July 19, 2011

Dividends and Buybacks

Would you rather ride your road bike in the sun or the rain?

What if riding in the sun means peddling across Death Valley in the summer, while the rain is a passing shower in the Italian Dolomites?

Context is essential. Let’s apply the same thinking to decisions about stock-repurchases and dividends. Conventional wisdom has long held that both actions appeal to the kinds of stock buyers who hold securities and count on fundamentals.

No argument there. But ponder the third dimension in the IR chair. The first dimension is your story – what defines and differentiates your investment thesis. The second is targeting the kind of money that likes your story. The third dimension is the state of your equity store.

Your equity is a product, competing with other products, with unique supply and demand constraints. If you suppose that your story is correct for a particular buyer without considering whether the buyer can act on interest in your story, you’re leaving money on the table. So to speak.

For instance, if I want four Keith Urban tickets at Pepsi Center in October for no more than $50 each, I’m already sold on the investment thesis – “Keith Urban puts on a good show.” What if there are only two tickets available at $50? Well, I’m not the right buyer for the investment thesis, then.

Back to buybacks and dividends. Our data show that roughly 12.5% of volume on a given day is “rational,” or focused on fundamentals. The rest of the volume – nearly 90% — is either managing risk by tweaking with balances, or speculating on divergences. So if buybacks are designed to benefit money that buys and holds things of value, but that segment constitutes only 12.5% of the audience, are you matching message to audience? Context matters.

What’s more, much of the passive participation in your market depends on liquidity. Asset managers need it to control risk. Speculators – a bona fide constituency in any healthy market – game the changes in your liquidity.

Take high-frequency trading, which is both speculation and a form of risk-transfer or risk-management. It starts the day at zero, trades intraday, and ends at zero whenever possible. If you’re engaged in a buyback, often all you’ve created are magnified opportunities for short-term traders, who sell to your buyback manager’s algorithms to end the day and head home with profits, fleecing your company’s treasury. Without helping your target buyback audience.

Plus, the Federal Reserve is continuously depreciating the US dollar that denominates your earnings, which you hope to enhance by reducing outstanding shares. At best, it’s a wash. So why not cut out the middle man – all that noise in the market – and pay dividends straight to holders?

We’re not saying it’s the panacea for ages. But in the current market structure, the best thing you can do for fundamental investors is bestow cash on them. The market has sound and fury but limited rational substance.

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