Financial Mathematics Text

Sunday, August 25, 2013

Shareholder Yield (Quasi-Book Review)

Mebane Faber has a nice read entitled Shareholder Yield: A Better Approach to Dividend Investing. If you keep an eye out, you may be able to get it the kindle edition for free. Regardless, it's still less than $6 for either the Kindle or paperback edition. This will be a quasi review/discussion of the book.

To be successful, managers of a company need to be good at two things: operations and capital allocation. While Faber notes many books focus on operations, the focus of this book is devoted to (a subset of) capital allocation.

Capital allocation concerns itself with whether or not to obtain financing, what type of financing (debt, equity, preferred, etc), how and when it should be employed, and how and when it should be paid back. Faber's book is concerned with the latter aspect of paying back financing.

Dividend Yield

The initial focus of the book points out that dividends have played a critical role in contributing to overall stock returns. But something has shifted in recent years. Here's a couple of charts from Robert Shiller's Data on Dividend Yield (Dividends / Price) and Dividend Payout Ratio (dividend / earnings).

Figure 1

S&P 500 Dividend Yield and Payout Ratio

As a side note, I used normalized earnings (average of the last 10 years) to kind of smooth out the dividend payout ratio. But there is clearly a trend for both the dividend yield and the dividend payout ratio to decline.

Net Buyback Yield

Now that doesn't necessarily mean that companies are retaining more earnings to reinvest in the business. What has happened is that companies have significantly increased their share buybacks.

When a company buys back shares, it's equivalent to a company paying a dividend and the shareholder using that cash to buy more shares of stock (also known as a DRIP) assuming we ignore taxes. Since taxes are more favorable to share buybacks than to dividends, it should come as no surprise that companies have been increasing their buybacks and law has made it easier to do so.

Another reason to increase sharebuy is that it drives up the price. Since incentive pay often comes in the form of stock options, managers like strategies that will increase the price of their stock and by consequence, the value of their options. So there's something to be said for focusing on value here as managers may end up buying back expensive stock.

Faber defines the Net Buyback Yield as the amount spent on ( Buybacks - Stock issuance ) / Share Price. Subtracting out stock issuance is critical when considering buybacks so it's good that he subtracts that out.

This gets summed up to what he calls the Net Payout Yield which is the sum of the Dividend Yield + Net Buyback Yield.

Net Debt Paydown Yield

The last section of the book devotes to what he calls Net Debt Paydown Yield which is (net changes in short term + long term borrowings ) / price.

This one I think needs some follow-up on why this works (see below).

For starters, I'm inclined to believe that the market tends to overpay for leverage. As a result, a levered firm will receive a higher price than an unlevered firm. This, I hypothesize, has to do with the fact that there are asymmetries in the borrowing capacities of firms and individuals. But I don't have any hard data to back this.

Another issue is the fact that cost of debt ought to be lower than cost of equity. As a result, when a company pays down its debt, its akin to buying a bond (their own) which will have a lower yield. This isn't bad per se because it lowers the risk of the equity but it should, subsequently, lower the cost of capital as well. So I may have to do some followup research on why this works (it does, see below).

Putting this all together gets us to the title of the book . . .

Shareholder Yield

Shareholder Yield is defined as Dividend Yield + Net Buyback Yield + Net Debt Paydown Yield

So what does this all give you?

The Performance

I believe the following data comes from Enhancing the Investment Performance of Yield-Based Strategies. But I wasn't able to reproduce it (perhaps he had access to the data set.

Here's the performance of the highest 25% of the S&P 500 for dividends, buybacks, debt paydowns and total shareholder yield respectively.

The moral of the story here is that picking stocks with high shareholder yield can enhance returns.

Shareholders' Yield has a good discussion on some other topics such as adding momentum strategies and how that effects results as well as resources to find stocks that have a high shareholder yield.

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