The Observer: The sleight of hand in share buy-backs

Heather Connon
Sunday May 13, 2007

Share buy-backs are booming: BT is apparently about to spend £2bn on one – roughly double the cost of its annual dividend payment. Vodafone, Shell and BP have already spent a combined £21bn on them. According to Morgan Stanley, British companies will have spent £46bn buying back their shares in 2006, close to the £62bn they paid out between them in dividends last year.

But there is a growing body of research to suggest that buy-backs are not the best way for a company to return cash to its shareholders. The theory is sound enough: if there are fewer shares available on the stock market, the price of the remaining ones should rise. Simple arithmetic dictates that earnings per share will also rise, as the profits have to be divided between fewer shares. And rising earnings usually means higher share prices.

Not, apparently, if the rise is largely due to buy-backs. Morgan Stanley’s research shows that companies that do share buy-backs lag behind the rest of the market: in the last decade, the share price of the average buy-back company has risen by 8.2 per cent a year, compared with 10.3 per cent for the market as a whole. Contrast that with the 12.7 per cent rise enjoyed by companies that grew their payouts over the same period and it is clear that dividends, be they special or ongoing, win hands down.

Unsurprisingly, therefore, special dividends are better for most private investors. Not only can they rarely participate in share buy-backs – which are generally carried out by the company’s broker buying big blocks from a handful of institutional investors – but they also see no, or even a negative, impact on their portfolio. While they may have to pay tax on a special dividend, the net return is still likely to be better.

Indeed, dividends in general are a vital part of total investment return. The annual market statistics from Barclays Capital underline the fact that reinvesting dividends is a vital part of the superior returns that equities generate compared with alternative investments such as bonds and cash. And there is a growing body of research that shows that following the dividends is the best investment strategy.

The latest is from the investment strategists at Axa Investment Managers. Its analysis of the European market shows that £100 invested in the MSCI European high yield index a decade ago would now be worth £146, compared with £125 for the same investment in the index as a whole.

The authors of the research – Franz Wenzel, deputy director of strategy, and Charles Dautresme, a strategist at Axa Investment Managers – admit that the strategy failed spectacularly during the technology boom, when investors were far more enthusiastic about companies spending millions on websites than on old-fashioned things like dividends. But since that madness ended, cash has been king.

That partly explains the stellar performance of boring businesses such as water companies and other utilities – although they have recently been spurred by bid speculation as private equity firms and European rivals have realised the attractions of the strong cash flow and dependable profits that underpin these dividends. It also explains why companies that are out of favour with investors, such as Vodafone and GlaxoSmithKline, have woken up to the power of dividends to shift share prices. Indeed, even the mighty Microsoft, once revered as a growth stock that needed to harbour its cash to grow its business, now pays regular dividends.

Some income fund managers warn that the cult of the dividend could have over-run itself and that the traditional high-yielding companies, such as utilities and tobacco stocks, now look over-valued compared with more growth-oriented companies in areas like technology and media.

Certainly, the spate of bids for media companies – Reuters, and EMI and Dow Jones in the United States, have all attracted offers in recent weeks – suggests that these types of businesses offer good value. But the Axa strategists believe that the expected slowdown in earnings growth as the UK economy slows means that dividends will remain a crucial part of investment return.

They point out that while dividend growth has been healthy in the last few years, it has lagged behind the rapid growth in earnings over the last decade, which means that the payout ratio – the level of a company’s profits that have been paid out in dividends – is the lowest it has been since the mid-Seventies, at about 40 per cent. That gives them scope to continue increasing their dividends, even if earnings growth slows.

The Axa strategists pick a European portfolio of high-yielding stocks that they think will do well, including British companies such as Vodafone, National Grid, Aviva, Sage and Wimpey.

For most retail investors, investing in an income fund is probably a better route – and the excellent record of income fund managers such as Anthony Bolton at Fidelity, Neil Woodford at Invesco Perpetual and Tony Nutt at Jupiter are further evidence of the benefits of this kind of investment approach. Their funds are an excellent way of tapping into the dividend effect, while Richard Hughes’ income funds at M&G and Ted Scott’s Stewardship Income also have excellent performance records.

http://observer.guardian.co.uk/cash/story/0,,2078330,00.html

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