Why Some Fund Managers Prefer Dividends Over Share Buybacks

Now that the full extent of the market rout in 2022 is coming into view, some investors are reassessing their strategies and, in some cases, starting to consider dividend stocks and dividend-focused funds.

Record dividend payments in 2022

It’s no secret that 2022 was a bleak year for stock returns. However, companies in the S&P 500 paid out a record $565 billion in dividends throughout the year. Data from S&P Dow Jones Indices reveals that dividend payouts from the index grew an impressive 10% year over year.

In a press release in January, analyst Howard Silverblatt of S&P Dow Jones Indices said 2023 should bring another record year for dividend payouts—even in the event of a “full recession.” He expects rising interest rates and bond yields to “exert upward pressure on dividend payouts,” adding that competition for income will increase.

Of course, dividends aren’t the only way company managements incentivize shareholders to own their shares. Buybacks are another popular strategy, although some fund managers prefer dividends over buybacks for several reasons. In fact, investors who are considering buying into a company because of share buybacks should watch for a red flag.

Former PIMCO portfolio manager Austin Graff of Opal Capital, which just launched in 2022, warned that while many tech companies are buying back shares, they’re not reducing their share counts because they’re handing out stock-based compensation to executives and key employees — and issuing new shares to do it. In some cases, these companies are increasing their share counts even though they’re repurchasing shares.

A moral contract

Graff also prefers dividends because they act as a “moral contract” with management.

“For management to return capital to shareholders, it’s very public,” he added. “What companies are paying every quarter or year, they’re creating a moral contract to keep that up, or their stock faces negative ramifications. But they do buybacks when they want to, and there are negative consequences to buying back stocks at highs, not lows. It’s the opposite of what we would want to do with our own money.”

Warren Buffett and other high-profile investors speak very highly of dividend stocks. He added that if management teams did repurchase their shares at lows rather than highs, it would be great, but that’s not something most companies end up doing.

While dividends are anti-dilutive, many tech companies are in unique situations with heavy stock-based compensation. As a result, their stocks have declined as such companies lay off significant numbers of workers.

“Think of what that means,” Graff explained. “If they pay X dollars, and their stock’s at $100, they issue fewer stocks to that employee than if they’re paying X dollars and the stock is at $50. If the stock goes down, it creates more dilution for stock-based compensation than what was experienced at higher stock prices.”

How Warren Buffett rakes in billions on dividend stocks

Warren Buffett also likes dividend stocks, and it’s easy to see why. In fact, dividend stocks are one of the reasons the legendary value investor outperformed in 2022. Buffett’s Berkshire Hathaway is expected to generate over $6 billion in dividend income in the next 12 months.

Nearly half of Berkshire’s dividend income is estimated to come from only three stocks: Chevron
CVX
, Occidental Petroleum
OXY
and Bank of America
BAC
. Other top dividend payers for Berkshire include Apple
AAPL
and Coca-Cola
KO
.

Aside from Graff and Buffett, others started to see the value in dividend stocks in 2022. According to Morningstar
MORN
, investor interest in dividend-focused funds has jumped after the robust performance put up by dividend-paying names last year. Monthly net sales of the 128 U.S. equity funds with “dividend” in their names have jumped since the fall of 2021, while sales of those without “dividend” in their name have dropped.

Morningstar reported that dividend funds averaged a loss of 6.68% in 2022, versus the Vanguard Total Stock Market Index’s 19.6% plunge, which was similar to the average loss of other U.S. equity funds that don’t focus on dividends. One reason dividend funds performed better in 2022 is the lack of technology exposure.

Another reason is valuation. Last year, investors started to refocus their attention on valuations and multiples. Morningstar revealed that the price multiples of the companies that dividend funds tend to own are below the stock index average.

Protecting their dividends

At the end of the day, fund managers aren’t the only ones with a preference for dividends over buybacks. When the going gets tough, corporate managements have demonstrated a preference for protecting their dividend payments at all costs, meanwhile sacrificing their share repurchases to ensure their ability to keep paying their dividend.

S&P Dow Jones Indices reported that buybacks reached a new record in the first quarter of 2022 at $281 billion but declined in the second quarter to $220 billion and in the third to $211 billion.

While share buybacks ticked higher in the fourth quarter, Silverblatt said it may have been because companies accelerated their purchases to avoid the new 1% buyback tax that went into effect this year. In fact, that new 1% tax is one reason some fund managers prefer dividends over buybacks.

On one hand, a 1% tax isn’t much, but on the other, once a tax is in place, it creates the possibility of increasing that tax over time.