Think of a stock as a “slice” of a company, a piece of ownership of it. What goes into the value of that stock? What do we expect it to deliver to us, as an investor, over time? How do we figure out, as investors, whether to pursue stocks that pay dividends consistently, or pay higher dividends, or participate in stock buybacks, or are constantly in pursuit of new projects and do neither? In a time of coronavirus, do we stop thinking about dividends entirely and start trying to pick winners and losers for short-term gains? Let’s take a look at two key components to stock market strategy by going back to basics: 1) knowing where the “value” of stocks comes from, and 2) thinking about what changes lie ahead in how investors realize that value.
Would there be any point in owning a piece of company that promised they would never pay you anything, not now and not in the future? The simple answer is no. The value of any company is the expectation that, at some point in the future, they will return something to the investor: either through dividends (regular cash payout) or stock buyback (e.g. the company pays you cash for your share of the company). Even stocks that currently have no dividend are purchased because investors hope that these companies will invest their money in projects (often called “capital expenditures” or “capex”) that will one day lead to higher dividends. However, once a company cannot find a project that will be better than returning money to you as the owner of the stock, that company typically either increases its dividend or buys back its stock. Dividend-paying companies, therefore, particularly if they have been steadily increasing dividends for decades, tend to be larger, more stable companies with fewer growth prospects because they are already in the process of returning cash to the investors that own their stock.
In recent years, stock buybacks have skyrocketed in number and value, as companies bought back their own stock and pushed up the price of their stock in a rising stock market. Many companies used their cash reserves or borrowed money to do this. Once this sudden crisis hit, these companies no longer had cash to weather situations or owed money, and subsequently have had to ask for bailouts or other assistance. Now, as Barron’s, among others, is reporting, there is increasing pressure on many companies not to continue with these stock buybacks, particularly if they have received government bailouts due to the coronavirus crisis.
So what’s the alternative? If companies engaging in stock buybacks will no longer do so and cannot find projects that are better, where should investors turn? The answer might be the traditional method: dividends.
A stock buyback is a one-time event; it doesn’t require a long-term picture and can sometimes benefit company management in the short-term even at the long-term expense of growth. Dividends, however, are a different story. Investors often react badly to a company cutting (or decreasing) its dividends, so companies that increase dividends must feel relatively certain that they have the stability to keep paying that dividend over time. For this reason, many analysts consider dividends a better “sign” than stock buybacks that the company’s management believes in the long-term strength of the company.
As we have also discussed in previous blog posts, dividends also provide a cushion in times of stock price declines and cash that can be used to reinvest (following the philosophy of “buying low” and “selling high”).
Stock buybacks had surged in popularity in recent years, as companies as big as Microsoft, Apple, and Facebook engaged in them. And they certainly are one way for companies to return cash to investors who own their stock. Now, as large-scale buybacks have come back to haunt some industries in this pandemic crisis, only time will tell whether the market will turn back to dividends as a better indicator of confidence and strength.
Alex Urpí, CFA®
Photo by La-Rel Easter on Unsplash