Dividends Offer A Better Choice Than Stock Buybacks

Includes: BRK.B, CL, IBM, KMB, PM, SHLD, WMT
by: Tim McAleenan Jr.

Even though I generally write most of my Seeking Alpha articles with my preference for dividend growth in mind, I do acknowledge that many companies can run successful buyback programs. But in additional to my strong desire to receive regular income so that I don't have to sell an asset to benefit from it, I have previously expressed a longstanding criticism of stock buybacks in practice: when a company is flush with cash and strong earnings (and presumably a higher stock price), the prevalence and amount of the stock buyback program grows. But when a company has weaker earnings or the economy is in recession (and the stock presumably has a lower stock price), the stock buyback announcements become about as hard to find as a snail darter in the Little Tennessee River.

And this leads me to another reason why I prefer dividends over stock buybacks: dividends offer you a choice to reinvest, but stock buybacks do not. A stock buyback only creates value when a stock price is undervalued. In hindsight, it looks like IBM's (NYSE:IBM) decision to buy back shares at $80, Philip Morris's (NYSE:PM) decision to buy back shares at $20-$30, and Colgate-Palmolive's (NYSE:CL) decision to buy back shares at $80 all appear to be intelligently executed. But here's the thing: if you're receiving a dividend during this time period, you can also choose to create value by reinvesting your dividends: your dividend income can buy more shares of IBM at $80, more shares of Philip Morris at $30, and more shares of Colgate-Palmolive at $80. It is you that gets to make the judgment call about whether the market is appropriately valuing your stock or not.

Now, a common criticism of resistance to buybacks goes something like this: "Why would your money with a company if you don't have faith in the way it allocates capital?" My response is this: running the business side of a company are engaging in financial engineering require two different skill sets. When Sam Walton ran Wal-Mart (NYSE:WMT), I would have no problem trusting him to say, "We just made $10 billion in profit this year. I'm going to need about $7 billion of it to upgrade and expand, and you can ship the rest off the profits off to shareholders." But it takes an entirely additional circle of competence to make a determination on the shareholders' behalf that the additional profits should be used taking shares of stock off the market.

It's one thing for Sam Walton to successfully take down K-Mart and Sears (NASDAQ:SHLD) by consolidating distribution networks, negotiating lower prices, and using tremendous volume to undercut the competition on price, but it's an entirely different thing for Sam Walton to determine whether it's intelligent to use shareholder money to buy back stock at $80 per share. Plus, there could be a tendency for some executives to suffer from the Dunning-Kruger effect, believing that their ability to successfully grow sales and beat the competition also signifies an ability to determine the appropriate valuation for their stock. As Charlie Munger, the Vice Chairman of Berkshire Hathaway (NYSE:BRK.B) once said, "You can have the island to yourself if you only allow executives join you that think their stock is overvalued."

If Kimberly-Clark (NYSE:KMB) is only worth $80 and the company pays $90 to retire shares, value gets destroyed. And if you're a shareholder of Kimberly-Clark during this time, you're held captive unless you decide to sell the shares. But if Kimberly-Clark is trading at $90 and you receive a dividend, you get a choice: Do you want to reinvest in the stock at $90 when it is overvalued, or do you want to take the dividends and deploy them elsewhere? I would much rather be responsible for my own decisions, and dividends permit this: every three months, I get to make a decision on whether the stock is priced low enough to merit dividend reinvestment, or priced so high that the dividends should be taken and spent elsewhere. But when you're dealing with share buybacks, you don't get that choice: the company is going to pay price x for the shares, whether you like it or not.

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