Dividends are like marriage, buybacks are like dating

With Canadian stock buybacks at an all time high, author Ian de Verteuil explains the motives and mixed signals behind the newfound "love affair"

Ruth Saldanha 15 August, 2019 | 2:27AM

 

 

Ruth Saldanha: A recent CIBC report found that Canadian buybacks are running at 50% higher than the highest point ever. Author, Ian de Verteuil, calls it Canada's newfound love affair with buybacks. And he's here with us today to discuss his findings.

Ian, thank you so much for being here today.

Ian de Verteuil: Nice to be here.

Saldanha: What is driving this love affair that they have with buybacks?

Verteuil: Well, I think there are a variety of things. I think one of the issues certainly is the tax differential. So, it is far more beneficial for individual investors to have money returned to them in the form of capital gains as opposed to dividends. So, that's one particular element. But I also think there are other factors.

Canadian banks, which really had been locked out of the buyback game for really post the crisis until, say, 2013, they were not allowed by the regulator to buy back stock. They are now back in the game. So, I think that's another variable.

A third variable would be substantial issuer bids. So, we've had some one-time events, large transactions, done by Thomson Reuters, the Power Group of companies. That certainly helped it. And the fourth point, last point, I would say is, I think business executives, C-suite executives are less than confident in the future. So, buybacks are a less risky way of deploying capital than, say, dividends, and certainly much less riskier than a capital investment if you're not sure the demand is going to be there for the investments you're making.

Saldanha: You call buybacks less risky than dividends. Why is that?

Verteuil: The way I think of it is, I think of – I describe it as buybacks like dating and dividends are like marriage. What I mean by that is effectively that the dividends – shareholders come to expect dividend on a normal basis. And I think companies pay a very severe price if they cut their dividends. I would say they also pay a price if there's uncertainty that they can actually maintain the dividend. So, I think a dividend really – and I will absolutely say, do I prefer dividend over a buyback? I would say I do prefer a dividend over a buyback because it's really a commitment by the company to continue to return that money to me over time.

The issue with dividends versus buybacks comes down to the question of what is the right level of dividend. So, you pick any company. Suppose it's paying out 50% of its earnings every year but is generating more cash than it actually needs to reinvest in the business. So, you might say, well, why not go to 60%, go to 70%. The problem is that there is an appropriate dividend for the volatility of your business. No business – very few businesses have true stability through an economic cycle. So, to me, the dividend policy needs to be set quite separately than the buyback issue. It needs to be set on the basis of what's the right level of dividend for my business, what's the right level of dividend for the cyclicality of my business. Set it at that level. If your company is generating more cash than you need and there aren't sufficiently attractive opportunities to reinvest, then a normal course issuer bid becomes a normal part of returning the money to shareholders. It also allows a company to turn on or turn off. So, coming back to this point, it's dating rather than marriage. And I would say in some circumstances there's only so much you can do on the dividend.

Saldanha: On the buyback side, are there any circumstances in which a buyback might not necessarily be a good idea for companies?

Verteuil: Yes, the answer is absolutely yes. And in every case, you need to think of those separately. I'm speaking positively about buybacks, but you can't say that every single buyback is a positive one. I would say the best example I've seen of buybacks that are less than positive would be cyclical companies. And it's not every cyclical company. But what tends to happen with cyclical companies, if you think of a commodity company, a commodity-based company, when does it have too much money? It probably has too much money when commodity prices are high, when its stock price is high. So, you've got all those things going for you. If you buy back at that point – very often you're buying back at the worst point of a cycle. So, particularly in cyclicals, I think you have to look at it and turn and say, are you caught with too much liquidity now and buying back your stock when it's particularly high?

Cyclical companies that do a better job of it do a normal course issuer. So, they turn and say, you know what, I'm going to try to reduce my share count by 2%, 3% a year, and do that over the course of a cycle. And they would think this is the range of commodity prices. So, a great example of a cyclical company that has done a very good job of this would be a company like Suncor or Imperial Oil, which has been very good at deploying money, being consistent re-purchasers of their stock over time. So, there's a sense of we're going to shrink the share count as much as we can. Doesn't preclude them from doing investments, growing the business, doesn't preclude them from doing M&A even. But a concept of we want to continue to take the share count down if we can. So, I think those are good ones.

But I think particularly in cyclicals, you have to be a bit more careful. It comes back to this issue of consistency of buybacks. And we talked in the report, and we certainly are big supporters of buybacks where there's consistency, where you're seeing a company on a regular basis coming back and buying shares, not just coming back and doing one of that issue. So, on the SIBs, the substantial issuer bids, highly concentrated buybacks, we aren't as positive on those as we are on normal course issuers.

Saldanha: So, assume a company says that they are going to do a buyback, how should an investor react to this? What should they think about it?

Verteuil: So, there's a variety of things I would say. So, there is a signaling issue. What I mean by that is a company that does buyback is normally telling you, we have a lot of liquidity. So, generally, the street reacts positively, the market reacts positively to those things, because it's effectively saying, we are going to reduce the share count. Now, there's a difference between an announcement of a buyback and an actual buyback. So, in a normal course issuer bid, you announce it. But some companies announce buybacks but don't buy back as much as they say they're going to buy back. It gives you flexibility on a normal course issuer bid. So, it's a slight signaling issue I would say.

A more complex question that's along the same vein is what should an individual shareholder do when these things come up. And that, I would say, is very specific to the owner. And a variety – I would say the principal issue is a tax issue. So, on dividends as an individual investor in a taxable account, a dividend is taxed at about 40%. Depends on the province, but broadly 40% is a reasonable gauge on it. Whereas capital gains, and if you think of a buyback, you are tendering into something, so you're actually disposing of it, capital gains are only taxed at 26%. So, one of the things I raise with individual investors is, you know, is it worth – even a company with maybe a lower dividend, is it worth selling a few shares or tendering it into the buyback? And you're effectively as opposed to dividend getting a little bit of a capital gain, so you're taxing it at a different and a lower rate. So, I think a big issue on buybacks, on how an individual investor should treat buybacks is to understand their unique tax situation.

Outside of that, if you own shares, I like the dividend, I like the dividend stream I'm getting, I like the way the company is being run, I'm supportive of the management team, then quite frankly, you don't need to do anything. What the buyback does is it shrinks the residual shares outstanding. The way I think of it is, if there are 100 shares outstanding and the company buys back 1% a year, I own 1% more of the company every year. So, just holding on to it works quite well. And in fact, in the report, we referred to a buyback index you can track and buyback – companies that are consistent re-purchasers of stock over time tend to outperform over time. So, in that environment an individual investor may quite rightly say, I'm supportive of it, please go ahead and do your buyback. I don't need to tender into it. I like the dividend. I like the earnings growth.

Saldanha: Thank you so much for joining us today, Ian.

Verteuil: Nice to be here.

Saldanha: For Morningstar, I'm Ruth Saldanha.

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Ruth Saldanha  Ruth Saldanha is Senior Editor at Morningstar.ca