What This Strategy Aims To Do
This strategy aims to benefit from the investment community’s positive regard for companies that return capital (the portion of capital not needed for reinvestment in the business) to shareholders, not only through payment of dividends but also through repurchases of corporate shares.
Why It’s Worth Considering
We start with the proposition that a business should not retain more capital than it can profitably reinvest. Textbook finance teaches us that earnings should be retained and added to the company’s capital base if the company is earning risk-adjusted returns above what shareholders could earn on their own if the capital was given to them as dividends. Firms that retain capital that cannot be productively reinvested (as defined above) will see their returns on equity deteriorate and experience various consequences such as diminished growth, deteriorating share performance, and possibly even attracting the attention of hostile suitors willing to pay a premium to acquire the company and break it up under a whole-worth-more-than-the-sum-of-the-parts theory.
In the world of textbooks. companies that manage their finances well avoid such problems by paying appropriate dividends to shareholders. But as often occurs in finance, the relationship between theory and reality can be tense. Determining (future) risk-adjusted returns to the corporation and to shareholders is more an art than a science, and corporate executives can fall prey to human tendencies to paint rosy pictures of the future and to attempt to grow their “empires.” As a result, investors often develop cynical predispositions toward companies that retain a lot of capital and many presume positive things about more humble firms, those that are generous in giving capital back to shareholders.
The traditional way of returning capital to shareholders is through payment of dividends. The idea is simple: Business owners (i.e. shareholders) should get to keep for their own use (reinvestment elsewhere, personal enjoyment/consumption, etc.) whatever profit a business generates above and beyond what is needed to keep the business healthy. Therefore, the amount of dividend each year should vary based on the amount of surplus profit generated that year.
In the real world, that would translate to very “lumpy” dividend-payment trends as payouts rise, fall, soar, vanish, etc. as profits vary from period to period. Shareholders, eyeing competitive and steady returns on fixed income tend to frown on such volatile dividend streams unless they are compensated by extremely high levels of return. So companies aim for smooth dividend streams. They try to set payout policies at levels they believe they can at least maintain even in bad years; the best choice, in their eyes, is to allow the dividend to grow at a rate they believe they can sustain over a prolonged period. Shareholders are willing to accept such smoothing; i.e., they allow companies to bank big surpluses in boom years to maintain payments during lean intervals.
In recent decades, however, despite some bad spells, business has, on the whole flourished. Arguably, companies should have added a more or less comparable upward tilt to their dividend streams. But that has been and still is easier said than done. There is the risk that good times won’t last (with the result that dreaded dividend reductions would become more frequent). And, there is the aforementioned human inclination toward empire building, which, understandably, can grow during good times.
Over the course of time the challenge of reconciling the need to return adequate amounts of capital without pushing a regular dividend-payment policy too far has come to be resolved by the addition of another tool for use by capital-returning companies; a tendency on the part of companies to go into the equity markets to repurchase their own corporate shares. Sometimes this is done through a large-scale offer (e.g., a tender offer). More often, its done through periodic open-market transactions of varying sizes at varying times with varying degrees of publicity.
Buybacks are a successful means of tasking excess capital out of the corporate treasury and putting it back into the marketplace. And there is no cultural or psychological pressure on management to do this with the predictability or consistency that is expected of dividends.By running the business with fewer shares outstanding, earnings per share and so forth rise presumably leading to an increase in the share prices. Therefore, shareholders benefit by selling some shares and monetizing the capital distribution that way, or by holding on and accepting an unrealized gain while retaining their stake in the future of the business.
In contrast to other dividend-oriented strategies offered by Portfolio123 ADVISOR, this one seeks to profit from capital distribution to shareholders but is nonjudgmental as to whether this occurs through dividends and/or share buybacks.
How We Do It
When we search for stocks with good dividend yields, company quality is an important consideration insofar as it relates to the vital issue of dividend security (the ability of a company to at least maintain and hopefully grow its dividend). The same holds true when we consider share buybacks. However desirable buybacks may be in the eyes of investors, we don’t want to see companies going so far in this direction (buying too many shares and/or overpaying for the shares they buy) as to leave them with inadequate levels of equity capital and more debt than is prudent.
Our process starts by limiting consideration to S&P 500 companies. As we have noted in connection with other strategies, this is more than just a specification for a large capitalization universe simply for the sake of size. For one thing, size is an inherent indicator of quality in that it facilitates superior (relative to smaller companies) coverage of fixed costs and that, in turn, reduces earnings variability all else being equal. Larger companies also have greater opportunities for internal diversification (different kinds of businesses and even within what observers would classify as a single business category, different kinds of good or services and different kinds of customers or clients).
Among S&P 500 companies, our next step is to eliminate companies with poor scores under a multi factor Quality ranking system. When an investor speaks with reference to a particular style, it is usually assumed that the investor seeks the best in class. Often that is the way to proceed. But not always. There are many instances in which it is more important to eliminate the worst than to narrow down to the best. Use of Quality factors in the present context is one such example.
From within this group, we identify a group of good-yielding stocks. We do so in two ways.
First is the obvious: Dividend yield. We want dividend payers whose yields are at least respectable if not spectacular (and as per our usual approach, we systemically avoid the highest yielding stocks taking heed of the market’s apparent worries about the safety of the dividend). Because dividend yield is not the only kind of yield we consider, we are willing to accept a lesser number here than we would normally from a dividend-yield-based model.
The other kind of yield we look at is known as Shareholder Yield. This is where share buybacks are considered. We define shareholder yields as (i) dividends as a percent of the stock price (conventional dividend yield), plus (ii) the “net” value of shares repurchased (“net” means shares repurchased minus shares issued) as a percent of market capitalization.
We are, therefore adding two percentage figures to get shareholder yield, one based on the value of dividends paid and the other based on the value of shares repurchased. Recall that the former is a direct benefit to current shareholders (they get cash payments) while the latter is an indirect benefit (they can get opportunities to benefit from an increase in the share price associated with a reduction in outstanding shares).
Note that the second part of the computation, the part that deals with net shares purchased, might be negative; as would happen if the company issued more shares than it repurchases. This operates to reduce shareholder yield and make the stock less attractive in this context. Unless the economic climate changes to the extent that share issuance becomes more desirable than share buybacks we would not expect a portfolio based on this model to own shares of companies that are net issuers.
From among the stocks that have dividend- and shareholder-yields within the ranges we deem adequate, we select the 20 stocks that rank highest in a Stability ranking system we use. This is an adjunct to our Quality analysis based on fundamental company characteristics and metrics. Here, we analyze share price movements in various ways as indirect evidence of the company’s having demonstrated the levels of quality/we seek.
Is It Suitable For You?
This is not a mainstream income strategy. Think of it instead as an opportunistic approach. In that regard, it’s related to our “Expecting Dividend Growth” strategy in that the investor is willing to move to the lower end of the range of acceptable yields in exchange for the opportunity to enjoy some other benefit, namely opportunities to benefit form share price gains. With the other model, expectations of gains come from prospects of growth. With this model, expectations of gains have more of a special “situation flavor” due to the share buybacks.
Risk Notes
- Risk is low in comparison to most basic stock strategies due to use of quality-oriented fundamental factors but is no less then medium by Income standards due to the non-contractual nature of dividends and share buybacks
- Within the Income category, risk is raised by the role of share buybacks, which are even more discretionary and less predictable than dividends.
Trading Notes
- Although turnover is likely to be low relative to most strategies that hold stocks, it is likely to be high relative to what many see from ETF-based income strategies.
- Even so, the strategy is suitable for most brokerage-cost arrangements