Dividends vrs Buybacks

There are basically two ways a company can return cash to shareholders: dividends which are usually paid quarterly at a fixed rate set by the board of directors and stock buybacks which are also declared by the board but not on a regular schedule. I have mixed feelings about each method of rewarding investors and discuss my concerns in this post. Dividends are the most stable and reliable form of rewarding shareholders. An investor can reasonably estimate how much a stock will return via dividends for the entire year which helps when estimating the tax owed on the income. Dividends are also classified into two catagories: qualified and unqualified. Qualified dividends are the most common and are what domestic companies pay shareholders. They are taxed like capital gains which is capped at about 12% for most investors. I usually opt to reinvest these dividends into additional shares of stock which helps to increase my return over time. Even though I reinvest the dividend, the IRS still wants their cut at the end of the year which reduces my return. Dividends have been an important source of income recently because interest rates paid by banks and credit unions have been minimal for over a decade. Many quality stocks have yielded over 4% for many years and they often increase the dividend each year. To cipher your actual yield for a given year, simply divide your payments by the amount you paid for the stock. The result may suprise you. My only warning about reinvesting dividends is to retain your statements because they will be necessary when you sell a holding. A basis must be established to figure your capital gain or loss. Without this information, the IRS consideres ALL the proceeds as capital gain. Stock buybacks on the other hand are not a taxable event. When a company buys back their shares what happens is the outstanding number of shares are reduced. With a smaller number of shares outstanding, the same amount of earnings looks better when expressed as earnings per share. Higher earnings per share MAY result in a higher share price because many investors seek increasing EPS. The board of directors will authorize a share buyback when they feel that their stock is undervalued or when profits rise to a level that reduces their need for capital. While buybacks are the most tax efficient way for a company to return capital to shareholders and I feel that I am already overtaxed on my investments, buybacks have some inherent flaws. I like to make my own investment decisions such as what to buy and when to sell, that is why I invest in stocks over mutual funds. Stock buybacks bypass my choices of investing because the board of directors have decided to invest my money in their company instead of returning capital to me and allowing me to decide where I invest. Also history has shown that BOD's are not very good at timing the market, thereby wasting money on an overvalued stock. A dividend paid to investors gives me the choice of whether to reinvest or not albeit with the pain of a tax liability. Buybacks also come with the potential of financial engineering by directors. A company can increase EPS without increasing actual earnings through buybacks. If a business was really robust, wouldn't that buyback money be better spent on expanding operations than reducing shares outstanding? Finally, attempting to influence the stock price through buybacks dosen't always work because market trends are the defining force when it comes to stock prices. The current downtrend in stocks is a prime example. Do I prefer dividends over buybacks? There is no easy answer. While I like the steady income from dividends, I'm not too keen on the tax bite they come with. Buybacks are much more tax friendly but the possible abuses are clear. In the end, I want both from my investments. A reasonable dividend which is raised each year plus stock buybacks during times of plenty, sounds like a good balance between income and stock appreciation.

What's Going On

In 1971 Marvin Gaye released the hit album "What's Going On" with the hit single of the same name. The single topped the Hit Souls Singles list for 5 weeks and made it to the #2 spot on the Billboard 100 list. The album sold 2 million copies and is recognized as an important work in the history of police brutality in the black community. Irononicaly even though the words of the song pleaded for peace within his family, Marvin was eventually murdered by his abusive father. Many people are wondering what's going on in the stock market today. While I don't pretend to have all the answers, I take a big picture approach to understand and react to the mass selling of stocks. First of all, interest rates are going up radidly and will most likely continue to rise for much or all of this year. This means that alternatives to stocks are starting to look interesting for the first time in several years. Even though your local bank or credit union may not offer an attractive interest rate on savings accounts or CD's, the treasury market and some brokerage CD's are starting to look interesting. The big question people are asking is "how high will rates go". Many economists insist that the federal funds rate must equal the rate of inflation. With the current inflation rate around 8% and the current range of the fed funds rate at .75 to 1%, it seems that the Federal Reserve has a lot of work to do still. This means a lot more pain for stock market investors because money will be flowing out of stocks and into safer investments. The task at hand for Jerome Powell who is the Chairman of the Federal Open Market Committee is to muffle demand for goods and services by sopping-up liquidity in our economy. If people have less excess capital, they have less to spend thereby lowering demand for products. Given the amount of rate hikes needed to acomplish this, a recession is highly likely in my opinion. Over the past several years I have been carrying high cash balances in money markets which have basically yielded nothing. It's times like this that I am glad I took such a conservative approach to investing. I now have some cash to start buying safe products like FDIC insured CD"s and treasury bills of relatively short duration. Even though I expect rates to go much higher, I am satisfied with some current income while I build a ladder of fixed income of increasing duration over time. I have not been selling stocks during this carnage because I like the way I am positioned for the most part. My dividend paying stocks still yield more than any fixed income available and I expect these quality companies to recover when this interest rate cycle is over. In conclusion, I have always taken a hands off approach to investing until a paradigm shift occurs. The big change happining now is that interest rates must rise and the economy will slow as a result. That being said, I won't make any sudden or drastic moves. I liken my money management style to a pilot of a very large ship in the ocean, changes in course are accomplished by subtle bumps of the steering wheel. Any sudden moves can result in disaster. While my style of investing may not be suitable for every investor, everyone will be affected by what is going on in the current economic climate. I am content to continue to add to my fixed income portfolio and collect interest while navigating these choppy seas.