Whatever the outcome of the upcoming political machinations regarding the looming fiscal cliff, one thing is certain: The tax code will change.
One of the changes being debated is the tax rate on dividends, which could rise to as high as 43.4 percent from the current 15 percent.
An interesting consequence of a higher dividend tax rate is that it will encourage even more stock buybacks than have been seen in recent years. Buybacks are tax efficient because there is no taxable event for investors who do not sell.
Currently, many investors prefer a higher dividend to a buyback program because dividends are simple, and visible. The money just shows up in one’s brokerage account.
The incomparable Warren Buffett made news recently when his company, Berkshire Hathaway, announced it would step up its buyback program, purchasing $1.2 billion worth of Berkshire Hathaway at a premium of 20 percent over book value. Buffett feels that repurchasing stock at 120 percent or less of per-share net asset value is an excellent allocation of Berkshire’s cash resources.
During the second quarter of 2012, companies in the Standard & Poor’s 500-stock index repurchased nearly $112 billion of their own shares, up 32.6 percent from the previous quarter. Exxon Mobil, for instance, bought back $5 billion of its stock during that period, while ConocoPhillips bought back $3.1 billion of its shares.
Theoretically, buybacks should enhance investment returns.
When a company spends cash to repurchase its stock, it reduces the overall share count. This gives remaining investors a bigger stake. Stated differently, with a lower share count, earnings per share increase.
Buybacks give shareholders more flexibility than a dividend because they allow shareholders to choose when to sell and realize their cash.
One problem with buybacks, however, is that companies frequently overpay for the stock repurchased. Brett Arends noted in the Wall Street Journal of Dec. 22-23 in an article entitled “How to tell when a stock buyback is good for investors,” that “in the third quarter of 2007, when share prices were near their peak, members of the S&P 500 stock index spent $171 billion on buybacks. In the first quarter of 2009, with the market near its low, they spent just $31 billion.”
Arends also pointed out that “stock buybacks do not necessarily end up reducing the overall share count.”
“Since Dec. 31, 1999, members of the S&P 500 have spent $3.5 trillion buying back their stock — or about a quarter of the value of those companies’ equity at the start. Yet over that period, S&P estimates, their total share count has grown by about 7 percent. Stock grants to management are not the sole reason, but experts say they have played a big role.”
Michael Mauboussin, chief investment strategist at Legg Mason, noted in a June 2012 company investment publication, “Share Repurchase from all Angles,” that buybacks allow long-term investors to raise their effective stake without cost. Mauboussin explained that the best measure of a buyback is to compare the price paid with the per-share earnings.
He gave this example:
If Amalgamated Widgets trades at $100, and it is expected to earn $7 per share annually, then buying back stock at this price will effectively earn a 7 percent return.
With interest rates so low at the moment, buybacks are a tempting way for companies to try to earn returns better than they could get from cash.
There is no hard number, but companies that can earn 5 percent or more on their buybacks might be spending the money wisely.
The track record of the “Oracle from Omaha” is spectacular. He has committed substantial capital to the proposition that aggressive, consistent buybacks can enhance a company’s bottom line.
Given the high likelihood of a higher dividend tax rate, stock buybacks could become even more commonly used because of their tax efficiency.
Originally published in the Sarasota Herald-Tribune
