Rising Dividends Beat Stock Buybacks

This article was written with Oliver Pursche, the Co-Portfolio Manager of GMG Defense Beta Fund. It was part of a series of articles developed under an agreement with thestreet.com to work with a variety of contributors and assist them in delivering actionable investment ideas each week.

NEW YORK (TheStreet) — Herbalife(HLF) recently announced a share buyback for $427.9 million of its common shares. And since Apple’s(AAPL) $100 billion in cash was made public, dividends and share buybacks seem to be taking up everybody’s water-cooler talk.

Some investors claim share-buyback programs are always a good thing. And as an immediate rebuttal, I say that I am never fully trusting of the word “always,” as “always” has such a low success rate. Stock buybacks need to be taken into context and consideration with multiple other factors.

Primarily, take a look at what will happen with the shares once they are repurchased. Often they are used for executive-compensation or stock-option programs for employees — essentially recirculating them right back into the market.

Let’s take a look at Alcoa(AA), one of the worst-performing Dow stocks over the past five years. Without going too deeply into the numbers, the company’s operating margin has gone from 17.8% to 13.2%, or a decline of 4 percentage points, while revenue has plunged from $30.3 billion to $24.9 (for the period of 2006 to 2011).

And on the other end of the spectrum, McDonald’s(MCD), the best-performing Dow stock of the past five years, has grown revenue from $22 billion to $27 billion from 2006 to 2011, while net income has nearly doubled from $2.9 billion to $5.5 billion. In 2007 Alcoa announced a share buyback for up to 25% of its own stock which, with the clarity of hindsight, did not affect the shares in a significant way. By contrast, McDonald’s has not had a share buyback in a decade.

What this example suggests, and what my experience has borne out over the years, is that share-price return is more correlated to a rising dividend than it is to a share buyback. The top Dow performers have regularly raised their dividends, and the dividend raisers generally have, as a cohort, delivered alpha.

And, as I written before, it comes as no shock that companies that raise their dividends have outperformed companies that have not (see chart below). A share buyback can create a short tailwind, but it can’t make up for poor company fundamentals.

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