The Hidden Dividend

It’s hard to ignore that direct deposit that hits your investment accounts on a monthly, quarterly, or annual basis, especially when it is larger than normal deposits.

Although it’s nice it poses an interesting challenge for companies to manage, one that almost makes it not worth it. One that makes them turn to a more hidden type of dividends, share buybacks.

The business problem with dividends is once the business is well established in paying it’s dividend it can “never” stop paying it. If the business stops paying a dividend, it is viewed as a sign of weakness, which might come in a period of weakness which would manifest itself in earnings and revenue contractions, giving the market a negative feedback loop.

Some companies even go into debt to ensure that they can always pay their dividend.

And more often than not a high dividend yield is emblematic of a company on the brink than a thriving one.

The other form of dividend, share buybacks do a similar thing, but in a way I think is better.

How they work is the company buys back shares and places those shares in their treasury, effectively reducing the number of shares outstanding and increasing the price per share (because their are less shares than before).

Because they aren’t a direct deposit into your account, they aren’t taxed until you sell the stock itself (and it would ideally then be taxed at the long term capital gains tax rate).

In periods of weakness the company can say the stock is “overvalued” or “we want to maintain a healthy balance sheet to endure the next 24 months” and stop buying back stock.

Then when the fundamentals come back, they turn on their buybacks once again.

So:

• Dividends are obvious when they stop coming, and thus when they do it generally causes a sell off.
• Moreover dividends are taxed upfront as ordinary income.
• Share buybacks are only reflected in the price of the stock, therefor when they stop nobody really notices much.
• And share buybacks are only taxed when you sell, giving you more flexibility to take advantage of tax strategies.

The other reason a company would buyback shares rather than issue a dividend is they increase the ownership stake of the shareholders.

And what that means is even if the company is not growing earnings or revenues, the individual shareholders are getting a larger and larger piece of those revenues and earnings while the company is buying back shares.