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Don't Let Dividend Devotion Blind You to Buybacks

August 21, 2012

Don't Let Dividend Devotion Blind You to Buybacks

Photographer: Ross Anania/Getty Images

The tech boom, the real estate bubble -- and dividend mania? With Treasury bonds yielding almost nothing and Main Street mistrusting Wall Street, investors have been piling into dividend stocks. Such income enthusiasm has sent the iShares Dow Jones Select Dividend Index exchange-traded fund, which holds about a third of its $11 billion in assets in utility stocks, to a three-year high of $57.82 a share. It now yields only 3.56 percent -- less than the long-term historical average for the entire stock market.

That sounds a bit frothy. Utility stocks, which normally trade at a discount to the market, now trade at about a 30 percent premium -- their highest-ever premium relative to the broad stock market, according to Mark Freeman, co-manager of the Westwood Income Opportunity Fund. Because the companies have earnings growth in the flat-to-low single digits, "You’re paying a very high valuation purely for yield,” he says. So even though Freeman runs an income-oriented fund, he's cut his utility weighting to 6 percent, from his usual 10 percent to 15 percent.

Buyback bias

Eric Sappenfield, manager of the Mainstay Epoch Global Equity Fund, is also leery of utility valuations. While he's a frequent buyer of dividend stocks, he says investors shouldn't ignore the other ways companies use cash flow to reward shareholders. Those who believe that many big dividend-payers are too dear can find opportunities in companies that are using cash in other strategic ways, including buying back shares of their own stock, making acquisitions, paying down debt or reinvesting in their businesses.

Not long ago, paying a dividend was viewed as a sign that a company didn't have any better use for its cash. “In the 1990s there was a bias that if a company has got to pay a dividend, then it didn’t have the growth opportunities of other companies, which is patently wrong,” says Sappenfield. Today that sort of bias is often applied to companies that use free cash flow to buy back their shares because by doing so, management can manipulate earnings per share and possibly boost the bonuses of executives.

Just as dividend stocks don't all deserve to be tarred with the low-growth brush, companies that choose to use free cash flow to buy back shares aren't necessarily motivated out of cronyism. Buybacks have distinct advantages over dividends. When a company buys back shares and reduces the total shares outstanding, the gains in earnings and book value happen tax-free for shareholders; investors won’t pay taxes until they sell. When that happens, the capital gain would, in most situations, be taxed at 15 percent. Dividends, on the other hand, are taxed immediately at their current rate of 15 percent -- and there is speculation that the tax rate on dividends may soon rise.

Viacom, Time Warner -- and AIG?

Buybacks are well suited to companies that have solid businesses but are more cyclical and economically sensitive than, say, high-dividend-paying utilities. For such companies, it may not make sense to pay a regular dividend when times are lean, and it may make sense to use excess cash to do an occasional buyback if it determines that its stock is undervalued.

That's the case with media companies, says Jerry Jordan, manager of the Jordan Opportunity Fund. Jordan has been "really bullish" on such companies for three years. “Companies like Viacom and Time Warner have been aggressively buying back stock because they’re generating an enormous amount of cash, but the market continues to undervalue them," he says. It doesn't make sense for them to pay really big dividends because of the cyclical volatility in their business, says Jordan. “From their perspective, guaranteeing a dividend every quarter doesn’t make as much sense as buying back stock during the good times.”

Westwood's Freeman sees a buyback play in battered insurance company AIG. The company is cleaning up its balance sheet and streamlining operations, he says. It has plenty of cash to pay a dividend, but because the government -- still a major shareholder -- wants to reduce its position, buying back shares makes more sense financially and politically. The shares are up more than 49 percent this year, yet the stock still trades well below its book value, making it an ideal candidate for continued buybacks. “When you’re buying back stock at a discount to book value, it’s very accretive to earnings,” says Freeman, who owns AIG in another fund, Westwood LargeCap Value.

Another way investors can tap into companies with improving financials is by finding companies that are using free cash to pay off debt. Although interest rates are currently so low that servicing debt isn't too burdensome, paying down debt sometimes makes more sense than paying a dividend. Sappenfield points to automaker Daimler Benz and chemical company BASF, both of which temporarily cut or eliminated their dividends after the 2008 crash so they could pay off debt and shore up their balance sheets. “Managing a company well comes down to figuring out the correct allocation of capital,” he says. “You want to make sure the business you’re investing in is competitive, vibrant and can withstand the cyclical shocks thrown at it.”

(Lewis Braham is a freelancer based out of Pittsburgh.)

To contact the editor responsible for this story: Suzanne Woolley at swoolley2@bloomberg.net


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