So far this year, investors have poured billions into high dividend strategy ETFs. Yet almost all the big dividend ETFs have underperformed the market, even after including reinvested dividends. On the other hand, only millions have gone into ETFs whose strategy is based upon float shrink. Companies that have been shrinking the trading float of shares the most using free cash flow have not only significantly outperformed the high dividend ETFs, but the overall market as well.
Those of you who took finance 101 might have learned that there are two ways to distribute profits to shareholders. But before a company can distribute anything, the company first has to generate a cash profit, after taxes and after all capital expenditures. What is left is free cash flow that can either be added to the balance sheet or distributed to shareholders via dividends or float shrink.
A dividend is simple. Companies send cash to shareholders. That cash is taxable unless the shares are held in a retirement type account. Currently the average S&P 500 company is paying about a 2% dividend. High yielders obviously pay somewhat more.
Float shrink is the other way of using corporate cash to benefit shareholders. By reducing the number of shares outstanding, each of the remaining shareholders owns a bigger piece of the pie. Two reasons why float shrinkers outperform dividend payers: The first is that float shrink is much more tax efficient. To explain why, imagine you own 1% of a company that has generated enough free cash flow so that it is deciding whether to pay a 6% dividend or shrink the float 6%. If the company pays a 6% dividend, a California resident would have to pay 1.4% of that 6% in taxes, reducing the after tax yield to 4.6%.
On the other hand, if the company reduced the outstanding shares by 6%, a 1% shareholder would now own 1.06% of the company, a 6% gain in your ownership of the company-- and better yet, you do not have to pay any taxes on your increased holdings. Yes, you will have to pay capital gains when you sell. But if a company keeps growing free cash flow and uses part of the cash to keep shrinking the float, why wouldn't such a company outperform an equivalent dividend payer?
The second reason float shrinkers outperform is that insiders who really like their corporate future would be much more incentivized by owning a bigger piece of the pie via aggressive float shrink than by paying dividends. Does that make sense? If I owned a substantial piece of a big company that I also manage and this company has not only great prospects but an already big free cash flow, it would be in my self interest to use that cash flow to shrink the trading float so that I would own a even bigger % of a growing pie rather than get some cash in the form of taxable dividends.
The truth is that very few investors even understand float shrink. That is why those that do can outperform the rest for now.