Some people are obsessed with dividends, especially in a low interest rate environment like we have today.  A common mistake is fixating on the yield of a stock or exchange-traded fund (ETF) rather than thinking about total return.  As a stock investor, you risk your capital by taking ownership in a business and receive a return in the form of dividend payments, capital appreciation, or both.

Cash dividends aren’t the only way companies return earnings to investors.  One of the most overlooked by dividend junkies are share repurchases.  From a management perspective, share repurchases are an increasingly popular method of returning capital to shareholders due to the flexibility it provides with future payout policy.  Because cash dividends are considered a long-term commitment, there are dire consequences for a company that reduces or eliminates that payment.  Alternatively, share repurchases are temporary and allow companies to respond to changes in the economic environment.

Think back to 2008 when companies were squeezed for cash due to economic turmoil.  Those that slashed their dividend were punished by investors selling their shares, which caused a drastic drop in the company’s market value.  Companies that continued to pay cash dividends but reduced or eliminated share purchases did not experience the same sort of investor exodus.  It should come as no surprise that the reduction in total dollars spent on share repurchases was far greater than the total dollar reduction to dividend payments among U.S. companies that year.

From an investor perspective, I’m going to skip over a lot of theory to prevent boring you, but know that a rational investor should be indifferent to whether a company spends $1 on a cash dividend or a share repurchase – both methods reduce cash on the balance sheet and both transfer value directly to shareholders.  Unlike a cash dividend, share repurchases only provide current income to the investors that sell their shares back to the company.  However, investors that keep their shares following a buyback end up with a larger claim on the company’s future earnings, and theoretically the higher earnings per share should translate into a higher stock price (capital appreciation).

There is also a tax component to the dividends versus share repurchases discussion.  Historically dividends have been taxed at an investor’s ordinary income tax rate, while long-term capital gains were taxed at a lower rate.  This would normally make share repurchases more tax efficient, but currently dividends are long-term capital gains are taxed equally – that may change if there is tax reform in 2013.  Investors may still prefer capital gains over dividends in today’s tax environment because of the control over the timing of your tax liability (you are only taxed when you sell your shares).

Dividends are a good indicator of a company’s health, but they may also be a sign that management can’t find attractive investment opportunities for growth, thus cash is paid in lieu of expansion.  Consequently, this has an impact on a company’s potential for capital appreciation.

There are other ways management can enhance shareholder returns.  For example, shareholders may be better off without dividends or share repurchases if management can use earning to fund projects at a lower cost and/or earn a higher rate of return than they could using external funding like issuing bonds or new stock.  Another indirect reward to shareholders is using earning to pay off outstanding debt, especially if it lowers the cost of funding future expansion.  These actions enhance the value of the company, which leads to the capital appreciation component of total return that so many dividend junkies ignore.

The point here is not to be anti-dividend when selecting investments, but instead to bring some perspective to investors only looking at the dividend yield when making investment decisions. Your primary concern should be total return, not just the quarterly cash payment.

Thanks for reading.

Peter Lazaroff

St. Louis, MO

www.acrinv.com