders. Investors like share buybacks because they support higher stock prices5 and one can choose the timing of share sales (and tax consequences) at a point in the future; dividends, by contrast, are taxed at time of distributions and the investor has no choice for when she receives the dividends.
In practice, however, firms do not consistently implement a share buyback program at the regular quarterly frequencies that firms pay cash dividends. On balance, whether firms use their cash for share buybacks or dividends, at worst, finance theory leads me to believe investors should be indifferent, and at best prefer that firms undertake share buybacks. The key point to realize is that firms are distributing cash to shareholders both by dividends and share buybacks, and one must account for both ways when gauging the historical relative valuation levels of the market.
Historical S&P 500 Buyback Data
Howard Silverblatt of Standard & Poor's publishes historical dividends and buyback data on the S&P 500 Index only as far back as the last decade. As of Dec. 31, 1999, buybacks had surpassed dividends, but each was only slightly more than 1 percent, so the combined dividend and buyback ratio was just above 2 percent (see Figure 1). The collapse of the financial sector caused dividends to decline 20 percent from 2008 to 2010. Still, dividends increased cumulatively 45 percent over the last decade. Buybacks were more volatile than dividends over the decade but also increased significantly, and as of Dec. 31, 2010, the S&P 500 Index level was still well below its December 31, 1999, level of 1469.
Source: Standard & Poor's. Data as of Dec. 31, 2010.
The buyback ratio is a market valuation measure used to gauge what percentage of index market value is being reduced by share buyback activity of firms. The dividend and buyback ratio aggregates the dividends and buybacks together to represent a market valuation metric based on two common ways (dividends and buybacks) that firms distribute cash to shareholders.
Because the prices were down, and dividends and buybacks were each up significantly, the dividend and buyback ratios on the S&P 500 Index approximately doubled from Dec. 31, 1999 to Dec. 31, 2010. Note as of Dec. 31, 2008, the combined dividend and buyback ratio was over 7 percent, and at the bottom of the market in March 2009—when the S&P 500 Index touched 666—the dividend and buyback ratio was over 10 percent of the index price.