Study says buyback of stock can pay off

Investors have long debated whether corporations should use their profits to buy back stock or pay dividends. Luckily, new research offers some hard data.

More than 63 percent of the return on investment distributed to shareholders since 1997 was delivered through stock buybacks, according to MSCI, a firm that provides data for investment decisions. But such huge stock purchases only became possible in 1982, when the Securities and Exchange Commission loosened rules to prevent companies from manipulating their stock prices.

Critics have since complained that buybacks are nothing more than “financial engineering.”

By purchasing stock, a company reduces the number of shares available for sale. That drives up the earnings per share and often the price for the shares still on the market, making shareholders wealthier, on paper at least. The shareholder sees no benefit until they sell the stock.

Analysts worry that higher earnings per share, a key metric, can mislead investors into thinking profits are higher when only the number of shares has gone down. The return on a cash buyback is also less predictable. Stock prices change minute by minute, and a dip can wipe out the

benefits.

Boards of directors have also tied executive compensation to stock price targets and frequently pay bonuses with stock options. A management team can give itself a raise by buying back stock with cash that might better be spent on capital expenditures to boost capacity or research and development.

Traditionalists prefer corporations reward shareholders with cash dividends, giving them a choice between taking the money or purchasing more stock. Dividends are usually paid with after-tax profits making them an easy way to judge a company’s performance. Many blue-chip stocks are judged by how consistently they raise dividends.

Dividends and buybacks each have their advantages depending on the company’s and the investor’s goals. Some companies do both, like Apple, which just broke $1 trillion in market value. Retirees tend to want dividends for the income, while younger investors prefer buybacks to build wealth.

Of the 610 major corporations studied by MCSI over the last 15 years, 388 spent $5.19 trillion to buyback stocks, compared to $3.86 trillion paid out in dividends by the entire group. Many companies do both.

MCSI set out to detersion mine whether corporations that rely primarily on buybacks underperform in the long-run. Do stock buybacks reveal that the management team has no good ideas about how to grow the company through capital expenditures? Are they putting short-term stock gains over long-term growth? Is the management team just trying to make themselves rich?

Corporations are spending a lot less on capital investments and research and development, but that is true whether a company buys back stock or not. Both dividends and buybacks have risen as management teams have reduced the percentage of profits reinvested in their companies.

This is a worrying trend because studies consistently show companies that spend on research and development outperform those that don’t.

“We did not find any compelling evidence to indicate that these companies elected to buy back shares to the exclubuyback’s of investing in their own futures,” the report states.

Contrary to some expectations, buyback corporations earned higher ratings on environmental, social and governance issues. But the most critical question is whether buybacks hurt a company’s ability to create shareholder value over the long term.

The study compared how much revenue a company generated, as a percentage of money invested, and compared that to the cost of borrowing money. When the return on invested capital exceeds the cost of capital, the corporation creates value. Interestingly, corporations that paid out the most using both dividends and share buybacks performed the best.

“We did not find evidence that companies might be diverting resources to buybacks instead of reinvesting in their companies,” the report concludes. “The strongest companies were also the companies that were the most actively distributing cash to their investors.”

Corporations that reward investors by buying up their stock can deliver more value over the long run than companies that only pay dividends, according to the study.

There is one caveat. Investors should look out for companies that borrow money to buy back their stock. When adding debt is the only way to reward investors, that is a clear warning that potentially nefarious financial engineering is underway.

The MSCI study dives far deeper into these issues, but on it strikes a major blow against critics of stock buybacks. While there is room for abuse, and each corporation is different, this strategy can pay-off for investors.