Thought Experiment: Dividends, Share Buybacks, Or A Combination? Sure Dividend

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Thought Experiment: Dividends, Share Buybacks, Or A Combination?


This is a guest contribution from Peter Nees of Uncle Stock

High dividends are the cornerstone when investing for income. Especially if the dividend is increasing without too much volatility. In general, we learn about their importance from the investing gurus like Warren Buffett or Benjamin Graham.

As dividends are the most common way of returning cash to shareholders, this dividend adoration is justified. If a company can distribute a lot of dividends, it means shareholder wealth is built over time. Also, most investors like consistency and dividends are considered reliable over time. For younger companies, a drawback can be that every dollar that is distributed via a dividend cannot be invested in future company growth.

A close relative for a company that would like to distribute cash is share buybacks, which is more typical among technology stocks such as Apple (AAPL) and many others. A share buyback is the process where a company uses cash to buy back (and retire) outstanding shares. This makes the value of shares that remain on the market of a higher value. Share buybacks are in general considered as very flexible and tax-friendly.

This article will compare-and-contrast dividends and share repurchases through a process of backtesting.

Method of investigation: stock screening and backtesting

In this article we will take a look at the performance of a high dividend investing strategy. Also we will see what happens if we look at stocks that are buying back their own shares instead of distributing dividends. We define a set of criteria for stock selection and backtest our stock selecting strategies over the last 12 years. Based on these backtesting results we can get an indication on which strategy would have given the best results and might work better in the future. Uncle Stock, a stock screener for value and growth investors, is used for this analysis.

We compare three investing strategies: high dividend distributors, high buyback ratio stocks and stocks where the net payout yield (which is a sum of dividend yield and buyback ratio) is strong. We test our strategies in the USA as we would like to compare stocks with a similar tax regulation on dividends. Some extra filters are added such as exclusion of some markets (otc, alternative, foreign), low market liquidity (low dollar volume), a net payout yield under 100 percent and positive earnings results in order to increase reliability of the research.

For the backtest, we always use the following criteria: the best 24 stocks for every strategy are selected  equally weighted with a full rebalance of the portfolio every year at the start of the second quarter. The research looks at data from the year 2008 until the year 2020.

High dividend strategy (yearly return of 9 percent)

For high dividend stocks we look for the stocks with the highest dividend yield (how much a company pays out in dividends each year relatively to its share price). We also filter on companies for which the dividend is growing, so we expect a positive dividend CAGR. This strategy gives a yearly total return (total return means price + dividend return) of 9 percent since 2008, which is a very solid result, certainly compared to the risk taken. The current top three stocks based on these criteria are Alliance Resource Partners LP (ARLP), Exantas Capital Corp. (XAN) and Oasis Midstream Partners LP (OMP).

Buyback ratio strategy (yearly return of 12 percent)

For share buybacks, we are using the same filters as for dividends. However, now we are sorting on buyback ratio (the amount of cash paid by a company for buying back its common shares over the past year, divided by its market capitalization) instead of dividend yield. Also we replace the dividend CAGR filter by a filter on an average buyback yield over the last 5 years. The buyback strategy gives a backtested total return of 12 percent annually, which beats the pure high dividend strategy by 3 percent. The current top three stocks based on these criteria are Davita Inc. (DVA), Ocwen Financial Corp. (OCN) and MBIA Inc. (MBIA).

Net payout yield strategy (yearly return of 10 percent)

The net payout yield strategy sorts on net payout yield (shareholder return as sum of dividend yield and buyback ratio) and filters on positive dividend growth and positive average buyback yield over the last 5 years. This strategy has an average return of 10 percent which is between the return for the dividend strategy and the share buyback strategy. The current top three stocks based on these criteria are Exantas, Ocwen Financial Corp and Navient (NAVI).

Interpretation of results

We can conclude that all strategies give a very strong return of at least 9 percent. More specifically, the buyback strategy has the best yearly return of 12 percent, the pure dividend strategy scores yearly return of 9 percent and also the combined strategy scores very well with a yearly return of 10 percent. So, these results give an indication that all strategies that focus on wealth distribution score very well and share buybacks gave the best return. It is also interesting that the combined strategy that uses Net payout yield does not beat the share buyback strategy.

In highly taxed countries, the difference between share buyback stocks and dividend stocks is even larger in reality, because tax was not part of this research and share buybacks are more tax friendly. So based on these backtests, the share buyback stocks come out on top, but also other dividend based strategies were very profitable over the last 12 years.

However, a not to be underestimated element in favor of a pure high dividend strategy is that dividends are generally more constant over time. In this research stocks are held for only one year, it is likely that the constant dividends give much stronger returns when held over a longer period of time.  We must also realize that this research was only done for the US market using specific financial metrics and results from the past do not guarantee similar results in the future. Many variations of this research can be made for other countries, markets and using more advanced metrics as filter conditions.

Conclusion: Buybacks can be a good alternative for the dividend investor

These results provide an interesting indication on the performance of three wealth distribution oriented strategies. The general indication from this research is that all strategies give great results. Investing strategies revolving around dividends, share buybacks, or a combination, can all be considered as good strategies. We also learned that for one year buy and hold, stocks with significant share buybacks perform slightly better than pure high dividend stocks or high net payout yield stocks. Therefore, share buybacks can be a good alternative for the dividend investor.

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