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Over the last year, it seems like more companies are opting for share buybacks or repurchases as the preferred mechanism to return capital to shareholders.

Share buybacks are a surprisingly controversial way of returning capital to existing shareholders. Generally, though, an announcement of a share buyback is greeted with cheers among investors and market participants. It is not uncommon for the share price to increase in response to a buyback announcement.

Some investors, however, detest buybacks and prefer dividends as the preferred method for returning capital to shareholders. The common complaints generally fall in the following categories:

  • Dividends are cash for the investor.

When I first thought about the issue, I too had the same response. After all, paying dividends to shareholders, means the shareholder gets cash. However, after reflecting on this further and after discussing this with a few people, I now see the flaw in this argument.

First, a buyback allows you to determine your own level of dividends, so if you want, say a 5% dividend, just sell 5% of your holdings into the buyback, thus getting a 5% dividend. If you would rather your dividend be reinvested in the business, don't sell.

Second, buybacks are much more tax-efficient. That's just the way the code works. Sure, for some investors, dividends may be tax-free, but for a majority of long-term investors, buybacks are tax efficient. Thus, in terms of returning capital to shareholders, buy-backs are a much better mechanism with a less dead-weight.

  • Dividends lead to higher increases in Stock Price compared to Buyback announcements

To the extent that this is true, one could also argue that buybacks lead to higher EPS, which in turn will or should lead to higher stock prices. Suspending a dividend will also crush a stock, while suspending a buyback (or not buying in the open market) will often go unnoticed.

  • Management is a poor judge of when to buy its own stock. Management is taking control from the investor and transferring it to themselves

This is a strong argument in favor of the anti-buyback crowd. To the extent that management is a poor allocator of capital, this certainly has merit. Why long-term investors would invest a company whose management is poor allocator of capital is perhaps a question best left unasked.

Furthermore, one should recognize that when a company in which you own shares is engaging in a buyback - doing nothing is doing something - increasing your ownership in the company. As this Legg Mason Perspective points out:

...if you are a longstanding shareholder, it is inappropriate to criticize management for having bought back stock at a higher price. Provided that management used a proper process to assess the merit of the buyback, they have come to the same conclusion as you have (assuming that you own the shares because you think they are undervalued). Companies and investors have to make decisions in the face of incomplete information and uncertainty.

If you think there are better places to invest your capital, it makes sense to sell your shares into the buyback.

In general, I consider a properly executed buyback to be a superior method of returning capital to shareholders. It allows most investors a tax-advantaged way to invest their money in their company. Properly executed is important, and I would think it is a buyback that is widely announced and open to all shareholders.

Buffett's announcement that Berkshire Hathaway (NYSE:BRK.B) will buy back shares at 1.1x book value is an example of a well-executed buyback. Announcing the price (metric) does have the unfortunate effect of putting in place a floor on the stock price, preventing the company from buying more shares back and increasing value for remaining stock-holders. This does, however, serve to combat any criticism of taking advantage of your own shareholders.

An example of a poorly executed buyback would be the recent announcement by Asta Funding (NASDAQ:ASFI). The company bought back shares from one of its largest investors at a premium to market price. The company had previously announced a buyback, but bought zero shares back in q1 2012 because of a blackout period, and only 8,900 shares in q4 2011 because of volume limits (source: ASFI earnings calls on Dec. 14, 2011 and Feb 9, 2012). I think management could have explored other options that would have been fairer to all shareholders. A special dividend or a self-tender would have been more equitable.

One clue investors can use to judge whether management truly believes a buyback is value-creating or if they have simply run out of ideas to increase the stock price is to watch for what management and insiders are doing with their own shares. Jarden's (NYSE:JAH) recent buyback, described here, where management sold their shares into the buyback, is an example of a red flag.

Disclosure: I am long (BRK.B)..