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Investors continue to focus on dividends as the best and in some minds the only way to return capital to shareholders. That remains a big mistake as the population of stocks with a high dividend payout ratio, not to mention ones that even pay dividends has been shrinking just about every decade.

Several key factors have influenced these decisions. First, the historical tax disadvantage of dividends versus long term capital gains has worked to weaken the focus on dividends. Second, the SEC instituting rule 10b-18 back in 1982 made it easier for firms to implement buybacks without stock manipulation charges. Third, market participants place such a great emphasis on maintaining steadily increasing dividends that corporate boards prefer the flexibility of buyback programs over the negativity of reducing a dividend.

Mebane Faber at the World Beta blog posted a great summary of the decline in the dividend payout ratio and the percentage of companies in the S&P 500 paying dividends. Mebane has some of the best research available on the web.

Note in Figure 1 how the percentage of S&P 500 companies paying a dividend has dropped nearly 20 points since the early 1980s when the SEC instituted the buyback rule. (The shaded areas represent periods where dividends were not tax disadvantaged to capital gains)

Figure 1 - Percentage of Companies Paying Dividends, S&P 500

click to enlarge

As he points out, one major reason for focusing on this trend away from dividends is that Obama's budget proposal wants to increase the tax rate for dividends back to the ordinary income rate of nearly 40%. This could be devastating to dividend paying stocks that became ever popular in 2011.

Not only would large investors likely sell dividend stocks, but the companies themselves would likely freeze dividend hikes in favor of buybacks. Even at the extreme, some companies might cut dividends if there was a 20% difference in the tax rate. This scenario might seem unlikely due to the current negative mindset regarding dividend cuts, but it would actually be very logical to implement.

This highlights the very reason our model focuses on Net Payout Yields. It takes advantage of the best of both worlds in the dividend and stock buyback arena. Currently the model focuses on the stocks with the highest net payout yield, but going forward it might be logical to look at the highest after tax payout yield. As a long term investor, the stocks with the higher buybacks could start providing the better after tax returns.

After more than 3 years of tracking such a model (nearly 16 months for public view on Covestor), it still remains difficult to find investors familiar or in agreement with the concept.

The largest claim remains that investors are better off allocating the cash than management is at buying back stock. That still remains a debatable theory, but what isn't debatable is that companies that return the highest percentage of capital tend to outperform the ones that don't or can't. Either those companies are overvalued and have little ability to return cash compared to the market value or the company lacks the ability to generate the cash needed to return to shareholders.

Below are a couple of tables that analyze the different yields from some of the leading buyback and dividend stocks.

Figure 2 includes stocks from diverse industries that pay a decent dividend including Gap (NYSE:GPS), Kohls (NYSE:KSS), Northrop Grumman (NYSE:NOC), ConocoPhillips (NYSE:COP), and Travelers (NYSE:TRV). The kicker is that all of these stocks also repurchased stock for more than 12.5% of their current market cap in the last 12 months.

Figure 2 - Leading Buyback Stocks

StocksBuyback
Yield
Dividend
Yield
Net Payout
Yield
Gap18.32.220.5
Kohls17.52.620.1
Northrop Grumman14.83.318.1
ConocoPhillips12.63.515.1
Travelers12.62.814.4
Average14.72.917.6

Figure 3 had leading dividend stocks offering a diverse selection of S&P 500 companies paying very attractive yields. The list includes Altria Group (NYSE:MO), Verizon Communications (NYSE:VZ), Eli Lily (NYSE:LLY), Merck (NYSE:MRK), and Southern Co (NYSE:SO). These stocks are not intended to be the highest paying dividend stocks, but rather a strong group of companies favored for their relatively high yields.

Figure 3 - Leading Dividend Paying Stocks

StocksBuyback
Yield
Dividend
Yield
Net Payout
Yield
Altria Group2.15.57.6
Verizon Comm.0.05.25.2
Eli Lily0.05.05.0
Merk1.04.45.4
Southern Co.0.04.24.2
Average0.64.95.5

Hopefully investors take away that although the leading dividend paying stocks provide a 2% higher dividend yield, the stocks ultimately have a net payout yield substantially lower. So while giving up 2% in dividends one can gain over 12% in total yield.

To us this is an incredible stat that is routinely over looked. Even more incredible is the constant push for higher dividend taxes that could ultimately make long term gains via stock buybacks all the more attractive.

Disclaimer: Please consult a financial advisor before making any investment decisions.

Source: Focusing On Dividends Alone Remains A Big Mistake