Dividends or buybacks: Which benefits clients more?

What are companies doing with their cash? Some are paying dividends to shareholders, but increases in those dividends have slowed. The average dividend increase for S&P 500 companies was 13.1% last year, down from 26.5% in 2011.

Those companies have plenty of cash. In early July, S&P Dow Jones Indices reported S&P 500 companies held a record $1.35 trillion in cash and short-term securities at the end of 2016’s first quarter. The cash total excludes utilities, financials, and transportation issues.

But more often corporate cash is used for share buybacks, instead of dividends. In 2015, S&P 500 companies spent $572.2 billion buying back their own shares vs. paying out $382.5 billion in shareholder dividends.

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For clients looking for income, here are the large-cap companies that boosted their dividends the most in the past three years.

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This year’s first quarter was the ninth in a row in which more than 20% of companies in the S&P 500 used buybacks to boost per-share earnings by 4% or more. In fact, 28.2% of the companies did just that. Many advisers and their clients see nothing wrong with this. After all, ever-higher per-share earnings can drive stock prices up.

But share buybacks can be troubling.

Share buybacks can be troubling.

Buybacks can mask a declining business. While growth is the goal many investors espoused per-share growth is inflated by reducing the number of shares outstanding. When looking at companies that regularly engage in buybacks, it’s helpful to consider total, not per-share revenue. Total revenue is a metric more immune to tampering.

The PowerShares Buyback Achievers Portfolio (PKW) is an ETF based on a NASDAQ index that requires member companies to have at least a 5% reduction in share count over the trailing 12 months. Of the 10 largest holdings in the ETF, four exhibited declining revenue in 2014 and 2015. Three more showed revenue drops in one of the two previous years.

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Buybacks can benefit corporate management more than shareholders. To align management incentives with shareholder interests, many boards base compensation on earnings growth. When measured on a per-share basis, targets are easier to hit if the company is buying back shares.

Buybacks can benefit corporate management more than shareholders.

Consider fast-food giant McDonald’s. It is the largest position in PKW at 4.78% of the fund, and has posted declining revenue in 2014 and 2015. Using numbers from Morningstar, compensation for top executives at McDonald’s increased 39.7% in 2015, even though total sales declined 7.4% and gross profit dropped 6.4% from the previous year.

Buybacks prevent shareholders from deciding how to allocate their capital. Managements lump together buybacks and dividends as cash returned to shareholders. Nearly $6 of every $10 returned to shareholders is in the form of repurchases.

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Companies can use extra cash in their coffers in a number of ways to benefit clients. But if dividends are the goal, these companies aren’t likely to find a place in the mix.

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A McKinsey & Co. report notes that until the early 1980s, less than 10% of distributions involved share repurchases. From January 1936 through June 2016, the average yield of the S&P 500 was 3.65%. Through June, the trailing 12-month yield was 2.12%.

Dividends are the payments owners of the corporation should get to compensate them for their capital investment. If shareholders want to reinvest their dividends, they can. Excessive buybacks deny them that choice.

To be fair, many buyback leaders also pay dividends. Eight of the top 10 holdings in PKW are dividend payers.

If companies only used buybacks occasionally, such as when shares are undervalued, they would have more available for dividend increases. And dividend increases make for good total return. The PowerShares Dividend Achievers Portfolio (PFM), which requires 10 years of dividend increases, has bested its sibling PKW for the year-to-date, one-year, and three-year periods. It trails slightly in five-year annualized return.

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