The Truth Behind Ballyhooed Share Buybacks

By Andrew Gordon

Altria announced on January 29th that it would forego its generous share buyback program. The next day, Friday, saw its shares drop a couple of percent. But by the following Tuesday its shares had completely recovered.

The buyback program helped the giant cigarette company keep somewhat respectable earnings per share growth over the past year. Without it, earnings would have looked a lot worse.

So why wasn’t the company punished?

Before I answer, let’s look at another example.

3M suspended its share-buybacks last Tuesday. Market reaction to 3m wasn’t as kind as it was to Altria. Take a look...

Its shares fell 8.2 percent over the remaining four days of the week. But investors in fact gave 3M a small slap on the wrist. As you see, 3M dropped a little more than the S&P 500 (the red line), but the difference wasn’t dramatic.

Could it be that the market doesn’t care so much about this so-called “shareholder friendly” practice?

If so, it’s about time.

Companies love to parade these share buyback programs in front of shareholders and proclaim that they’re the best thing for shareholders next to dividends.

But the two aren’t even in the same league.

Dividends are a long-term commitment made to shareholders. And companies with mature business models that generate more cash than the need to reinvest back into the company can afford them.

The fast-growth days of these companies are long past. So they attract shareholders by giving them cash every quarter. Sometimes they give them more cash. They never give them less cash if they can help it. That would be breaking the critical quid pro quo they have with shareholders. That’s a no-no and companies know it.

So they also tend to be careful cash managers. They spend cautiously. And they borrow cautiously.

And because they’re slow-growth companies, they’re not hurt as much as other companies in a recession. That plus their careful cash conservation and their cash payouts make them appealing investments in the kind of market we’re experiencing right now.

Companies pursuing share buyback programs don’t compare. They’re not a definable class of companies like dividend companies. They’re not necessarily careful stewards of their cash. There’s no long-term commitment involved. They just happen to be sitting on a lot of cash.

Buying back shares is one way of getting rid of spare cash and it also benefits shareholders.

At least that’s the party line you’ll hear from CEOs and CFOs. And you won’t hear Wall Street disagreeing. So let me give you the real deal.

Corporate management does it mostly for themselves. Bonuses get triggered when certain earnings levels are reached. And to the extent that some of their compensation is in company shares, the more those shares are worth, the more pay they pocket.

It’s a win-win, right? Management and shareholders both benefit...

But I have a better idea. Why not give the excess cash directly to shareholders via dividends? Let shareholders pocket the extra money immediately. It seems like a much more simple approach if management truly has the interests of shareholders in mind.

In fact, share buybacks may be going the way of the dinosaur. Last year by this date, companies had bought back $63 billion worth of their own shares. So far this year they’ve bought back only $4.3 billion.

Yes cash is short. And cash is king. Companies can’t afford generous buyback programs anymore. And companies like 3M and Altria can’t afford to fund both buybacks and dividends.

One had to go. And they made the right choice. Keep the dividend payments going and shed the buybacks. Management bonuses will probably take a hit. But that’s only fair. Their companies are obviously struggling. Their compensation should take a hit.

But if they can maintain dividends when credit is so tight, it says something. You should consider investing in these companies. They are making a case for themselves. I have a portfolio full of these companies you can check out, if you want.

The companies making the strongest cases are the ones that are raising dividends. So far this year, 24 companies have hiked dividends. They definitely have my attention. You can find them in the Wall Street Journal. They track both the dividend cutters and raisers every day.