The discussion on dividends versus buybacks has been circulated over many years. Both are forms of distributing profits to shareholders, but they differ in many ways. A dividend provides a (usually) regular cash payment to investors while a share buyback is when a company purchases its own shares.
The buyback reduces the number of shares outstanding in the company, usually increases earnings per share (EPS) and increases share price. According to popular financial literature, in a world without taxes or transactions costs, a shareholder should be indifferent about whether receiving a dividend or capital gain in the form of a share buyback.
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However, in the real world, there seems to be many other aspects to consider for investors when choosing between dividend paying stocks or companies that repurchase shares. For example, certain industries are more prone to paying dividends rather than issuing share buybacks and vice-versa.
As well, stock repurchase programs are much more uncertain than dividend paying programs; where the latter may be more attractive to investors relying on an income stream from their investments. Furthermore, perhaps one of upmost importance to investors is the difference in stock returns that can be expected between dividend paying companies and share buyback companies.
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To test the possible difference in stock returns, I used Morningstar CPMS to perform back-tests on stocks that repurchase shares vs. dividend paying stocks from January 2009 (the earliest date with relevant data available) to March 2018. I executed back-tests on strategies using stocks from the TSX/S&P Small Cap Index, TSX/S&P Composite Index and the S&P/TSX 60 Index.
One strategy picks stocks with the highest dividend yield while the other strategy would pick stocks with the highest buyback yield (stocks with the greatest amount of share buybacks as a percentage of their outstanding shares). Stocks would be purchased at the beginning of the year and held until the following year, at which time, a new set of stocks would replace the portfolio based on the dividend or buyback yield.
|Stock Universe||Dividend Yield||Buyback Yield||Difference||Index|
|S&P/TSX Small Cap – Best 25 stocks||12.1%||20.9%||8.8%||8.7%|
|S&P/TSX Composite – Best 25 stocks||12.8%||15.6%||2.8%||9.6%|
|S&P/TSX 60 – Best 10 stocks||11.9%||12.9%||1.0%||9.4%|
The buyback group of stocks edged out the dividend paying group, but the magnitude differed depending on the index. The largest divergence came from small cap stocks, with large cap stocks producing a small difference over the period.
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This does not necessarily mean buyback stocks are better choices than dividend stocks. There are other implications that may contribute to the performance separation. For example, the pool of dividend paying stocks is much larger than stocks that repurchase shares, so it is possible that the stock quality range is correspondingly wider.
Also, sector allocation is far from identical. The dividend paying strategy held a large allocation in the Energy sector (whose companies are much more likely to offer dividends). Energy stocks had a large decline in 2015 which hindered the performance of the dividend paying stock group.
These back-tests are grossly limited in many ways and should by no means be considered complete. However, they can give at least an idea that a difference exists in the returns between the two sets of stocks. Comparing dividend yield and buyback yield as factors is not a straightforward exercise. Nevertheless, investors should be mindful that dividends are not the only way companies reward shareholders.
A Starting Portfolio for Share Buybacks
There are many portfolios and strategies focused on dividend paying stocks. However, when considering stocks that buyback shares, the choices are far more limited. Again, using Morningstar CPMS, I attempt to create a stock strategy that could be a starting point for picking stocks based on buyback yield. Some companies that buy back shares also experience declining revenues, which could indicate a misuse of repurchasing shares.
To mitigate this risk, the strategy includes a restriction to only include stocks with positive revenue momentum. Stocks must also have a positive return on equity, to ensure they are a profitable company. A market cap restriction of $250 million or higher was incorporated to exclude micro-cap stocks, which pose higher risk and uncertainty.
I back-tested the strategy using the same period above with a maximum of 20 stocks held and equally weighted. A maximum of five stocks per sector was implemented to provide a degree of diversification. Annually, the portfolio would be reselected based on the strategy’s criteria. Over this period, the strategy produced an annualized total return of 18.3% while the S&P/TSX composite total return index advanced 9.6%.
The strategy’s latest stock picks based on December 2017 month-end data are below:
|Rank||Symbol||Company||Sector||Buyback Yield||Annual Sales Momentum||Return on Equity||Market Cap (in $millions)|
|1||WN||Weston Ltd., George||Consumer Staples||8.4%||1.4%||13.3%||$15,109|
|2||DOO||BRP Inc||Consumer Discretionary||7.5%||18.4%||347.0%||$1,816|
|3||GIB.A||CGI Group Inc., A||Information Technology||6.1%||4.5%||17.2%||$17,404|
|4||CTC.A||Cdn Tire Corp. Ltd.||Consumer Discretionary||5.3%||10.7%||14.4%||$11,008|
|5||MFI||Maple Leaf Foods Inc.||Consumer Staples||5.3%||6.3%||9.5%||$4,561|
|6||MG||Magna Intl. Inc.||Consumer Discretionary||4.9%||9.3%||20.6%||$25,599|
|7||GMP||GMP Capital Inc.||Financials||4.7%||9.7%||4.9%||$274|
|9||GIL||Gildan Activewear||Consumer Discretionary||4.4%||9.1%||19.5%||$8,902|
|10||L||Loblaw Companies Ltd.||Consumer Staples||4.4%||3.8%||13.5%||$26,480|
|12||TRI||Thomson Reuters Corp||Financials||4.0%||3.5%||14.4%||$38,892|
|13||CIX||CI Financial Corp.||Financials||4.0%||8.4%||34.0%||$8,230|
|14||DOL||Dollarama Inc.||Consumer Discretionary||3.7%||16.6%||1461.5%||$17,540|
|15||MRU||Metro Inc.||Consumer Staples||3.4%||6.9%||21.3%||$9,166|
|16||WJA||WestJet Airlines Ltd.||Industrials||3.1%||11.7%||14.3%||$3,039|
|17||CNR||Cdn National Railway||Industrials||2.7%||11.3%||25.4%||$77,275|
A Word of Warning
While the strategy’s performance is quite impressive, it is from a back-test which comes with implications that may not be realistic for an investor to follow in real life. Transactions occur only on the last business day of the year. In reality, you may trade more frequently than once a year. Also, the strategy is based only on a few quantitative factors. I would not recommend taking this portfolio solely based on the performance results and these few factors. As always, do your own investigation and ensure stocks are appropriate to your investment profile.
Worthwhile consideration, but do your research
There is no shortage of discussion or debate on share buybacks vs. dividends. Specifically, on buybacks, discussions include whether they are appropriately used by companies, are they a form of stock manipulation, and whether they are a benefit or detriment to the marketplace. As an investor considering share buybacks as a factor in your investment process, it would be prudent to do your research on the individual companies, likely more so than other traditional value, momentum or quality factors. However, the extra work may be worthwhile.
Michael Pe, CFA is an Institutional Product Specialist at Morningstar Research Inc.
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