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Dividends vs. buybacks and why investors are missing the point

By Mitchell Manoff

Category: Investment

Ideas get bigger when you share them...

Visit: Corinthian Partners

New York, NY - January 21, 2013 (www.investorideas.com newswire) Corinthian Partners: There has been a number of articles written comparing dividends vs. share buybacks. I believe that the first decision is comparing buybacks with other growth opportunities, then comparing the best growth strategy to paying a dividend and at what payout rate.

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As a shareholder of a public company you are an owner, however small, and need to think of the investment not as just some piece of paper, but with you as a business owner. No different than if you owned the corner grocery store. Just like the corner store, the larger public company needs to invest their free cash flow in the most efficient manner. Broadly speaking there are only 5 ways for a public company to deploy excess cash flow.

Cash in the bank, keeping it for a rainy day

Organic growth- R & D, develop new products, expand existing products and markets, etc.

Make an acquisition- buying products, technology, personnel, market share etc.

Buyback shares

Pay a dividend

Keeping money in the bank has the disadvantage that in our zero interest rate environment that's what it gets, zero. If a large amount of cash remains on the balance sheet the company becomes a takeover candidate (frequently not bad for shareholders but not a creative corporate policy). Obviously the company needs to have a proper cash cushion, but if the company can't use their cash for a better return than what banks are paying, you might want to reconsider investing in the company in the first place.

There are many scenarios which can be played out with the next 3 options, but with all of these options you are speculating that management has made the right choice, and frequently will not know for some time.

The eternal question is which is better: building vs. buying to achieve growth. The use of capital for organic growth, and R & D are ways to build out the existing company. If the company has internal growth opportunities great you use the free cash to hire more people, build more plants and keep doing what you are doing only on a larger scale. R & D when used successfully ( the operative word is successfully) is frequently the difference between a world class company and an also ran. However, one could argue that the massive sums spent by many drug companies could be better spent. There have been multiple of years when Pfizer (PFE), Merck (MRK) and others spent billions without any products being created. Yes I know there is a long, bumpy cycle for drugs to be approved but billions are billions. As for acquisitions they are almost always dilutive, thus lowering the price of the stock in the near to intermediate time frame and frequently with disastrous consequences. Witness the many write offs from Cisco (CSCO) over the years and more recently Hewlett's (HPQ) $10 billion disaster in Autonomous.

So the question comes up if there are not attractive acquisitions, R & D is properly funded and a steady internal growth plan is in place then and only then is a buyback something to do. Only now the question come up which is better a buyback or a higher dividend?

Buybacks will shrink the float thus will have a positive near term positive effect on earning, it's just math. However those earnings gain will disappear if the shares go in the front door and out the back in the form of egregious stock options. Buybacks will work best with a disciplined approach. Warren Buffett, who certainly makes acquisitions, will buy Berkshire's stock if it is trading below 120% of NAV, as he believes the company's intrinsic value is far higher. Others will buy their shares if it trades below a certain p/e ratio or price to book. These are well thought out, disciplined approaches which unfortunately are not followed by all firms.

What's interesting is that according to a December 2012 Wall Street Journal article, "since 1999 members of the S&P 500 have spent $3.5 trillion dollars in buying back their stock, a quarter of the value of those stocks at the start of that time period, yet the total shares of these companies have grown 7% during that time period stock grants to management while not the sole reason play a big role." If you are buying a company because of their share buyback program make sure that the number of shares are lower than last year. Make sure the shares are not re-circulated.

Dividends reward shareholders, not stock option holders. Corporate executives who own unexercised stock options are not owners, therefore do not benefit from dividends, thus may have more interest in the near term earnings pop created from a share buyback program as opposed to higher dividends. You are a shareholder, remember an owner. Dividends are never a bad thing, it puts money in your pocket, with you having the option of reinvesting back in the company through a dividend reinvestment program (DRIP) and as a result having your position grow. Please check how each company handles this, some are free, others not. Dividends can provide the cash flow to increase the number of shares that you own, albeit with possible taxable implications.

As a retiree or near retiree, if you follow the rules that I set out in my December 31st 2012 Seeking Alpha piece Replacing Income The 4,5,8 dividend growth strategy which is 4% dividend yield, 5% dividend growth and 8% earnings growth and you have the start of a solid strategy. Learning where the company's growth is coming from raises your level of sophistication.

That said one of the best signs of corporate health is when a group of senior executives buy shares in the open market. Having an executive of a company use their after tax dollars, like you, to buy his company's stock, and be restricted from taking short term profits, unlike you who can buy and sell as you please, is the best news that an investor can hear. If income is important to you remember that you can't go to the supermarket and say that I don't have the money (from dividends) to buy groceries, but all ten of my companies have a share repurchase plan in place. Own stocks that meet your financial needs.

Mitchell Manoff
Chief Executive Officer
Corinthian Partners
www.corinthianpartners.com

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