The Contrarian Case For Stock Buybacks

There is no shortage of articles criticizing corporate America for buying back so much of its own stock.

According to the New York Times, these articles have dispelled the illusion of stock buybacks. Yet they only provided a few examples of individual stocks, and managed to ignore the fact that the PowerShares Buyback Achievers ETF (PKW), holding hundreds of stocks, handily bested the total return of the S&P 500 since its launch in late 2006, in spite of expenses.

To see why buybacks can be better than dividends, let’s take an imaginary case and a very simplified scenario where dividends would only be paid once a year.

Chart courtesy of StockCharts.com

Dividends Or Stock Buybacks?

Say one year ago, you bought 100 shares of “Shareholder Value Inc. (SVI)” for $45 a share. It performed well and now sells for $50 per share. So your $4,500 investment is now worth $5,000. SVI earned $4 per share and has determined it can only invest half of the money to earn more than the rate demanded by shareholders (its cost of capital). Thus, management wants to do the right thing and return $2 per share to its owners. It knows it has two options—dividends or stock buybacks.

If SVI pays you a $2-per-share dividend, you will pay dividends taxes on $200, typically at 15% plus state taxes, which amounts to $30 in Federal taxes. The price of your stock will immediately fall by $2 (as it no longer has the cash), and you will own 100 shares at $48 per share, or $4,800 of stock, and have $200 in your pocket before taxes.

The Buyback Scenario

SVI knows if it instead bought back stock, shareholders could be better off. Instead of the dividend, it buys back its own stock and you decide to take part on a pro-rata basis and sell four shares at $50 per share.

The price of the stock doesn’t drop because the cash outflow and the fewer shares outstanding offset. You net $200 and your basis is $180, so now you have to pay taxes at a 15% rate on the net $20 gain (wait one extra day to get the long-term capital gains rate).

Instead of $30 in taxes, now you owe only $3. Even if you have to pay a small commission, you are better off. You end up with the same $5,000, with $200 from the sale of four shares and $4,800 in stock based on 96 shares at $50 per share.

My View

SVI management clearly acted in the shareholders’ best interest in this example.

Management has an obligation to return cash to shareholders if it can’t invest money and earn a return greater than shareholders’ expectations. To invest at lower returns is to destroy shareholder value. It should have nothing to do with management guessing whether the stock is under- or overvalued. And stock buybacks are a more tax-efficient way of returning capital to shareholders.

Now before you think I’m in total defense of corporate America, let me first admit that most management probably buys back stock for the wrong reasons.

As noted in the example above, the share price dropped by the dividend amount, but not in the buyback example. Management typically gets stock options, so the option value is maximized with buybacks. Second, dividends are viewed as more permanent, and stocks are punished far more when they reduce dividends than when reducing stock buybacks.

And finally, like individual investors, management times the market poorly. After the 2008 stock plunge, when stocks were on sale, stock buybacks were drastically reduced.

So while I admit that management does buybacks for its own benefit, it also happens to help shareholders. Though I don’t pick funds that concentrate on stock buybacks, I don’t see buybacks as a bad thing either.

At the time of writing, the author held no positions in the security mentioned. Allan Roth is founder of Wealth Logic LLC, an hourly based financial planning firm. He is required by law to note that his columns are not meant as specific investment advice. Roth also writes for the Wall Street Journal, AARP and Financial Planning magazine.