Investors Turning to Dividend-Paying Stocks See Benefits of Buybacks, But Must Heed Caveats

NEW YORK (MainStreet) — It keeps going and going and going — life with low interest rates, that is. And that's been awfully tough for income-oriented investors such as retirees.

That's why many have turned to dividend-paying stocks, or funds that favor them. Today, the dividend yield on the Standard & Poor's 500 hovers around 2%, versus less than 1% in a money market account.

And some experts say dividends are even higher when the extra boost from stock buybacks is added in. That "buyback yield," as Morningstar terms it, is around 3% for the S&P 500, bringing "total yield" to 5%. Any income-oriented investor should be happy with that.

"To take full advantage of this phenomenon, investors should look beyond dividend-focused strategies to funds that invest in companies that have above-average total yield," writes Tim Strauts, senior markets research analyst at Morningstar, in an analysis of yield. Focusing on dividend yield alone, he says, is "shortsighted."

In a buyback, a company uses cash to purchase its own shares, effectively reducing the number in circulation. If corporate earnings remain the same, earnings per share rise after the buyback, pushing up the share price.

Over the years, many companies that once would have raised dividends to disburse extra cash have come to prefer buybacks, partly because a rising share price does not cause a tax bill until the shares are sold, while dividends are taxed in the year received. Also, many executive compensation plans emphasize rising share prices, and shareholders, who object strenuously to dividend cuts, don't fuss if buybacks aren't conducted every year.

About 85% of S&P 500 firms have conducted annual buybacks in recent years, up from less than 50% in the early 1990s, according to data assembled by Business Insider. Annual buybacks equal about 3% of those firms' market capitalization, up from less than 1% over the same period.

So if you could earn 5% by focusing on "total yield," why wouldn't you? It may be a perfectly good strategy, but there are some caveats.

First, share price gains from buybacks aren't guaranteed. Other factors come into play too.

"In theory, there shouldn't be a difference between share repurchases and dividends; but in practice, I don't think the theory really holds up," writes Matt Coffina, editor of Morningstar StockInvestor newsletter. "What we see is that companies tend to be much more aggressive with share repurchases at exactly the wrong time."

A typical company buys shares when it is flush with cash due to strong performance, he explains. But share prices tend to be high at this point, so the company pays top dollar to get back its own shares. Repurchases shrink in down times, so companies pass up the chance to buy shares at bargain prices, he says.

Second, while a dividend gives the fixed-income investor cash right away, it takes a share sale to convert buyback yield into cash. There's nothing wrong with that — long-term capital gains on share sales are taxed at the same rate as dividends. But a sale can be a headache, often requiring the investor to choose which block of shares to sell to minimize capital gains. Many investors torture themselves deciding how to time the sale for the best price. By comparison, an automatic flow of cash from regular dividends is worry free.

But since the typical company spends more on buybacks than on dividends, this practice should not be ignored. Investors are wise to consider buyback history, along with dividend payments, when deciding whether a given stock can produce cash to live on.

— Written by Jeff Brown for MainStreet

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