Investors in US companies that return cash through dividends and share buybacks have reaped significant rewards in recent years. Research shows that firms returning cash through dividends or share buybacks have outperformed the S&P 500 since 2007. Furthermore, a combination of such cash returns has boosted these companies to even greater outperformance.
On average, those S&P 500 firms that return cash to shareholders deliver a yield of 5-6 percent when both dividends and share repurchases are considered. Some two-thirds of this yield comes from buybacks.
With US companies having accumulated large sums of cash on their balance sheets since the financial crisis, the question becomes how shareholders can benefit from them in today's low interest rate environment.
Firms find ways to spend cash. Ideally, they do so for the benefit of shareholders, such as when they invest in growth either through acquisitions or organic expansion, ie by increasing manufacturing or sales capacity or by pursuing new business activities abroad. During times when the return on such outlays is uncertain, however, companies become reluctant to invest.
Cash return opportunities
If a company's return on its expenditures is meager, prudence and good business practice dictate that management return the cash it has in its coffers to shareholders rather than retain it unproductively or spend it unwisely. The primary methods of distribution are dividends and share repurchases. The former provide shareholders with a direct and stable income stream, while the latter constitute an indirect benefit that reduces the number of a company's outstanding shares and thus increases earnings per share.
S&P 500 firms that have paid out a dividend above the S&P 500 median, which has averaged 2% over the last five years, have tended to outperform their S&P peers that pay below the median on a total return basis. Historically, companies whose stocks that have consistently increased dividend payments year after year have generated solid investment results. Given today's low interest rates, dividend-paying and dividend-growth companies look especially appealing, offering the prospect of higher yields on an initial investment as dividends compound over time.
Since September of last year, more than 20 US firms have authorized buyback programs valued at USD 1bn or more. In the first quarter of this year, S&P 500 companies repurchased shares to the tune of USD 97.8bn, and companies spent 71% of their free cash flow in share buybacks. Data shows that S&P 500 companies conducting share buybacks generally have a much higher free cash flow yield than those that haven't shrunk their share count. All recent indications are that S&P 500 firms should remain able to increase their free cash flow since growth prospects look fairly attractive amid the gradual economic recovery and earnings momentum has been good.
Opportunities for investors
A share buyback strategy is best implemented by choosing a diverse selection of companies, which will serve to reduce risk while still yielding returns that outpace the market. The crucial risks to this strategy include selecting stocks ahead of buyback announcements and selecting companies that overpay for their own shares. Stock selection needs to focus on a company's ability to generate free cash flow, the amount of cash on its balance sheet, and the track record of management.
In our house view we recommend to use a professionally actively managed fund, where portfolio managers make sure that the selected companies fulfil high quality criteria such as a strong balance sheet, strong and stable earnings. Our CIO Research analysts have identified those stocks that have the capacity to give more money back to shareholders and fulfil the strict quality criteria.
* Stefanie Scholtysik is analyst at UBS AG Switzerland.