Hold Shares, Get Rewarded
Investing in the companies that pay you back
Do you like owning stocks that pay a dividend? I certainly do - it’s pretty great getting cash deposited in your account. You can see your investment at work. It’s tangible.
Less well known is an equally beneficial method for companies to reward shareholders - stock buybacks.
But first, some background.
So how do we identify these companies?
Style factors, also known as systematic factors, allow investors to categorize companies based on select traits. These traits can be valuation metrics, stock price volatility, earnings growth, etc. These style factors can be be helpful in constructing a diversified, balanced portfolio.
Morningstar (an investment research firm) provides lot of free tools for investors. One of these tools is the matrix below, which provides a quick assessment of a fund’s underlying stocks. For example, here’s the $SYLD Cambria Shareholder Yield ETF. Relative to similar funds, it is weighted more towards Value and Small companies.
The two most common factors referenced in the news are Value and Growth. While the exact definition of each can vary, in general Value seeks to identify companies with lower stock prices than what their “fundamental value” would suggest - calculated by the company’s cash flow, net profit, book value, and/or other metrics. Growth investing seeks to identify companies with lower stock prices than what their future earnings suggest they should be. At a basic level, Value identifies companies undervalued based on their current state whereas Growth assess companies on their potential future state.
This distinction is especially relevant as higher inflation makes future dollars less valuable. Among other reasons, such as rising interest rates increasing cost of capital, this is why Value has outperformed Growth in 2022 so far.
A few other popular factors include:
Low Volatility - Smaller stock price swings based on historical data. This is typically determined using the standard deviation of the stock’s price movements. This is the slow and steady turtle in the race.
Quality - Strong balance sheet, indicated by low debt, healthy cash flows, stability of earnings, and more.
Momentum - Stocks that have recently gained in price are likely to continue rising. Goal is to “ride the wave” until the momentum fades, at which point you find the next wave.
Dividend Yield - Higher dividend rate relative to peer companies.
For now, let’s focus on Dividend Yield, a very popular factor since it selects for the companies that pay you for owning them - again, what’s not to like?
Dividends are distributions from a company to its investors, usually in the form of cash, but it can also be additional stock. It’s one of the primary ways a company can directly reward investors. The typical companies that issue dividends are mature businesses with more limited growth opportunities. Giving investors a portion of their profits is a better use of the cash than reinvesting internally. This last point also explains why Dividend-focused strategies tend to have fairly significant overlap with Value strategies.
An investing strategy focused on dividends is popular among retirees, as the cash distributions from the portfolio can help replace paycheck income, and there are tax advantages for those in lower taxable income brackets. Furthermore, the types of companies in a typical Dividend portfolio typically have lower volatility than the overall market - extra peace of mind when your investing goal has shifted from growth to preservation.
Some countries do not tax dividend income - this becomes a key investing decision since selling stocks generates capital gains taxes. Dividends are clearly preferred in that context. Sadly, the US is not that context. Dividends are taxed in the US at a rate based on your taxable income (15% for most investors). For this reason, the typical investor would prefer to receive Dividends in a tax-advantaged account (401k, IRA, HSA, etc.) rather than a taxable brokerage account.
Still, dividends are pretty great. Just don’t forget about that other popular method for companies to return value to shareholders…
“A stock buyback, or share repurchase, is when a company repurchases its own stock, reducing the total number of shares outstanding. In effect, buybacks “re-slice the pie” of profits into fewer slices, giving more to remaining investors.” (Bankrate)
Instead of paying investors dividends, companies can use those same funds to repurchase their own shares. It’s essentially the same net benefit to shareholders as paying a dividend, with the important note that there are no tax consequences for shareholders.
Think of it this way - Company A wants to give shareholders $100. They can pay $100 in dividends and investors will collectively owe $15 in taxes (depending on investor’s tax bracket and account type), for a net benefit of $85. Or Company A can use the $100 to repurchase its own stock, increasing each remaining shareholder‘s ownership.
You’ve likely heard about stock buybacks from politicians. They accuse different companies of buying their own shares simply to enrich the company’s own executives, who are generally compensated via shares in the company. It’s also contrasted with the minimum wage at the company - if a company has enough cash to buy its own shares, why not pay its employees more?
It’s important context, but for our purposes, stock buybacks are just another tool for rewarding shareholders. As someone looking to invest for the long-term, I actually prefer stock buybacks to dividends. I get the same amount of reward as a dividend, but pay no taxes until I decide to sell the stock (in my taxable brokerage account).
The concept of Total Shareholder Yield helpfully incorporates both dividends and stock buybacks to reflect a company’s net return of capital to shareholders. Morningstar even produced an index to track this.
The idea is that focusing narrowly on Dividends as a strategy misses out on great companies with the same goal of rewarding shareholders - they just happen to use stock buybacks. So take a step back and use Shareholder Yield instead.
Quick plug for a Meb Faber podcast on this topic.
One popular ETF for this is the $DIVB U.S. Dividend and Buyback ETF from iShares. The top 5 holdings are all household names - Apple, Microsoft, Meta (Facebook), Alphabet (Google), and Berkshire Hathaway. You won’t find these names at the top of any Dividend Yield strategies, since most of them use stock buybacks, but they hold some of the top spots in the S&P 500.
I’ve previously highlighted Cambria’s Global Asset Allocation ETF $GAA. Cambria also manages the $SYLD Cambria Shareholder Yield ETF, which takes the strongest shareholder yield companies in the US. They also manage the similar $FYLD and $EYLD ETFs for Developed markets (excluding US) and Emerging markets, respectively. These three ETFs are the primary equity funds used in $GAA.
Unlike iShares, Cambria incorporates additional style factors as you can see from the funnel below.
As a result, the iShares $DIVB ends up looking much more like a “vanilla” S&P 500 fund, whereas Cambria’s top holding, as of July 9, 2022, is… *drumroll*… Dillard’s!
That’s why it’s always important to take a deeper look into a fund’s holdings. Both of these funds emphasize Shareholder Yield, but take very different approaches.
“Diversification is a concrete nod to the luck and uncertainty inherent in money management and an admission the future is unknowable.”
- Daniel Crosby
Is a recession coming? Are we already in a recession? Is this a Vibecession?
No one knows.
And I’m a firm believer in constructing a portfolio where you don’t need to know the answer to those questions. My investing journey is young and I’m admittedly still tweaking my portfolio on the margins. But I’m resisting the urge to make any drastic changes simply because of all the scary headlines.
In a future post, we’ll cover some great tools and resources for designing your own portfolio, which I hope will pay… dividends.
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