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How Can Falling Buybacks Foreshadow Future Dividend Growth?

October 2016

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After observing company share buyback patterns over the last year, some investors started wondering what this could mean going forward. After all, buybacks recorded a 21% reduction during the second quarter. Considering these results in perspective of the bigger picture however, what seems like a trend and an answer to the questions starts to emerge. At first glance, the reduction in buybacks could seem like a sign of distress, but looking deeper, some interesting detail can be uncovered. First, at the same time as buybacks fell, cash and cash equivalents increased 2.0% to a record $1.374 trillion. What could this mean? This likely indicates that financial strain was not the cause of the reduction in buybacks. Instead, this shift in corporate maneuvering hints at a different aftermath: companies can use this excess cash to increase dividend payouts to investors rather than buying back shares, contributing to the potential for increased dividend growth for shareholders.

Interestingly, corporate share buybacks during the second quarter were very concentrated. The top 20 issues in the S&P 500 accounted for nearly half of total disbursements. Apple spent the most on buybacks in the second quarter, repurchasing $10.9 billion worth of shares. This was a 9% increase from the same quarter last year. These buybacks helped contribute to a 5.5% year-over-year reduction in its shares outstanding. Though impressive, Apple’s repurchasing behavior is somewhat atypical of the market as a whole. Across the rest of the market, the trend in buyback reductions indicates the possibility of corporations looking to conserve and reallocate cash for other expenditures, including future dividend growth.

Many companies look at raising their dividends as an opportunity to strengthen investor confidence. Especially in the case of companies with solid financials and low dividend payout ratios, those with growing cash reserves may be signaling their capacity and intention to increase their dividends to drive shareholder value. Though dividend investing has often been seen as an income strategy, dividend growth is also very useful in indicating a company’s overall financial health. Unfortunately, devising an effective dividend investment strategy isn’t quite so easy. Chasing dividend yield without regard to underlying fundamental quality only adds to the overall risk level and many stocks offer high yields despite weak financials, adding the potential for volatility stemming from dividend cuts and financial setbacks.

Interestingly, although many of the stocks exhibiting high payout ratios are generally trading near their all-time highs, stocks exhibiting lower payout ratios are trading at roughly half their all-time highs. As a result, stocks with lower, growing yields, or those with lower current dividend payout ratios might possess substantial value for investors going forward in the form of both dividend growth and capital appreciation. As great as this sounds, identifying these gems can be challenging.

The ability to pinpoint and access the future of dividend growth is more important than ever today. Going back to 1972, companies that have cut or eliminated their dividends have underperformed the market, while companies that have grown their dividends have significantly outperformed dividend maintainers, non-dividend payers and dividend cutters. In order to better predict the dividend actions of companies moving forward, Reality Shares developed DIVCON®, a proprietary dividend health rating system utilizing a forward-looking focus to predict future dividend growth. DIVCON® forecasts and ranks a company’s ability to increase or decrease their future dividends by evaluating each firm based on seven quantitative factors, seeking to deliver a more accurate picture of a company’s fiscal health and better predict the probability of an increase or decrease in a company’s dividend over the next 12 months. One especially noteworthy takeaway from the DIVCON analysis is the low fundamental quality of the higher yielding names – the Energy, Utilities and Telecom sectors all have average DIVCON scores below 3, meaning they have below average dividend health.

When coupling escalating valuations in high yielding stocks with reductions in share buybacks, evaluating future dividend growth opportunities has the potential to be a beneficial investment strategy today. Incorporating a dividend health rating system can help investors uncover the companies that could be poised for dividend growth as corporations put these record cash levels to work. As dividend growth investing is really about the quality of the dividend growth prospects over the quantity of the yield, investors should take notice of corporate financial health and the key drivers of future dividend growth.

 

This article was written by Eric Ervin from Forbes and was legally licensed through the NewsCred publisher network.

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