I enjoy reading about the history of investing, finance, and business. Like any other historical subject, reading about these topics can help us gain perspective on the present. That’s especially important in the context of investing, as it can help up us understand the best ways to plan for the future.
One thing that always shocks me when looking at older records is how high average dividend yields used to be for stocks. It’s no secret that over the past 100 years, there’s been a decline in average dividend yields. There are many reasons for this, but one contributing factor is an increasing shift to using stock buybacks instead of dividends.
In this post, I want to explain why that shift has made things harder to understand, even if, in the end, these changes have benefits for investors.
Dividends vs. Buybacks
First, a bit of background on dividends and buybacks. Remember that stocks represent partial ownership of a company. But why do investors want to own a company in this form in the first place? The most important reason is that such ownership represents a claim on the earnings and assets of a company. To have any value, a company must through one way or another distribute these earnings to stock owners at some point (or at least have a hypothetical prospect of doing so in the future). There are several ways this payout can be done, but the most important mechanisms are through dividends or buybacks.
With a dividend, a company pays out a certain amount of money, called a dividend, per share of the company. For example, if the dividend per share is 10 cents, and you own 10 shares, then you would receive $1. This is a very direct way of returning earnings to shareholders.
With a buyback, a company instead uses its cash to purchase shares from shareholders. These shares can be “stored” in the company’s treasury (to be potentially resold at a later date), or “retired”. The exact method by which the shares are puchased can vary, but at the end of the day, money has been transferred out of the company to shareholders. That’s clear in the case of shareholders who sold their shares to the company: they now have cash in place of their shares. What about those who retain their shares? Because there are fewer total shares outstanding, each of those shares now represents a larger fraction of ownership of the company, hence a larger claim on future earnings.
Now in theory, there ought to be no difference in the aggregate behavior between these two mechanisms. In both cases, the net result is that money is transferred out of the firm to shareholders, and more advanced economic analysis of the effects would suggest that in principle there should be no reason to prefer one mechanism from the other.
Why the shift?
If there’s no difference in principle between the two, why has there been an enormous shift from the use of dividends to buybacks in the last 50 years? There are a few big reasons:
Taxes: When shares are sold as part of a buyback, the seller pays capital gains tax. Importantly, only shareholders who decide to sell are taxed. On the other hand, every shareholder pays taxes on the dividends they are issued, even the ones that choose to immediately reinvest those dividends back in the stock. For a long time in the US, dividends were always taxed as income, instead of capital gains. For most people, capital gains tax rates tend to be lower than income tax rates. Nowadays, so-called qualified dividends can be taxed at long term capital gains rates, so this difference is less significant. Still, the fact that all shareholders are compelled to pay taxes on dividends makes them less tax efficient.
Legality: For a long time, the legality of various forms of stock repurchase was uncertain. There was concern that companies repurchasing stocks in this manner were engaged in a form of illegal price manipulation. Then, in 1982, the SEC issued rule 10b-18, which clarified that stock repurchases conducted according to certain rules would not be considered market manipulation. This cleared the door for corporations to begin using repurchases without fear, a trend that has continued to the present day.
Flexibility: Buybacks are generally more occasional or sporadic, whereas dividends are commonly issued on a regular basis.1 While that regularity of dividends sounds good, the downside is that markets react very negatively when dividend rates are lowered. Thus, managers may be conservative about dividend rates, building in a buffer that will allow them to not lower the dividend rate even in a downturn. Alternatively, they may unwisely keep the dividend rate higher than would be prudent to avoid signaling bad news in a downturn. Buybacks typically do not constrain managers in this way.
A Confusing Change?
The tax advantages of buybacks are important and positive for many investors. But I believe that in some ways, this shift has made it harder for the “average Joe” to understand long-term investing in equities. Here’s why:
Psychological effects: Investing aficionados know there should be no difference between receiving a dividend and selling shares of stock for an equivalent amount of cash (except for tax treatment). But many, many people psychologically prefer to receive a dividend over selling shares. This leads people to deliberately seek out dividend yielding stocks, sometimes at the expense of lower total returns and less diversification. Investment management companies that we normally think of as encouraging prudent practices even cater to this: Vanguard offers special dividend-focused funds like VDIGX and VHYAX. If all stocks used dividends instead of buybacks, this artificial distinction would apply to fewer stocks and lead to less confusion on this point.
Less transparency: With dividends, it is very easy to understand how much money has been returned to investors. With buybacks, the situation is much less clear. Of course, you can look at individual filings of a given company to see how much money was spent on buybacks, but the effect of buybacks on an overall index is hard to piece together.
For a buy and hold index investor, you might argue that this reduced transparency is irrelevant. I think that’s true, but psychologically I believe it helps investors to “stay the course” if they can better understand such fundamentals.
More complicated withdrawal “rules of thumb”: A dividend is effectively no different from a forced sale of a share, which can be unfavorable when a shareholder does not want to sell, such as while they are still in an accumulation phase. However, with non-dividend paying stocks (and the shift to lower yields overall), this means retirees must decide for themselves how many shares to sell to generate cash to spend. Now of course, there is much discussion about safe withdrawal rates, and there are many “rules of thumb” that have been developed, like the 4% rule. But this is a subtle and fraught point of discussion.
In contrast, with dividends, the directors of a given company have judged that the issued amount was prudent and sustainable, so a less well-informed retiree might regard “living off dividends” as having been safe. Of course, this judgment can be fallible, but they presumably might be better to judge what a safe dividend rate would be for that company. With buybacks, this information is not as clearly communicated, and there is less consistency in year-to-year buybacks. Alas, as we explained above, this consistency of dividends can also be a negative factor, because the expectations of the market about dividends can pressure management to try to avoid lowering dividend rates.
I think the answer to the question posed in the title of this post is yes. Economists and experts in corporate finance have compelling explanations for why corporate buybacks are equivalent to dividends (or superior, in light of taxes). But these explanations are hard to understand for non-experts. After all, if buybacks were clearly equivalent to dividends, why did it take until 1982 for the SEC to clarify that buybacks were not a form of illegal price manipulation?
But in spite of that, I don’t think this trend is going to reverse, especially because the tax advantages are real and significant for many individuals. Many other aspects of life have become more complicated over the decades as they’ve improved: your phone, computer, and car are all unfathomably more complex than their predecessors from 50+ years ago. In that sense, innovation in the financial sector is no different from other areas. What’s important is to focus on the key essentials even in the presence of this complexity.
There are also special dividends, which are intentionally meant to be one-off dividends with no implied expectation that the source of cash being paid out is recurring. ↩