By Jorik van den Bos and Wybe Blankenvoort – High Dividend portfolio managers at Kempen Capital Management
It is that time of the year when decisions are made as to how excess cash can be best deployed. The ideal way to utilise cash is to reinvest it in existing operations. Whether it is to become more efficient, improve the product offering or widen the already existing competitive advantage – we believe that this is the wisest approach to increasing shareholder wealth. However, companies currently have record levels of cash which either implies that management is unable to find profitable investment projects or that the fear which evolved from the crisis is still prevalent and clouds decision-making. The question becomes, how can the cash be best returned? Repurchasing shares is often preferred by management; however, it might be in shareholders’ best interests if more dividends were distributed.
There is no surer and simpler way to increase shareholder wealth than through a corporate buyback, as long as the axiom holds that management buys below intrinsic business value. As in investments, what is smart at one price is dumb at another, and nowhere else is this more clearly illustrated than with corporate buybacks. The same irrational emotions that impede prudent decision making by investment professionals also stymies management’s ability to repurchase shares at the right time. As American indices are hitting their peak – so too, are the announcements of share repurchases. But where were these same companies in 2009 or 2010? Surely the very companies currently repurchasing shares were then trading at an even steeper discount to intrinsic value.
Since the 1980’s, the amount of share buybacks has grown, so much so, that it is now the preferred way to dispose of extra cash and reward shareholders. Coincidentally, in this same time period, the average holding period has decreased from a period of years to days. Share buybacks seem to be favoured by today’s investment crowd as its impact is more immediate and hence it provokes short-term behaviourism. Essentially, when buybacks are executed incorrectly they are akin to a one-night stand, fun for a while but worthless in the long-run. The pitfall of buybacks is that it is difficult for management teams to utilise them in a shareholder accretive way. Consequently, dividends should be considered as the more sound approach to deploying excess cash.
The most common argument against distributing dividends is that it is a firm commitment and more difficult to discontinue than a buyback. Although seemingly correct, this same conundrum can also be perceived positively. It is precisely because dividends are a firm commitment that management will be more sensible and frugal with the remaining cash. To further substantiate the point that dividends are not ill-advised, research has shown that companies with higher dividend payouts have higher earnings growth. We are not asking to increase the dividend to such a level that it becomes troublesome to run the business and that the company has to forego profitable investment projects. What we hope is that the company is disciplined with its capital.
If the board and management want to be aligned with short-term speculators, then please do follow the path of buybacks. If you wish to have a long-term investor, and hence a partner, then look no further than dividends.