Share Repurchases are a Much Better Means of Distributing Funds to Shareholders than Dividends - Example

SHARE REPURCHASES ARE A MUCH BETTER MEANS OF DISTRIBUTING FUNDS TO SHAREHOLDERS THAN DIVIDENDS The emergence of Share Repurchases as an open option to Dividend Pay-outs available to firms in the distribution of earnings to stockholders has been the subject of researches and investigations to determine long-term implication since its popularity has substantially increased only during the last two decades. In 2008, financial economist Douglas J. Skinner published recent results of his study show the growing number of firms listed in the US stock exchange implementing stock repurchases as an indication of acceptance in substitution fore traditional payment of dividends. In 2004, more than 20 years after stock repurchases were used as scheme to distribute profits repurchases increased to $233 Billion. Stock repurchases surpassed dividends in the years 1999, 2000, 2004, and 2005. This paper builds-up on existing studies and researches and examines the growth of stock repurchases by first describing stock repurchases and establishing the factors for its upsurge in popularity over dividends and evaluates its preponderance in the stock market. Finally an assessment on the impact of stock repurchases on shareholders are cited, and personal insights are likewise offered. How does stock repurchase differ from dividend payments ? Investors, investing in public listed companies through the purchase of common stocks at prevailing market rates, expect appreciation of this price in the long haul. On a continuing basis, they share – based on subscribed volume of shares held- in the retained earnings of a company though annual cash pay-outs or dividends which is the more established manner of pay-out for most publicly-listed corporations. Reports and announcement of level of dividends actually influence market sentiment on a company’s current stock price where positive developments result in upward movement or fall with negative news. Moreover, it was widely held that dividends were indicators of a firm’s long-term viability, though subsequent studies showed no correlation existed between earnings changes and sign and magnitude of the dividend change (Bernartzi et.al, 1997). Dividends payments are deducted from declarations of retained earnings for the year. Shareholders measure their effective returns by deriving percentage between dividends paid per share over purchased price per share. Dividend declaration and eventual pay-outs may be affected by strategic plans such as capital expenditures - acquisition of equipment, R & D, investments plans and strategic decisions as increasing manpower benefits . Nevertheless, shareholders may also gauge long-term viability and attractiveness of the company through the prevailing market price in the stock market. On the other hand, share repurchases which gained popularity during the last two decades, is a buy-back concept whereby common stocks held by shareholders are reacquired by the firm at specified points in time at a price based on recent stock exchange listing. Share repurchases have now been viewed as providing higher returns for investors over dividends because the reduction in share volumes – it is assumed that redeemed stocks will reduce total volume of shares in circulation– will impact to higher stock prices and increase a stockholder’s ownership of a firm. Stock repurchases do not impact into a further erosion of earnings, as these are purely capital transactions resulting in an improved income for a firm. What were the drivers that contributed to the rise of share repurchases? As early as 1958, Modigliani and Miller advocated in popular Proposition 1, that in perfect capital market, the value of a firm is independent of its capital structure, and posing a challenge for the consideration of other options besides the dominant practice of dividend declaration. It was widely recognized then that the cash flows of a firm and its capability to service dividends are reflective of long-term growth. Reforms in major government regulations such as the Securities Act and Tax Code pushed the firms’ consideration of stock repurchases. The Securities Act discouraged and delayed firms from implementing more innovative mechanism to distribute income. Notwithstanding criticisms attributed to the tax burden on dividends income vis-à-vis capital gains as will be discussed below , prevailing SEC regulations hindered firms take-up of stock repurchases, for threat of sanctions against price manipulation, inside information and trading under the Securities Exchange Act of 1934. This has changed in 1982 with Rule 10b-18 in 1982 virtually unfreezing the stringent SEC provisions and firms were given more liberty in the disposition of retained earnings . As part of SEC’s deregulation in the 80s, 10b-18 formulated guidelines in the execution of stock repurchase such as requiring firms to use only 1 broker or dealer on any single dealing day, avoid trading during opening or last half-hour before closing of the market, and maximum volume of purchases. (Grullon and Michaely, 2002). The implementation of reforms in taxation namely the 1997 Tax Reform in UK, and the US Tax Reform Act of 1986 also provided impetus for shift to share repurchase. In UK, prior to the 1997 Tax Reform, investors favored dividends pay-outs because of the tax credits generated from the transaction, which can be set-off against tax liabilities. Hence, for regular tax payers with minimum payments , the amount could actually eliminate their tax obligations. The Reform of 1997 reduced the tax credit by 20% with the investors placed at a point of indifference between dividends and stock repurchase (Bell and Jenkinson, 2002). In the US, the 1986 reform effectively changed the current set-up of imputing heavy tax on dividends payments over capital gains and corporate taxes making stock repurchases more attractive. The emerging firm characteristics likewise found stock repurchases highly advantageous for their purpose. These were the start-up companies but with strong growth potentials, small, new entrants to the stock market, initially with unpredictable profits patterns hence unlikely to pay dividends. The companies invested highly in R & D, and their investments exceeded earnings at their early stage. These companies have higher ratio of the market value of assets to their book value. Volatility in earnings was a major reality which tilted favorably towards stock repurchases. The new rules of competition where giants were challenged by the small start-ups, or where the valuation of companies are based on future earnings than hard facts (evident in Information Technology-based companies) put pressure on the profitability of companies. To survive, companies had to manipulate corporate earnings or face the ire of stockholders. Dividend pay-out or any form thereof of dividing their profits pressured companies notwithstanding current financial position. This period saw business giants such as IBM, and HP, Motorola being outwitted by small companies such as Dell, Sun Microsystems. (Skinner, 2008) The concept of dividend payment itself has caused wider acceptability for stock repurchases. In the study conducted in 2005, where finance managers were surveyed, it was a consensus that dividend pay-outs may have created on investors undue expectation compelling firms towards regular and increasing dividend declaration based on historical levels or encounter market penalties. Given an opportunity to shift earnings pay-out, these manager prefer either starting at very low dividend levels or shift to stock repurchases. (Brav, et.al 2005) The rise in stock repurchases is grounded in stock market activities during the last 2 decades. Various financial economists have evaluated trading activities and showed common results. Eugene F. Fama, Kenneth R. French widely referred study entitled “Disappearing Dividends: Changing Firm Characteristics or Lower Propensity to Pay?”, provided perspective into the profile of firms that applied stock repurchases and the extent of acceptability. Their study was based on based on findings from the New York Stock Exchange (NYSE), American Stock Exchange (AMEX), and Nasdaq Stock Market (Nasdaq) and showed the following: Firms practicing dividend pay-outs declined from 66.5% in 1978 (its peak) to 20.8% in 1999 Firms practicing dividend pay-outs are more established and profitable, with market values of $ 1,076.20 Million whereas those that do not pay, have market value of $167.5 Million The “explosion” of newly listed firms by around 2,000 from 1978 to 1997 and the drop in their profitability was widely attributed to have caused the decline in dividend payments Big stock portfolios are abandoning the practice of dividend payment by a ratio of 5:9 The general perception of firms as revealed by the study is the firm’s acceptability of stock repurchases and were less inclined to pay dividends. Alon Brav, John R.Graham, Campbell R. Harvey. Roni Michaely study on “Payout Policy in the 21st Century” conducted a survey in 2005 on financial managers on factors contributing to a policy of dividend pay-out or stock repurchase. The following are the highlights: In contrast to past practice of regular dividend payments, small companies were inclined towards pay-outs during sustainable increase in earnings, and when upon pressure from institutional investors Executive agree that the existing dividend practices have placed firms in a certain mould creating expectations with investors for higher pay-outs The flexibility factor notable in stock repurchases has made the scheme a more viable option than dividend pay-outs What then are the early indications of stock purchases from the perspective of investors? In Leonie Bell and Tim Jenkinson’s “ New Evidence of the Impact of Dividend Taxation and on the Identity of the Marginal Investor” a study on the impact of stock repurchase on pension funds which constitute about 30% of UK’s equities discussed how the sector cope with the UK Tax Reform of 1997 and favored stock repurchases over dividend pay-outs as a result of the increased tax levied on dividend income. From the various studies and researches, there is a consensus that stock repurchases proved more beneficial to stockholders due to lower tax impact and the prospects of higher stock prices for firms with good fundamentals. More importantly, the major consideration as cited by finance economist Douglas Skinner for the preference of stock repurchases is the volatility of earnings. Firms are provided more flexibility in timing their distribution of earnings, the benefits of which will redound to the stockholders. But these are all from the perspective of firms as listed in stock exchanges. This same advantage for firms may place stockholders at a disadvantage. By stockholders, I refer to the ordinary investors vis-à-vis institutional investors. Whereas institutional investors given the size of their investments may create influential impact on a corporations earnings distribution policy, and they can withstand negative market realities for longer stretches of time, ordinary investors with their limited resources prefer predictable and regular pay-outs. Dividend payments create some psychological comfort with the assurance of constant stream of earnings. This may weigh down on the liquidity needs for the ordinary investor, resulting in heavy losses. Consider an old couple, who have placed substantial savings on retirement to investments on equities that offer stock repurchases. Market volatilities may result in paper losses with the up and down swing of prices thus weighing on their liquidity needs. Sudden withdrawals because of unscheduled needs may find them receiving lower amounts than during market placements. The availability of information as basis for action will be very critical. Besides earnings volatility, there is a market volatility that needs to be factored in, such as the current global slowdown or bear market being experienced as the price of stock repurchases is a function of existing market condition. The actual redemption of repurchased stocks takes timing to be able to hit the market at its optimal point which means, an investor may keep in custody shares of stocks longer acceptable period. An individual stockholder may be subjected to various machinations of firms such as declaration of stock repurchases when prices are down, or instead of stock volume reduction, the same are merely transferred to other potential stockholders such as firm’s executive and employees as part of benefits. The avowed advantage of higher capital gains due to lower volume of stocks is hardly evidenced in these transactions. Thus investors may shift to more stable forms of investments. This include Mutual funds which are pooled money invested by authorized firms through their fund managers. Investments in Mutual Funds can be easily converted to cash, and is management by professional managers thereby reassuring investors over the more volatile equities. Bonds may also offer more stable, less riskier option for investment though returns are low but secured. References: Bell, L. and Jenkinson, T. (2002), ‘New Evidence Of The Impact Of Dividend Taxation And On The Identity Of The Marginal Investor’, Journal of Finance, Vol.57, No.3, pp.1321-1346. Benartzi, S., Michaely, R. and Thaler, R. (2002), ‘Do Changes In Dividends Signal The Future Or The Past?’, Journal of Finance, Vol.52, No.3 (AFA Conference proceedings), pp.1007-1034. Brav, A., Graham, J, Harvey, C, and Michaely R. , (2005), ‘Payout Policy In The 21st Century’, Journal of Financial Economics 77(3), 425-456 DeAngelo, H., DeAngelo L., and Skinner, D. (2004), ‘Are Dividends Disappearing? Dividend Concentration And The Consolidation Of Earnings’, Journal of Financial Economics 72(3), 483-527 Easterbrook, F., (1984), 'Two Agency-Cost Explanations Of Dividends', American Economic Review 74(4), 650-659 Fama, E. and French, K. (2001), ‘Disappearing Dividends: Changing Firm Characteristics Or Lower Propensity To Pay?’, Journal of Financial Economics 60(1), 3-43 Grullon, G. and Michaely, R. (2002), ‘Dividends, Share Repurchases And The Substitution Hypothesis’, Journal of Finance, Vol.57, No.4 (August), pp.1649-84. Miller, M., (1988), ‘The Modigliani-Miller Propositions After Thirty Years’, Journal of Economic Perspectives, Vol.2, No.4 (Fall), pp.99-120. Skinner, D., (2008), ‘The Evolving Relationship Between Earnings, Dividends, And Stock Repurchases’, Journal of Financial Economics 87(3), 582-609 Read More