investing-in-sharesAll businesses, both public and private, work constantly to balance returning profits to shareholders and investing for future growth.  Not surprisingly, smaller growth oriented companies tend to put more of their capital towards building the business for future growth.  As a result, they return very little to shareholders in the way of dividends or share buybacks.  We have looked at dividends in the past but share buybacks are unique.

To understand management’s attraction to share buybacks it is important to understand how they interact with dividends and investing in the business.  Companies like Facebook, LinkedIN and Twitter do not pay dividends because they think they can create more value for shareholders by investing in the business.  Other companies like Coca-Cola have grown so large that profitable expansion programs may be few and far between.  As a result, companies can create more value for their shareholders by returning excess cash to them.

Management teams are often cautious about initiating a dividend because of their stickiness. When companies agree to pay a dividend, say $1.00 a year, they believe that they can continue to fund (if not grow) this payout amount for the foreseeable future.  The ability to payout a steady cash flow signals to investors management’s confidence in the business.  However, if management elects to payout too much to shareholders and the business has a rough patch, they may not have the capital on hand to fund the business.  In this time of weakness they would be forced to cut the dividend signaling to investors the precarious situation they are in.  As a result dividends tend to be very sticky, either staying level or growing over time.  Dividend cuts are typically met with a sharp decline in the stock price as investors relate the dividend reduction to a difficult operating environment.

Because of investors’ sensitivity to dividend cuts, stock buyback programs have become more and more popular for management.  In these programs, companies go out into the marketplace and buyback their own shares.  Management likes these programs because they are a less permanent way of returning capital to shareholders.  In short, by buying their own stock they are reducing the number of shares outstanding.  This reduction in supply, all things equal, should drive up the price of the stock providing a return to those shareholders who keep their stock.  Management likes these programs because there is no long-term commitment to the program, they can start and stop as they see fit (or as cash needs demand).

While there are other reasons for share buybacks, it is important to be aware of a company’s buyback activities as it is yet another piece of information in determining whether it is a good investment!

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