Wednesday, August 24, 2011

Dividends or Stock Buy-Backs?


About a year ago, I had the chance to have lunch with Patricia Yarrington, CFO of Chevron.

I was one of several money managers at the meeting, and it was a great opportunity to hear about how one of the largest oil companies in the world operates.

One of the parts of the meeting that stuck with me occurred towards the end of lunch. After her remarks, Ms. Yarrington turned to the assembled group of investment professionals and asked a question.

"As you know," Ms. Yarrington said, "Chevron throws off a tremendous amount of cash flow each year - more than we need for our company's operations. We already pay a fairly generous dividend (more than 3%) but we could certainly increase our payout. Or we could begin to buy back more of our stock, which we believe is currently undervalued. Which option do you think we should pursue: higher dividend or stock buy-back?"

For me, the question was pretty simple: as someone who manages money largely for individuals and smaller institutions, a higher dividend yield is always welcome, which is what I indicated to Ms. Yarrington.

However, somewhat to my surprise, the majority of managers in the room thought that buying back stock was the preferred choice.

And, sure enough, a few weeks later Chevron announced a major buyback program.

I was reminded of this meeting recently when I was reading a number of research pieces which discussed the huge cash hoards that corporate America has amassed. With the S&P 500 now offering a 2.2% yield, and only a 26% average payout ratio, it seems to me that dividends should only begin to increase in the months ahead.

On the other hand, if my experience at the Chevron lunch is any indication, corporate managers will be swayed by the stock buy-back argument, so perhaps dividends will not increase as much as I expect.

But as it turns out, according to an article published by Reuters, if companies really wanted to do what was best for shareholders, they would increase dividends. Here's an excerpt from a piece titled "Resisting the Urge to Buy Back Shares" that appeared in today's International Herald Tribune (I have added the emphasis):

The number of U.S. companies announcing buybacks is at its highest level in nearly three years, according to TrimTabs Investment Research, though the volume of buybacks is shy of what was seen in the past two earnings seasons. Given the recent vulnerability of the market, a wave of buybacks suggests U.S. companies may be doing better than usual at buying low and selling high.

Terry Smith, the veteran analyst and investor, has observed that, since 1972, U.S. dividend-paying stocks have produced annual total returns — meaning appreciation, including any fueled by buybacks, plus dividends — of 8.3 percent a year. Stocks in companies that don’t pay dividends, but may still sometimes undertake buybacks, have returned a paltry 1.4 percent per year.