When Dividends Beat Stock Buybacks

Includes: AZO, GE, IBM, KO, MMM, XOM
by: Tim McAleenan Jr.

I was recently reviewing an old article at The Motley Fool that discussed how blue-chip stalwart 3M Company (NYSE:MMM) ran its buyback program prior to the recession and through it. In 2007, 3M bought back $3.2 billion worth of stock before halving stock buybacks to $1.6 billion in 2008. And when the financial crisis was in full swing in 2009, 3M only bought back $17 million worth of stock before the number moved up to $854 million in 2010. What's the problem with this?

Well, share buybacks can be a useful tool if the company is buying back the shares at a moment when the stock is trading for less than what it's worth. But here is the problem: that is a heck of an assumption to make. In 3M's case, the stock hit a low of $40.90 in 2009 when the company essentially cancelled its stock buyback program, yet repurchases billions of dollars worth of shares in 2012 when the low price point so far has been $82.70.

Let me put this in broader terms:

"Buybacks by companies in the Standard & Poor's 500 index totaled $91.5 billion in the final three months of 2011. That's down nearly 23 percent from last year's third quarter, when repurchases totaled $118.4 billion. That was nearly five times as large as the amount companies spent on buybacks during the second quarter of 2009.

Repurchases, as well as dividend increases, are attractive options now for companies to put their cash reserves to work. Reserves among S&P 500 companies recently topped a record $1 trillion. Most companies have been building up cash exiting the Great Recession, which officially ended in mid-2009."

One sentence from the passage above illustrates the biggest problem with stock buybacks in practice: That was nearly five times as large as the amount companies spent on buybacks during the second quarter of 2009. One of the most oft-repeated investing maxims is the advice to "buy low and sell high." There seems to be a strong tension between the theory of stock buybacks and the practice of stock buybacks.

This is a problem-the best time for companies to repurchase shares are during moments of severe economic recession that depress stock prices. Late 2008 to 2009 would have been a great time for many companies to add value by aggressively repurchasing shares. But the numbers show that blue-chip firms generally responded by choosing to conserve cash during the Great Recession instead of choosing to repurchase shares. When Lehman and Bear Stearns were crumbling while icons of American industry like General Electric (NYSE:GE) were coming perilously close to collapse, it's a hard sell to get management to say, "We should part with cash and engage in buybacks. History shows that depressed prices are the most effective times to run a stock buyback program."

Dividends, meanwhile, can be a different animal. This is especially the case with blue-chip firms that have long records of raising dividends every year. Take 3M for an example. The stock buyback basically disappeared in 2009. Yet, the company raised its dividend modestly that year. What partially accounts for this difference? Culture.

3M has a strong dividend culture of raising dividends dating back to the 1950s. It would be a tremendous blow of confidence to investors if 3M's management declined to raise the dividend in 2009. It might signal to investors that things are really bad on a historical basis and it might be time to sell. This perception needs to be accounted for: while some companies might consider it a sign of weakness to ship out cash to engage in share buybacks during times of crises, this same management might consider it a signal of strength to raise dividends during moments like the financial crisis, effectively saying, "Of course, we'll weather the storm. This, too, shall pass."

This difference is significant. The best time to capture value is the moment when stock prices are depressed due to some kind of macro crisis situation. A blue-chip like Coca-Cola (NYSE:KO) traded in the upper $30s and lower $40s for a large part of 2009. It would have been a great time to buy back shares at the moment. But alas, Coke only reduced its share count from 2.321 billion shares to 2.303 billion shares over the course of 2009. However, Coke raised its dividend 7.89% to $0.41 in 2009 from $0.38 in 2008. This is important - if you received $1,000 in Coke dividends that got reinvested at $42.50 per share in 2009, you would have received 23.5 shares that are now worth $1,833. And plus, those new 23.5 shares pay dividends, and those fractional shares will go on to pay dividends, and so on.

I don't want to give the impression that stock buybacks cannot be run well. Companies like Exxon Mobil (NYSE:XOM), IBM (NYSE:IBM), and AutoZone, Inc (NYSE:AZO) have been able to use sustained share buyback programs to create wealth for shareholders. But I've yet to come across much evidence that suggests that raising share buybacks during times of economic crisis is a normative experience. That's the moment when buybacks create the most value. Many blue chip firms, however, have records of raising dividends in all environments, and particularly during times of widespread recession. Although buybacks in theory can hold their own with dividends, the practice in reality is often much different.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.