Apple Stock Reaches a Milestone

Apple Stock

Apple stock reached a symbolic milestone last week as the total value of all the company’s stock—its “market capitalization”—surpassed $700 billion for the first time. Some analysts are now speculating that the company could grow to become worth over $1 trillion. These numbers are gaudy, and they reflect the fact that Apple’s business has been booming. But they may distract from what Apple shareholders should really focus on, which is the stock’s total return.

“Total return” refers to the combination of the change in the price of an investment and other payments made to investors, such as dividends. This concept reflects how an investment actually affects the value of an investor’s portfolio.

A bigger market capitalization can be associated with a higher total return, but that’s not always the case. When a company pays a dividend to its shareholders, for example, the company’s market capitalization decreases (because the company now has less cash), but the total return does not (because investors have received the cash).

Since it reintroduced its quarterly dividend in 2012, Apple has been paying its shareholders more than $10 billion a year in dividends (it’s spent an even greater amount buying back its own stock, another way of returning money to shareholders). Each dividend payment lowers the total value of the company’s stock, making it slightly harder for the company to reach a new market capitalization record.

But the dividends are arguably very good for shareholders. Even after the tens of billions of dollars in dividends and buybacks, Apple still has more than $150 billion in cash and other assets that it could easily convert to cash. This large amount of cash suggests that Apple may be having trouble finding profitable ways to deploy its money, and that more dividends and buybacks may be better for Apple’s shareholders than simply watching the cash pile continue to grow. Investors cheering for Apple stock to achieve new market capitalization milestones should keep that in mind.

Are More Share Buybacks a Good Sign?

Share buybacks—companies using cash to buy stock in their own company—are becoming a more common way for American corporations to spend their money. In the first quarter of 2014 share buybacks from the largest US companies increased by 50% relative to the first quarter of last year, according to analysts at FactSet. Is such an increase a good sign or a bad sign for investors? The answer (perhaps unsurprisingly) is “it depends”.

First the positive aspects of share buybacks. They indicate that companies are confident about their future prospects, since otherwise they presumably wouldn’t be spending money to buy their own stock. They also are a way, like paying dividends, of returning cash to shareholders (when a company buys back its stock it reduces the total number of shares outstanding, increasing the remaining investors’ stakes in the company). Returning cash to shareholders is therefore a bullish sign for those who believe that companies would otherwise squander their excess cash by failing to invest it profitably. And share buybacks are more tax-friendly than dividends, since they don’t count as income for investors.

For each of these positives aspects, though, there is a negative side. Making substantial share buybacks may indicate a short-term focus on boosting earnings per share rather than trying to grow a business over the longer term. It can also increase vulnerability to an economic downturn: many companies that had repurchased shares in the mid-2000’s found themselves without enough spare cash when the financial crisis struck in 2008. And studies have shown that companies tend to destroy value for their investors by repurchasing shares when stock prices are high.

The bottom line: each company’s decision may be good or bad depending on why it’s doing the buyback and how good it is at predicting the future. Share buybacks can’t be universally categorized as “good” or “bad” for investors.

Why Dividends Matter

In a recent post we discussed how taking a total return approach to investing can have benefits relative to focusing on dividends when trying to generate income from your portfolio. Does that mean dividends (and the numerous funds and commentators who focus on them) are irrelevant? Not exactly.

Historically, stocks that pay higher dividends have outperformed stocks that pay low dividends or no dividends at all. And contrary to the investing principle that higher returns should go along with higher risk, higher-dividend stocks on average have actually been less risky investments. They’ve historically outperformed lower-dividend stocks in both bull markets and bear markets.

Dividends
Source: BlackRock, via Business Insider

There are a number of possible explanations for this phenomenon. One hypothesis is that investors tend to overestimate that potential of high-growth companies, which also tend to be the companies that pay lower dividends (since the companies are choosing to use their money to try to grow their businesses rather than returning it to shareholders). As a result, the stocks of lower-dividend companies are often overvalued, so the subsequent returns are lower than for higher-dividend stocks.

Other possible explanations relate to how paying dividends affects companies’ decision-making. For example, it’s possible that having to consistently pay a dividend to shareholders keeps companies’ management more focused on only investing in profitable ventures.

That’s not to say that higher-dividend stocks always do better: there have been extended periods of time when they’ve underperformed lower-dividend stocks. And while some investors consider the collapse of internet stocks in the early 2000’s to be a warning against investing in high-flying stocks that don’t pay dividends, higher-dividend stocks are not immune from big declines of their own: banks were among the highest-dividend stocks in the US prior to the financial crisis in 2008.

So what’s the verdict? There’s no definitive explanation for why higher-dividend stocks have done well in the past, and there’s no guarantee that they’ll continue to outperform in the future. But there is compelling historical evidence that dividends do matter.

 

Meeting Your Income Needs with a Total Return Approach

If you need to generate income from your investment portfolio to pay for expenses, the process of selecting investments can seem a lot more complicated. Since almost all bonds, many stocks, and some alternative investments provide periodic income in the form of interest or dividends, almost any portfolio will generate some cash. But in the current low interest rate environment, there aren’t many investments that yield more than a few percentage points.

Instead of trying to generate enough income by limiting your choices to only high-income investments, a better tactic may be a “total return” approach.  This philosophy suggests ignoring your income needs when choosing your investments, and instead focusing only on selecting investments that create the portfolio most likely to have the highest total return (i.e. the combination of income and capital gains) for the amount of risk you’re willing to take.

If you need income from the portfolio, you can then “create your own dividend” by selling a portion of your holdings. For example, if your portfolio happens to only produces $1,000 of income but you need $3,000, you can simply sell $2,000 of your holdings to meet your income needs (of course your calculations need to account for how much you’ll owe the government, since interest income, dividend income, and capital gains are all taxed).

With this approach you can maintain a better-diversified portfolio: focusing on hitting a specific income target can result in a portfolio too heavily weighted toward bonds or too heavily weighted toward stock sectors (such as Utilities and Consumer Staples) that tend to pay higher dividends. By thinking about the total return rather than a specific income target, you don’t have to worry about your income needs skewing your portfolio.