" Why Dividends Are Better Than Stock Buybacks"

" Nvidia CEO Jensen Huang: The chipmaker’s stock yields a paltry 0.02%.
© Nathan Laine/Bloomberg
Stock buybacks are replacing dividends as the biggest source of capital returns. That may be creating big risks for income investors.

Investors love buybacks and dividends, but the two forms of capital return aren’t exactly the same. Dividends are a cash payout to a shareholder, while buybacks remove shares, giving remaining shareholders a larger stake of a company.

The S&P 500’s dividend yield has been shrinking. The overall index yields about 1.2%, near the all-time low reached during the dot-com bubble, dragged down by the relatively low payouts of tech giants like Nvidia, which yields only 0.02%.

The index’s paltry yield is a big change from the past. The S&P 500 typically yielded more than the 10-year Treasury note up until the 1960s, notes Deutsche Bank strategist Jim Reid. Just 10 years ago, the S&P 500 and 10-year yielded close to 2%, with the index trading for 17 times earnings. Now it yields about three percentage points less than the 10-year while trading for 22 times estimated earnings over the next 12 months.

Dividends are lagging, but buybacks have picked up the slack. Nvidia, for instance, has repurchased some $40 billion worth of stock over the past year. Combined with the meager dividend, its shareholder yield is a more respectable 1%.

Nvidia isn’t the only company favoring buybacks. Over the past decade, S&P 500 dividends paid have grown about 7% a year on average, according to Bloomberg, while net buybacks—repurchases minus stock issuance—have grown 10% a year. As a result, dividends make up just 43% of capital returns, down from roughly half 10 years ago.

On the surface, the buyback tilt doesn’t look like a problem for anyone besides income investors seeking cash payouts. Nvidia is near an all-time high, and U.S. stock markets have performed well, beating international indexes. “It’s hard to argue with the results,” Reid writes.

An overreliance on buybacks, however, creates a new risk, as stock market valuations get stretched and the U.S. economy shows signs of weakening. “If a downturn hits, buybacks will stop far more quickly than dividends, potentially pulling away a key pillar of market support,” Reid warns. “In a crisis, the lack of durable income from dividends may matter more than markets currently appreciate.”

What can investors do, given the new buyback risk? Preparing is always a good idea. Knowing which stocks are relatively more reliant on buybacks and which stocks have attractive dividend yields with ample earnings to continue protecting and growing dividends in a downturn can mean the difference between pain and gains.

Marathon Petroleum, Boyd Gaming, Kroger, and Nike stand out as heavy buyers of their own stock. That isn’t a problem on its own, but the companies have bought back twice as much stock over the past 12 months than they are projected to earn over the next 12, according to Bloomberg. Losing buyback support could be material for that quartet.

On the other hand, biotech Royalty Pharma, retailer Bath & Body Works, bank Popular, packaging maker Sealed Air, insurer MetLife, and oil-services provider Halliburton yield an average of 2.6%, while paying out only about 25% of net income projected over the coming 12 months. Wall Street likes the stocks, too. The average Buy-rating ratio for the shares is about 75%, above the 55% for the average stock in the S&P 500. The average Buy-rating ratio for the four buyback-heavy stocks is about 47%.

Fundamentals matter, of course, and appearing on a list doesn’t justify buying or selling a given stock. But as buybacks continue to displace dividends, income investors should be aware that all capital returns aren’t created equal.

Write to Al Root at allen.root@dowjones.com