Why dividends trump buybacks for beating the markets

Buybacks are all the rage. In the UK, corporate Britain spent a record sum of about £46bn buying back its own shares in 2006, 64% up on 2005, says Nick Hasell in The Times. Last month, four FTSE 100 firms announced buyback programmes worth £5.4bn in a single week. In the US, S&P 500 firms spent $800bn on buybacks in 2005 and 2006. Financing a company with debt is cheaper than doing so through equity, and debt is especially cheap and widely available at present. Buybacks can demonstrate management's confidence in the stock and give it a boost by increasing earnings per share.

But while all these buybacks have given the markets on both sides of the Atlantic a fillip by reducing the supply of shares 4% of the UK market disappeared last year they're not nearly as effective a method of increasing individual share prices as returning cash to shareholders through dividends, according to a Morgan Stanley UK Strategy note.

Since 1997, the average stock producing positive dividend growth has gained an annual 12.7% a year, compared with 10.3% for the overall market; the average stock pursuing a share buyback rose just 8.2% a year. Buybacks only helped stocks outperform in the bear market of 2000-2002 and in 1997.

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Company dividends result in more growth

The quartile of stocks with the strongest dividend growth rose by 20% a year, while the top quarter of buyback yielders (those buying back the most shares relative to their market value) grew by just 12%. Buybacks work in a bear market because the company provides demand for the stock, says Morgan Stanley's Graham Secker. All in all, they "do nothing for income investors". Dividends are "a much more powerful signal of confidence in the company's long-term performance".

The research is just the latest illustration of the crucial importance of dividends to long-term returns, and it should give "finance directors on both sides of the Atlantic pause for thought", says Hasell. US firms in particular are increasingly opting for buybacks rather than dividends; in the mid-1980s, S&P 500 firms paid out over half their earnings in dividends, but this year that figure is set to fall to a record low of 30% (in Britain the payout ratio is 43%). But while US firms are becoming increasingly stingy, in Japan a "dividend culture" is gradually taking root, says Barron's. According to Lehman Brothers, Japanese dividend growth will reach 20% this year, the fastest among major equity markets. Yet another reason, then, why Japan is well worth a look.