Yesterday we reviewed the 2006 – present data regarding the corporate reinvestment rates of S&P 500 companies: how much of their earnings get plowed back into the business versus paid out to shareholders. The conclusions were that large cap US companies have been returning most (89%) of their operating net income in the form of dividends/buybacks over that long period, and that recent (2017) reinvestment rates are actually higher than the 2014 – 2016 experience.
Today we want to extend the conversation further and discuss the tradeoff large US companies make between dividends and buybacks. How publicly held enterprises choose to return cash to shareholders matters because:
- Dividends signal management confidence in long run earnings power. Right now many investors are (rightly) worried about US equity valuations given the long duration of the current business cycle. Current corporate dividend policy is one way to assess how much company managements share those concerns, but you need a long cross-cycle historical perspective to judge this accurately.
- Buybacks are typically pro-cyclical; companies repurchase stock with excess cash flow generated from mid-to-peak-cycle earnings. As such, they are not as reliable an indicator of fundamental corporate confidence in future earnings.
Using the same dataset from S&P Dow Jones Indices as yesterday’s note (let us know if you want to see the spreadsheet), we have the following observations:
#1. From 2006 to 2017, the companies of the S&P 500 spent an average of 52% more capital buying back their stocks than paying cash dividends. The only calendar quarters when dividend payouts exceeded buybacks were, of course, during the depths of the Financial Crisis. The low water mark here: Q2 2009, when large cap US corporates spent $47.6 billion on dividends and just $24.2 billion on buybacks.
The upshot: as a rule, large US companies return more cash to investors via buybacks than dividends. This no doubt stems from a reluctance to signal material changes to long run earnings power over shorter-term horizons.
#2. How companies chose between buybacks and dividends after the Great Recession tells us a lot about their reluctance to believe the worst was past. A few points here:
- As the US and global economy stabilized after 2009, buybacks quickly increased as a percentage of total cash returned to shareholders. In Q1 2010, the S&P 500 companies bought back $55.2 billion of stock versus paying $49.3 billion in dividends (12.2% more). By Q3 2011, the ratio climbed to 2:1 with $118.1 billion of buybacks and $59.2 billion of dividends paid.
- The third quarter of 2011 was actually the peak for buybacks relative to dividend payments. Since then, the ratio has steadily increased in favor of cash dividends. In 2014, US large caps spent 59% more on buybacks than dividends. In 2015/2016, that ratio fell to 50%/35%. Last year, it was 24%.
Why this matters: theories about efficient markets aside, company managements know a lot more about their businesses than public shareholders. When they choose buybacks rather than dividends, they are saying, “Business conditions are good, but we’re cautious about the near future.” The period after the Great Recession is a useful benchmark here: when buybacks are 50-100% higher than dividend payments, you know managements are very skittish indeed.
#3. All the recent chatter about stock buybacks hides an important fact: companies are increasing dividends much more quickly than buyback activity. Annual buyback totals peaked in Q1 2016 at $589 billion for the trailing 4 quarters. That dropped by 11% last year, to $519 billion. Dividend payments, by contrast, have increased by 8.8% from $386 billion to $420 billion over the same period.
Summing up: we believe this work highlights an important/overlooked and ultimately bullish argument for US stocks. With all the focus on buybacks, much market commentary ignores the steady increase in dividends. That’s a fundamental sign of business confidence that buybacks (no matter how large) can never provide. Moreover, these increases in regular payouts come from management teams old enough to remember the Financial Crisis and are therefore not the result of uninformed optimism.
Could managements be whistling past a graveyard with recent dividend bumps? Of course the answer is “Yes”, just as US equity investors might be clueless about unforeseen risks. But remember: managements know more, at least about their businesses. By increasingly opting for dividends rather than buybacks, they are expressing confidence in long run earnings power. And that, we think, is an important and positive signal.