A primer on evaluating how a company uses cash

How a company handles its cash reserves says a lot about the priorities of its executive team

Sep 21, 2017 @ 11:14 am

By John Waggoner

Let's assume you could go back in time one second for every dollar that nonfinancial companies in the Standard & Poor's 500 stock index had in cash. If we were talking about $1 million dollars, we'd be just 12 days younger, and we'd be able to take back that unfortunate remark about our neighbor's haircut. If we were talking about $1 billion dollars, we'd be able to talk to President Reagan.

But companies in the S&P 500 currently have $1.5 trillion in cash, which means we'd be traveling back 47,565 years, and our only conversations would be with woolly mammoths. The current level of cash in S&P 500 companies is an all-time record. While we can debate the reasons why companies have so much cash – taxes, lack of demand, a fondness for rolling around in crisp $100 bills – the real question for investors is how those companies manage their capital.

When you buy a stock, you're technically buying a stream of earnings. "The question is, how do I want those earnings to be distributed?" said Sam Stovall, chief investment strategist of U.S. equity strategy at CFRA. Companies have several options: Paying dividends, buying back stock and reinvesting in the company. All have their advantages and disadvantages.

The traditional way for investors to benefit from corporate earnings has been dividends. The past decade, the Standard & Poor's 500 stock index has gained 7.61% annually, assuming reinvested dividends; without dividends, the blue-chip index has gained an average 5.31%. Stocks that have consistently raised their dividends, as measured by the S&P 500 Dividend Aristocrats index, have gained 9.98% during the same period.

Michael Finke, dean and chief academic officer at The American College, believes dividends are a mug's game. After all, when a company pays out a dividend, the stock price drops by the amount of the dividend – the equivalent, Mr. Finke argues, of a forced sale, which may not occur at the most opportune time. In addition, reinvested dividends in a taxable account incur a tax drag that doesn't affect non-payers.

A better use of corporate capital, he argues, is corporate buybacks. "If firms don't pay a dividend, I can just make my own dividend by selling off a few shares," he wrote. "But I can do it when I need it, not arbitrarily every quarter."

Corporate buybacks, however, have their own set of problems. The first is that many companies, like many individuals, are lousy investors. JC Penney, for example, bought $6.2 billion of its own stock in a buyback plan that ended six years ago: The program had a -91% return. Investors probably would have been happier with that cash in check form.

"When CEOs or boards are buying a small part of their own company, though, they all too often seem oblivious to price," superstar investor Warren Buffett wrote in his 2016 shareholder letter, which largely defended stock buybacks. ""Would they behave similarly if they were managing a private company with just a few owners and were evaluating the wisdom of buying out one of them? Of course not."

Furthermore, companies can use buybacks to make their earnings seem rosier than they are, a financial slight of hand that can mean a bumpy ride if the policy ends abruptly. If a company buys back 4% of its stock, it inflates its earnings per share. After all, if earnings remain the same but the share count shrinks, then earnings per share rise. About 14% of companies added at least a 4% tailwind to their earnings in the second quarter, down from more than 20% a few years ago, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.

U.S. companies bought back $2.1 trillion of their own shares between 2010 and 2015. Not surprisingly, the S&P 500 Buyback Index – which measures the performance of the 100 members of the S&P 500 with the highest buyback ratios – has inched out the Dividend Aristocrats, rising an average 10.49% a year the past decade.

Of course, there's another use for cash, which is to reinvest in the business, buy other businesses or – a peculiarly outlandish thought these days – reward employees. (If Apple were to use 1% of its $261.5 billion in cash to give a one-time bonus to its 116,000 employees, each would get about $22,500.) Those companies that use their cash efficiently, as measured by the S&P 500, have lagged both dividend achievers and buyback kings, rising an average 7.32% a year the past decade.

But that could be changing as the economy heats up, demand increases, and companies start to increase productivity and capacity. The past 12 months, the capital efficiency index has gained 16.11%, vs. 10.46% for the dividend aristocrats and 16.38% for the buyback index.

What's an adviser to do? The fund industry, obligingly, offers several variants on dividend strategies, the most popular is based on companies with long histories of raising dividends. The $15.2 billion SPDR S&P Dividend ETF (SDY) does just that, with a 0.35% annual expense ratio. The Vanguard Dividend Appreciation Index Fund ETF Shares (VIG) does the same for 0.08% a year. For buyback fans, there's the PowerShares Buyback Achievers ETF (PKW). A capital investment ETF, alas, liquidated last year.

Of course, the best solution might be to take a more philosophical approach. Dividend stocks tend to fare best when investors are wary, and prefer stocks with reliable earnings and boring businesses. (Interestingly, old-school tech companies, such as Apple and Microsoft, are now in this group: Tech companies pay out more in dividends than any other sector except banks). Buyback champs tend to outperform when investors feel frisky. The most prudent approach might be to simply buy a broad-based index fund and collect the best of both worlds.

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