Some Good News For Long-Term Dividend Investors

Includes: CL, CSCO, GE, IBM, XOM
by: Tim McAleenan Jr.

If you review historical data of the major American stock market indices during the 20th century, you can find plenty of periods during the 1940s, 1950s, and 1960s when the dividend yield for the index was often over 4%. Unfortunately for investors that like a good dividend, the advent and constant growth of stock buybacks as an alternative form of "creating shareholder wealth" has emerged as a source that drains funds that could otherwise be used for stock buybacks. This is something that has proved to be a problem for shareholders of many stripes, and not only those that want reliable business income.

As Matt Krantz of USA Today recently reported:

Nearly half, 48.9%, of a sample of 232 top buybacks since 2000 have cost companies and their shareholders dearly since shares were bought back at a higher cost than the current stock price, Gumport says.

I find that statistic to be absolutely insane to the point that it should cause a shareholder revolt. Nearly half of all the buybacks in the generous sample size actually destroyed value. That represents your money. That's your profit being flushed down the toilet. It is obnoxious to constantly see companies announcing new stock buyback programs this year because it seems to have echoes of 2007 all over again. Right now, corporate profit margins are at an all-time high, and even excellent companies like Colgate-Palmolive (NYSE:CL) are buying back shares at prices well above their historical ten-year P/E ratio average.

The best way to navigate these waters is to focus on companies that actually, well, retire their shares. Take a company like Exxon (NYSE:XOM). If the stock price remains relatively stable, the oil giant is on pace to retire 1.25% of its outstanding stock every 90 days. Since 1984, the company has actually bought back more stock than the annual GDP of Sri Lanka. When you buy shares of a company like Exxon, you can be reasonably assured that the company is going to be retiring 4.5-7% of its stock count each year, barring merger/acquisition activity or rapidly changing commodity prices in the oil and oil equivalent markets.

There are other companies with buyback programs where dividend investors can be reasonably assured that their capital will be "respected" in the buyback process by actually retiring shares, as opposed to just mopping up executive compensation. IBM (NYSE:IBM) is one such example of this, as the management team has pointed out repeatedly that a strong, relentless buyback program is the key to achieving the anticipated $20 per share in earnings target by 2015.

The point is that you want to avoid companies like Cisco (NASDAQ:CSCO) because, from a historical buyback standpoint, the company has been a mess. From 2000 to 2010, the company spent over $60 billion stock buybacks without a whole lot to show for it. Considering the high executive compensation and the fact that management bought back stock in a range from 20-42x earnings during the 2000-2008 stretch, it should be no surprise that value was not created considering that the company now trades in the 12-14x earnings range.

Not only do we as dividend investors have the ability to selectively choose the dividend stocks with the most intelligent buyback programs, but it also looks we are catching a bit of a tailwind as the Board of Directors across corporate America seem to be coming around to dividends again. Per Matt Krantz:

But something very different is happening in 2013 than has happened in past profit-buyback cycles: companies are giving more importance to dividends…

…a significant portion of the cash being returned to investors, 40%, is coming in the form of dividends. They're a much bigger share of returning profit-earned cash to work than during past market rallies.

There are two main reasons that cause stock buybacks not to work: (1) the first reason is that a company does something like dilute stock in the form of executive compensation that offsets any positive effect to shareholders that a share count reduction could produce, and (2) companies buy back their stock at high prices.

The fact that companies are starting to tilt more in the direction of dividends again is something that gives us as investors control over Option #2. If General Electric (NYSE:GE) were to buy back its stock at a high price, there is nothing that we as investors can do but sit and watch. But when the industrial giant pays us that $0.19 per share dividend, we have the choice to determine whether the prevailing market price would constitute an intelligent reinvestment price. With dividends, we are allowed to control our own destiny.

I was happy to read Matt Krantz's piece and see that companies are starting to tilt in the direction of dividends again. Back in the 1980s, Sam Walton initially resisted a buyback policy for Wal-Mart (NYSE:WMT) stockholders, favoring dividends because "it is really hard to mess up giving people money." Although buybacks are still in favor by a 60%-40% ratio across corporate America, it is heartening to see that the allocation to dividends is creeping up. And if the cycle turns in favor of buybacks again, we can continue to do what we have always done-find companies with sensible buyback policies that complement a dividend growth program.

Disclosure: I am long XOM, GE, IBM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.