THE year 2022 was a bad one for global investors as the US Federal Reserve raised interest rates at a record pace to tame runaway inflation in the aftermath of the Covid-19 pandemic, widespread supply chain shocks and a shortage of workers in key sectors. The main US benchmark, the S&P 500, fell 18% last year while earnings for the 500 component companies in the index grew 4.6% during the year. Tech stocks were hammered the hardest, down 29% if you measure them using XLK, or the Technology Select Sector SPDR Fund, one of the more widely used tech indices.
Yet, over-hyped large-cap tech stocks weathered the storm much better than their counterparts. Since the start of the year, Big Tech stocks have outperformed the market. Here’s why: Global tech giants also have the largest cash hoards and are the biggest purchasers of their own shares.
Little wonder, then, that just as the Fed was raising rates and everyone was rushing to sell down stocks, companies that were buying back their own shares did relatively better than those that did not buy back any of their own shares or only paid out dividends. In 2021, the world’s biggest purchasers of their own stocks were iPhone maker Apple Inc, software behemoth Microsoft Corp, social media supremo Facebook’s owner Meta Platforms Inc, search giant Google’s parent Alphabet Inc and another large software firm, Oracle Corp. Those five firms accounted for 28% of buybacks in the US. In 2022, of the top five companies buying back their own shares, the order changed slightly with oil giant ExxonMobil Corp replacing Oracle.
Here is a short and simple primer on dividends and buybacks. When a company has a ton of profit hoarded up, it can spend it on expansion like new plants or buying out another company, hiring more workers or spending on research and development. Or it can pay it out as dividends or buy back its own shares. Both dividends and stock buybacks are ways of distributing income to shareholders.
To understand why so many people love dividends but hate buybacks, look no further than the history of dividends. Bond markets existed long before stock markets and bonds, like those issued by, say, American railroad operators, paid a regular annual interest coupon. To win over bond investors to the stock market, the early listed companies guaranteed a dividend. So, an investor could invest in either a stock or a bond and still get that regular “income” or a coupon. Stocks were cleverly sold as something with the optionality of price appreciation. These days, fewer than 400 of the 500 biggest US firms pay a dividend, though about 120 of them pay so little that they might not even bother doing so. Oh, one more thing: About a third of the firms that pay dividends borrow money to pay it.
A dividend paying firm is not one that is necessarily profitable or, indeed, has a lot of spare cash lying around. Many pay dividends because they are just desperate to attract investors. If they did not pay a dividend, their stock would probably tank. And if their stock tanks, they might not be able to raise more money in the bond market. Look at the big telecom companies such as AT&T Inc, or mid-sized banks like Citizens Financial Group Inc, or commercial real estate firms like SL Green Realty Corp, the largest owner of office space in New York’s Manhattan. All have huge dividend yields and stocks that are selling at five times the next 12-month earnings. Yet, no value investor in their right mind would touch them with a 10-foot pole.
The problem is not just that most firms don’t have profits to pay dividends and are leveraging up to keep paying them every quarter, but that even their long-term prospects are not good, notes Aswath Damodaran, professor of finance at New York University. “Dividends, because they are sticky, require some degree of confidence about future earnings,” he said in a recent podcast. These days, Damodaran notes, because just about every business is being disrupted, it is difficult to say who has reliable and predictable earnings. Twenty years ago, General Electric Co was the world’s biggest company, which consistently grew dividends every year even though it could barely afford to pay it. The company has since been broken up. “If earnings become less predictable, what company in its right mind wants to increase dividends by 20% and then face the problem two years later of saying, ‘We’ve been disrupted, we have to go back and cut dividends’?” he says.
Damodaran sees buybacks as “flexible dividends”. There is a belief that when a firm cuts dividends, it’s because there is a disaster on the horizon, he notes. Companies are stuck with paying a dividend even when they know it is not in their best interest to pay it. They don’t want to send the wrong signal. The way he sees it, the world has changed since 1934, when Ben Graham wrote of stocks with a bond-like coupon and price appreciation in his seminal tome, Security Analysis. Moreover, there were no Amazon.coms or disruptive technologies back then.
That brings me back to stock buybacks, which were illegal in America until 1982. Under President Ronald Reagan, the Securities and Exchange Commission in 1982 allowed companies to legally repurchase their own shares. Buybacks grew rapidly in the 1990s. By 1998, buybacks and dividends for the S&P 500 firms were around US$150 billion each. Buybacks grew substantially in 2018 after the passage of the US Tax Cuts and Jobs Act under President Donald Trump, growing from US$519 billion in 2017 to US$806 billion in 2018, declining slightly in 2019 and then exploding in the aftermath of the pandemic in 2020. Last year, stock buybacks in the US were almost twice as large, or over US$1.26 trillion, compared with just US$550 billion for dividends.
Clearly, listed firms are waking up to the reality that share buybacks make a lot more sense than old-fashioned dividends. If you compare two similar-sized US companies that were returning a similar amount of money, one that only paid dividends and the other that only did buybacks, you would find that buybacks trumped dividends all the time when it came to stock prices. Shareholders love buybacks. Corporate boards, which until a few years ago were lukewarm, are now embracing buybacks.
Increasingly, companies that have buybacks and also pay dividends are allocating less of their spare cash towards dividends and more towards buybacks. For example, in recent quarters, Apple repurchased around US$20 billion (RM88.05 billion) of its own shares and paid out US$3.7 billion in dividends. Over the years, it has been accelerating its buybacks and decelerating dividend payouts. Oil giant Chevron Corp recently announced a 6% increase in its quarterly dividend to US$1.51 per share as well as a new buyback authorisation of US$75 billion.
Firms buy back shares for a number of reasons, including purchasing them when they are undervalued and can subsequently be sold at a higher price, or to increase their earnings per share by reducing the number of shares or to offset the increase in outstanding shares through the exercise of employee stock options, particularly at tech companies where option plans and not basic salary are used to lure staffers.
Buybacks have been criticised by left-wing politicians like Bernie Sanders, who say firms should use their cash to boost long-term growth by ploughing more of it into employee benefits or capital expenditure that creates jobs. They also allege that buybacks help boost management compensation because CEOs get more bang for their stock options if the price of the firm’s stock is pumped up. Here is the problem with that argument. If you look at the companies with the biggest stock buybacks in the US, you might find that in about half of those, the CEOs or the top managers didn’t get the kind of boost the critics allege they get. The CEO who has got the most bang for his buck in history is Elon Musk, who made US$56 billion from EV maker Tesla Inc’s 2018 stock option plan. Tesla, unfortunately, has never bought back any shares.
Other politicians have criticised companies for wasting their retained cash on buybacks and then asking for government handouts as soon as things sour. From 2014 until 2019, US airlines spent US$45 billion on stock buybacks even as they cut costs and laid off workers. At the start of the Covid-19 pandemic, the airline industry asked the US government for US$50 billion in bailouts. Yet the pandemic was a black swan event and it was Washington that implemented a nationwide lockdown, which forced airlines to shut down their operations. Earlier this year, a freight train carrying toxic chemicals derailed along the Norfolk Southern Railway in a small town in Ohio, spurring an environmental clean-up. In the aftermath of the disaster, Norfolk Southern was accused of prioritising US$10 billion in stock buybacks over maintenance, which might have prevented the derailment.
Berkshire Hathaway CEO Warren Buffett in his recent annual letter to shareholders weighed in on the buyback controversy. Buffett, a disciple of Ben Graham, was once himself a critic of buybacks and loved to talk about collecting dividends from invested companies. He has since transformed into a big proponent and defender of buybacks. “When you are told that all repurchases are harmful to shareholders or to the country, or particularly beneficial to CEOs, you are listening to either an economic illiterate or a silver-tongued demagogue,” the Oracle of Omaha intoned. “The math isn’t complicated,” Buffett wrote. “When the share count goes down your interest in the businesses goes up. Every small bit helps if repurchases are made at value-accretive prices.”
Berkshire itself has never paid a cent in dividend. The Nebraska-based conglomerate initiated a buyback programme in 2011. It spent a US$27 billion in share buybacks in 2021. However, buybacks plunged to just US$8 billion last year when Berkshire went on a shopping spree as stocks sold off, acquiring insurer Alleghany Corp for US$11.6 billion and building big stakes in firms like Occidental Petroleum Corp.
Because buybacks are gaining popularity and companies are ditching dividends, governments want to use them to squeeze more tax revenues to pay for huge pandemic-era budget deficits. President Joe Biden’s Inflation Reduction Act of last year includes a 1% tax on stock repurchases by listed firms. The Congressional Budget Office estimates that a 1% tax on all US share buybacks could raise up to US$74 billion over the next decade. In early February during his State of the Union address to the US Congress, Biden proposed to increase the tax rate on buybacks to 4%. Unfortunately, buybacks have such a hefty advantage over dividends that taxes are unlikely to turn the tide back in dividends’ favour.
Time for Asia to embrace buybacks
While buybacks have caught on in Europe, Japan, South Korea and Australia to a varying degree, they are rare in much of the rest of Asia, which is home to some of the fastest growing economies in the world.
The argument against buybacks is that Asia has many high-growth companies and they need a lot of cash to fund that growth. Stock buybacks tend to drain corporate cash hoards. Yet, the world’s fastest growing firms are US-based tech plays, which also tend to be the biggest purchasers of their own stocks. Buybacks enhance stock performance, which in the end helps companies grow even faster and in turn allows them to further innovate and build a stronger platform to keep growing. Consider this: Over a 10-year period, Singapore’s Straits Times Index is flat and the FTSE Bursa Malaysia KLCI is down 16% in local currency terms. In comparison, the S&P 500 is up 158% over the same period, while the tech-focused Nasdaq 100 and Technology Select Sector SPDR are up 263% and 384% respectively, in US dollar terms. Growth companies as well as growth markets are probably better suited for buybacks than dividends, which of course were invented to mimic bond coupons.
Is it time for Asia to ditch dividends too and embrace buybacks? I believe it is.
Assif Shameen is technology writer based in North America