Expanding the Opportunity Set with Shareholder Yield

By Justin J. Carbonneau (@jjcarbonneau) — 

When most investors hear the word “yield” they immediately think about dividends. Things like stock buybacks and debt paydown typically don’t come to mind. But those are also yields, or ways companies can return cash to shareholders. When dividends, buybacks and debt paydown are combined, they give us something called shareholder yield. Calculating and sorting stocks by shareholder yield is a systematic way to identify companies that are returning cash to shareholders via these three capital allocation activities.

In this article, I’ll take a look at the three components of shareholder yield as well as how selecting stocks using this metric has performed over time. I’ll also briefly look at how shareholder yield can be combined with other fundamental investment criteria to aid in stock selection.

I’ve also recorded a supplemental video below highlighting some of the models on Validea that utilize shareholder yield. Please read the full article and come back to the video if you are unsure what shareholder is and why it can be helpful in analyzing companies returning cash to shareholders.

Roots of Shareholder Yield

Shareholder yield can be traced back to a 2005 research paper written by William Priest of Epoch Investment Partners. In the paper, “The Case for Shareholder Yield: As a dominant driver of future equity returns“. Priest makes the case that shareholder yield “will become one of the two dominant drivers of future equity returns.” The paper was written roughly 14 years ago, and Priest’s thesis has been directionally accurate, as stock buybacks have continued to ratchet higher, and companies with strong free cash flow generation have performed very well over the past decade.

Here is a look at the individual components:

#1 – Dividend Yield

If a company pays $2 a year in dividends and its stock trades at $100 a share, its dividend yield is 2%, and the investor receives this payment as long as the company continues to pay a dividend. If the stock falls to $50, the dividend yield increases to 4%. Many investors value dividends, and when you look at the overall long term return of the stock market over the past 90 years, the dividend yield is a significant part of that overall return.

The critique with dividends is they’re not the most tax efficient way to return money to shareholders in that they are double-taxed. The company distributing the dividend has paid tax before the dividend is distributed and investors who receive dividends in non-qualified investment accounts will also need to treat the dividends as income.

Warren Buffett’s Berkshire Hathaway doesn’t pay dividends since he believes he can allocate the firm’s capital over time to more productive assets (i.e. public stocks and buying companies outright). Still, dividends are an important component of equity returns, and if a company doesn’t have a productive use for their cash, then giving the money back to shareholders is a sound capital allocation decision.

The dividend yield is the first input we need in order to calculate shareholder yield.

#2 – Buyback Yield

Buyback yield is the second component of shareholder yield. It looks at the value of shares that have been repurchased over a given period (typically the past year) and divides it by market capitalization. If shares have been bought back on a net basis, you have a positive buyback yield and if they have been issued on a net basis, you have a negative buyback yield.

Share buybacks have increased significantly in the U.S. equity market over the past three decades. In 2009, three researchers published the paper, “Share Repurchases and Stock Valuation Models“, in which they showed a significant increase in share buybacks from 1987-2006. This makes sense since in the early 1980s, the SEC removed restrictions on companies buying back their own stock. This regulatory change set off a long term trend of companies returning capital to shareholders via buybacks. Buybacks also have the advantage of being more tax efficient than dividends since they are not taxable to the end investor when the shares are purchased.

The importance of buybacks is not just something we see at the individual stock level. In a recent article in The Wall Street Journal, “A Surprising Connection Between the Bull Market and Stock Buybacks“, author Mark Hulbert highlights research that shows how buybacks influence overall stock market returns. “The result is that, over the long term, net buybacks dominate all other factors. For example, the researchers found that net buybacks explain 80% of the difference in countries’ returns between 1997 and 2017.”

As you can see from the chart below, buybacks in the S&P 500 have been on the rise and are significant.

Source: https://www.yardeni.com/pub/buybackdiv.pdf

#3 – Debt Paydown Yield

The final way companies can return capital to shareholders is through debt reduction. This is calculated by looking at debt today and comparing it to the level of debt in a past period (again, typically the past year). The number is then divided by market cap to get the debt paydown yield. If debt is falling over time, this is a positive for shareholders.

As Priest wrote in his paper, “To understand why paying down debt results in shareholder yield, it is helpful to consider the famous finance paper by Franco Modigliani and Merton Miller. These two Nobel laureates proved that a firm’s value is independent of how it is financed, provided that one ignores the tax effect of debt interest. If Modigliani and Miller are correct, then using free cash flow to repay debt results in a wealth transfer from the debtor to the shareholder. Since the value of the firm remains the same, shareholder wealth is increased as debt is reduced.”

Shareholder Yield = Dividend Yield + Buyback Yield + Debt Paydown Yield

Expanded Opportunity Set and Use in Models

Patrick O’Shaughnessy, CEO of O’Shaughnessy Asset Management, published a research piece a few years ago that showed the effectiveness of selecting stocks based on shareholder yield. The chart below shows the long term performance of high shareholder yield vs. dividend yield vs. the overall market. From 1927-2011, the top decile of shareholder yield ranked stocks produced an annualized return of 13.1%, which was 1.4% more than the top dividend paying stocks and 2.8% better than the overall market over the 84 year period.

Source: https://www.osam.com/pdfs/research/_35_commentary_mar12.pdf

As O’Shaughnessy pointed out in his paper, looking at shareholder expands the opportunity set because we are not just limiting ourselves to companies that pay dividends. Approximately 40% of stocks globally don’t pay a dividend, but many of those companies are engaged in buybacks or debt reduction, so shareholder yield gives us a method to assess a wider array companies.

On Validea, we run four quantitative models that incorporate all or part of the shareholder yield formula. With all of these, they are using shareholder yield as one criteria within a larger variable set. For example, our James O’Shaughnessy based Value Composite model looks at five distinct value criteria (Price/Book, Price/Sales, Price/Earnings, Price/Cash Flow, EV/EBITDA and shareholder yield) to rank stocks.

ModelGuruBook Description
Value Composite InvestorJames O’ShaughnessyWhat Works on Wall StreetThis value strategy looks for inexpensive stocks using a composite of value factors.
Shareholder Yield Meb FaberShareholder Yield: A Better Approach to Dividend InvestingThis strategy looks for companies returning cash to shareholders via dividends, buybacks and debt paydown.
Multi-Factor InvestorPim van VlietHigh Returns from Low Risk: A Remarkable Stock Market ParadoxThis multi-factor model seeks low volatility stocks that also have strong momentum and high net payout yields.
Millennial Investor Patrick O’ShaughnessyMillennial Money: How Young Investors Can Build a FortuneThis strategy looks for inexpensive stocks with high shareholder yield and return on invested capital.

As Priest theorized, and as we can see based on the underlying concept behind shareholder yield and the long term performance in O’Shaughnessy’s research, returning cash to shareholders via dividends, buybacks and debt paydown are all ways to increase shareholder value over time. Having a systematic way to identify high shareholder yield stocks can help investors take advantage of this factor.

Justin J. Carbonneau is Partner at Validea Capital Management and Validea.com. You can follow Justin on Twitter @jjcarbonneau.