The chart below shows a new tailwind the stock market has going for it now that the earnings recession is over. As you can see from the chart on the top, the green line showing operating earnings has surpassed the combination of dividends and buybacks. This decline in capital returned to shareholders is only because of the decline in buybacks as dividends can’t be cut that easily. Many income investors rely on dividends which is why they are sacrosanct. Often firms highlight their consistency with paying dividends as reason to buy their stock. As you can see from the chart below, buybacks are almost always larger than dividends which means they are more important than dividends. Then you must add in the tax benefits of buybacks which only supports their case as being more important. My point isn’t that buybacks are better than dividends; it’s that buyback changes have a greater effect on shareholders’ returns, so they must be studied.
The capital returned is a lagging indicator as the buyback and dividend plans are announced before they occur. It takes time for the capital returns to respond to changes in earnings. Capital returns are similar to the 12-month moving average of operating earnings. As you can see, it’s a great time to buy stocks when operating earnings are above buybacks + dividends and it’s a time to avoid stocks when the reverse is true. There’s two reasons why the increase in operating earnings above buybacks + dividends is good. First, it means corporations aren’t buying back stock with borrowed money which is an unsustainable practice. The addendum to that is it means buybacks are about to start increasing in the next few quarters if earning are stable.
The most recent quarters are the best part of the trailing 12 months in earnings, making it even easier to maintain this trajectory. The second chart below makes this trend clearer. The capital return to operating earnings ratio in 2016 didn’t reach the levels in 2008 because the earnings collapse caused the increase in 2008, while overzealous buybacks and dividends caused the increase in 2016. The trough likely won’t be as low because the earnings recession ended quicker in 2016 than 2008 as there was no economic recession.
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