As global bond yields dwindle below 1% annually, investors have been seeking fixed-income strategies elsewhere, particularly in dividend-paying stocks. These so-called bond proxies have been well-heeded due to their steady shareholder payouts, many in excess of 3%. But with so much demand, the prices of these securities have eclipsed all-time highs, leading to inflated valuations.
Nevertheless, investors have not stopped chasing these stocks, many believing in the greater fool theory, which states that while someone may be a fool to overpay for a security, he or she can offload it to a greater fool who will pay even more for it.
All the while, corporate managers have been fueling the frenzy by boosting dividends, even though unadjusted GAAP earnings have not increased. What’s more, many companies have been aggressively buying back their own stock. In fact, during the first half of 2016, S&P 500 companies have collectively returned 112% of their earnings to shareholders through dividends and buybacks, meaning these firms distributed more money than they earned.
Now, dividends and stock buybacks are not inherently bad. Dividends provide cash compensation to owners; buybacks reduce the amount of shares outstanding and boost per-share metrics. But when a company returns too much capital to its shareholders, it puts long-term growth at risk.
So what other options are available to a corporation flush with cash and access to cheap capital?
One alternative is reinvesting in the business. This includes streamlining projects for efficiency, expanding and refining product lines, and staying ahead of competing products.
Another possibility is an acquisition to expand an existing horizontal, or to jump into a new vertical. This strategy can breathe new life into a current product line or quickly capture a new market. And significant top-line revenue growth as well as product diversification are simultaneous benefits.
This is not to suggest that a stock buyback is unwise. On the contrary, it can be a shrewd investment if the company is undervalued and better alternatives are not available. And modest dividends are also healthy as they provide steady income to their owners, even when the market has a bad year.
Ultimately, always question if something seems too good to be true. When interest rates rise, which they surely will, consumer spending may weaken and unsustainable dividends and buybacks will bring heavenly valuations back to earthly levels. Meanwhile, companies that have prepared for tighter monetary policies will fare the best. And their investors will not have to fret about finding a greater fool.
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