Archives for November 2012

What Are Money Market Accounts and How Do They Work?

November 25, 2012 by Karl Leave a Comment

Money market accounts aren’t new, nor are they particularly complicated or restricted (in fact, virtually every sizable financial institution offers one), but for some reason most people still do not know a lot about them.

Instead, other asset classes steal their thunder, classes like stocks, bonds, mutual funds, exotic instruments like exchange-traded funds, and even certificates of deposits. Yet, to make a truly informed decision for your investments, it’s important to know about money market accounts, how they work, and the benefits and drawbacks of each.

What Are Money Market Accounts?

A money market account (MMA), also known sometimes as a money market deposit account (MMDA), is a financial account that is based on money markets. I’ll explain what those are below. The money placed in a MMA is subject to interest, which is how you grow your wealth.

An MMA is very similar to a savings account. A savings account accumulates interest, but this is paid to you by the banks based off their interest rates. A MMA is based off the interest rates in the money markets. Plus, you can write checks against an MMA (for the most part; more on this later).

What is the Money Market?

A money market is exactly what it sounds like – a market for money. Specifically, the market is made up of financial institutions, like banks, credit unions, and brokerages, who want to borrow or lend money with those who have access to funds. What is being traded in these markets is called paper, which is basically a short-term financial instrument. Paper is used for short-term – less than a year – financial needs. You can think of paper as an IOU of sorts; government entities, corporations, and financial institutions all issue paper as a way of financing short-term needs.

Another way to picture a money market is to imagine a bank coming to you asking for a loan (instead of the other way around). You deposit your money into your MMA. The bank then uses this money, with other money from other people like you, to buy paper in the market. The return on this paper gives the bank a profit, which is divided between you and the other creditors (investors). You receive profit based off the interest rate for the paper.

What Kinds of Paper Can You Find in a Money Market?

A money market has several types of paper that can be bought and traded.

Treasury Bills

Treasury Bills (T-Bills) are one major type of paper in money markets. These are issued by the U.S. Treasury and are generally viewed as the safest investment securities in the world. These are bonds, and have maturity dates of one year or less from the time they are issued, in three-month, six-month, and one-year increments. At maturity, you are paid the par value (face value) of the bill. Your profit comes from the difference between the par value and the purchase value, which is lower than the par value. This is basically the same as interest.

T-bills are very safe and not subject to state or local taxes. They offer low returns, though, because they do not carry any risk.

Commercial Paper

Another main type of paper is commercial paper, or, securities offered by corporations as a way to raise money without taking out a loan from a bank. You purchase this paper at a discount, and it matures anywhere from one month to nine months. Most mature between 60 and 90 days, making them an effective way to accumulate money in the short term.

Commercial paper is pretty safe; they’re usually only issued by institutions with solid credit ratings. They are unsecured, but defaults are rare. The downside is that they are very expensive for the average individual investor, since one piece of commercial paper is worth at least $100,000 in most cases.

Certificates of Deposit

A certificate of deposit (CD) is a financial instrument that has a specific interest rate and maturity term. You place your money in a CD and you know how much you’ll receive and when you’ll get it. Since it’s a time deposit (i.e. it has to be in there for a certain period of time), it’s not as liquid as other kinds of investments.

The advantage of a CD is that return is very predictable. Plus, they are very safe, only slightly riskier than T-Bills. They also offer a higher yield than a T-Bill. Additionally, virtually any sizable bank or credit union offers CDs. Finally, they are FDIC insured up to $100,000 and typically beat savings accounts.

The downside is that rates aren’t very competitive and yield is small compared to most other assets. Also, you’ll have to pay a steep penalty if you withdraw money from your CD before maturity.

Municipal Notes

A municipal note is very similar to a T-Bill; it is a bond offered by a city to raise money. The city banks on tax receipts or other sources of revenue in the future, and issues notes against that amount to fill in short-term financial needs. You can take advantage of that by purchasing municipal notes at a discount and receiving payment when they mature.

Municipal notes are not as safe as T-Bills, but they are usually viewed as safe, since municipal defaults and bankruptcies aren’t very common. Because they are riskier than T-Bills, they generally offer a higher return (depending on where you are). Plus – and this is a big plus – the interest you receive from a municipal note is exempt from state and federal income tax (in most cases). Furthermore, you can trade them as often as you like.

A downside is that repayment is usually contingent on some future source of revenue. This is the case with revenue bonds. General obligation bonds by contrast promise to be repaid as long as the government is solvent, which means they carry less risk and lower yields. With revenue bonds, if tax receipts are significantly lower than expected – as with a recession – it is difficult to pay back municipal notes without risking bankruptcy.

Still, if you compare a municipal note with a piece of commercial paper with the same rate, you’ll often see that the total return for a municipal note is higher because of tax advantages.

Money Market Funds

Finally, there are money market funds, which are basically mutual funds with debt securities instead of stocks. These are groups of debt securities – like T-Bills or commercial paper or municipal notes – that are bundled together and sold to investors. This limits exposure to risk and gives an individual investor the chance to indirectly invest in securities that otherwise would be inaccessible due to their high cost.

Money market funds rarely lose value, but it does happen.

There are more than just these few types of paper traded in a money market, but these are the major ones you will more than likely encounter.

Why Have a Money Market Account?

The main advantage of an MMA is that it offers a higher rate of return than a savings account. Plus, it is far more liquid than a CD. Your money, with a MMA, gathers interest and can be withdrawn as you wish. Other assets, like a CD, do not have this feature.

Money market accounts are great for those who want to avoid the risk of the stock market and do not want to get involved in other types of riskier securities. Investors who also want a simple approach to saving and increasing money, yet want a higher rate than just opening a savings account and receiving a pretty paltry return, turn to MMAs.

For those who want to aggressively grow their funds, though, MMAs probably aren’t the best assets. Still, they have advantages for a wide range of savers and investors alike, and have a place even in advanced, aggressive portfolios as a way to hedge against risk.

What About Monthly Dividend Stocks?

November 22, 2012 by Karl Leave a Comment

Most companies that pay dividends do so on a quarterly basis. Others pay semi-annually or annually.

For those investors that require a monthly income for budgeting purpose, this would seem to rule dividend stocks out of the list of options for creating income, leaving the poorer rates of cash savings accounts, certain fixed income products, and other mutual funds. This selection of products can be problematic for various reasons: cash savings offer poor rates, fixed income products give no potential for increasing income or wealth, and mutual funds give little flexibility or control over investments.

The good news is, although much more difficult to find than quarterly paying dividend stocks, some stocks pay monthly dividends.

How monthly dividend stocks work

Most of these stocks invest in income producing stocks, bonds, and property companies. Many are investment trusts, and all trade on the stock exchange just like any other publicly quoted company. That means that shares can be bought and sold cheaply and quickly, and are not subject to other costs that, perhaps, would be incurred by investment into mutual funds.

Most of the monthly dividend stocks operate in the real estate, or energy and utility sectors, and invest in income producing assets. Income is generated from a mix of capital growth, corporate profits, interest on bonds, and income from rental property. Investments, and income, can be from a diverse portfolio of assets.

Benefits of monthly dividend stocks

Obviously, for budgeting purposes a monthly income makes sense. Most bills are collected monthly, and a regular stream of income makes this process easier to manage. For pensioners, a move from the normality of a regular monthly paycheck to a quarterly or half yearly income payment can be particularly traumatic. Cash flow is just as important to the individual as it is to multi-billion dollar company.

For those not wanting to take income, and looking for a longer term strategy of dividend reinvestment, a monthly payment of dividends also makes sense. Consider stock A that pays a dividend of 5% annually. The investor has to wait for twelve months before the dividend is available to reinvest.

The investor in stock B, that pays its 5% dividend in equal proportions each month, will be able to reinvest those dividends earlier. This means that the compounding process from which dividend re-investors benefit is started earlier, and wealth creation benefits.

The disadvantage of investing in monthly dividend stocks

Monthly dividend paying stocks are few and far between when compared to quarterly payers. This limits the number of companies available to invest in. This limitation means that there are fewer quality stocks from which to choose for monthly income seekers. By their very nature, monthly dividend payment stocks can suffer from fluctuating income streams, which may mean the amount of the dividend also fluctuates. Monthly income is great, but it may be that the lack of stability in income creates problems of its own.

Selecting monthly dividend stocks

As with any investment, it is important to conduct full research into the companies into which you are considering making an investment. There are steps you can follow to narrow down your search:

Search on Google for monthly dividend stocks. A good list of monthly dividend stocks can be downloaded from here to an excel spreadsheet which will help to order the stocks by selection criteria;
Look for dividend yield, but then research the company’s dividend paying history. A long history of high and increasing dividend payments can be an indication of the board’s willingness to continue with such a policy;
Consider the fundamentals of the company: does it have good cash flow, and benefit from low levels of debt, for example. What are the prospects for the business and the sector in which it operates? How stable is the company’s management?
Just as with any investment portfolio, consider diversification. The energy sector may offer the best dividend yield, but if the sector suffers an unexpected shock and share values fall, or profits are restricted by new laws or safety regulations, for example, then not only could your portfolio value suffer but also your income stream;
If you don’t need the income, then consider reinvesting dividends to benefit from compounding growth and future dividend payments

To sum up

For those investors who desire a monthly income with the flexibility of investment choice, and the potential for better returns than achievable from a savings account, then investing into stocks that pay their dividends monthly could be the answer.

Proper research should be conducted into any stock before an investment is made, and this should include consideration of business, industry sector, and dividend payment history. Within your portfolio, it would be wise to ensure appropriate levels of diversification.

The dividends paid can be erratic because of business conditions and income stream, but these dividends can be reinvested as they are paid by those investors that want to compound their capital growth and look toward income in the future.

An alternative strategy for those investors that want to receive a monthly income would be to invest in a range of quarterly paying dividend stocks, with different payment cycles to build up a monthly income stream.

Before I go, I just need to give a special thanks to Daniel at Sweating the big stuff for hosting the Carnival of Personal Finance #388.

9 Investing Mistakes You Don’t Want To Be Making

November 18, 2012 by Karl Leave a Comment

You don’t make investing mistakes because you’re smart, right? Um, ok. Whether you’re a veteran with handling savings and investment decisions or new to the investing world, it pays (literally) to learn, and avoid, investing mistakes that so many others have made before you. So, before you buy your first shares of the next Amazon or Google, check out the nine most common mistakes that investors make:

Jumping on an overhyped stock

Hey, big shot! You got in on that Facebook IPO, didn’t you? Wow, you’re a player! Wait – you really did buy shares of Facebook on the first day they became available? Sorry to hear that. If we learned anything at all from the recent Facebook IPO debacle, it’s that the small retail investor should steer clear of any IPO.

In fact, the more media hype that there is around an IPO, the more wary any potential investor should be. IPOs are “initial public offerings” that mark a private company’s debut on a stock exchange, when the company becomes publicly held. For well-known companies, an IPO can garner significant attention (translation: “hype”) from the media. This is bad for you, the small investor, who probably thinks very little about the stock market at any other time. Let the “big fish” play in the IPO sandbox.

If you’re interested in an individual company stock, invest in it for the long term – and wait until the hype (and the share price fluctuation) dies down. By the way, in case you didn’t know: Facebook shares dropped over 25% in their first two weeks of trading. Be very glad you didn’t get in on this particular IPO, hot shot.

Avoiding diversification

OK, so you own some shares in the Acme MegaFund Value mutual fund, and you also own shares in the HugeCorp Growth mutual fund. You think you’re invested in lots of different companies, don’t you? Think again. Check out the companies that your mutual funds invest in, and you might find that there’s some “overlap”: two very different funds with significant chunks of their portfolios in identical companies.

So, read your mutual fund prospectus. Sure, it’s pretty boring (do so when you’re getting ready for bed, and are having trouble falling asleep). Then you’ll know what companies are being purchased by your funds.

By the way, the only time you should have to read a fund prospectus (yawn) is before you invest in the fund for the first time. After that, you might glance at it once every two years or so to make sure your mutual funds are buying companies you like, and avoiding companies that you don’t care for.

Avoiding international opportunities

It seems that half the countries on the planet are involved in guerrilla conflict, drug smuggling, nuclear weapons testing, and counterfeiting Disney DVDs. Still, even with this cynical view, that means that the other half of the countries around the globe are involved in legitimate trade and possibly on the verge of becoming homes to the next Google or British Petroleum.

Avoid investing in countries outside your own borders at your peril. Most economic growth taking place right now is within countries that may have offered risky investment opportunities not long ago. But times have changed, and just because opium poppies are a major cash crop in Afghanistan doesn’t mean that the next superpowered microchip can’t be developed in Brazil or India.

Too much of your portfolio in one company

Do you have most of your retirement portfolio invested in the company that employs you? You dummy! Sell, sell! Well, ok – at least slowly spread out your investment around a few other companies. What happens if you get laid off? Not only will your biggest source of income disappear, but the company you once worked for might be in trouble. Do you want to be invested in that company? Of course not.

Thinking you can outperm the market when your a newbie

Yeah, sure. newbie sign You and every other bloke who opens up an online brokerage account and reads a couple of books about “how to get rich in the stock market”. Trust me, odds are that the folks who write books on this type of stuff are getting rich off of their book sales, not their investing prowess.

Highly paid stock traders with skilled research staffs are going to battle against you, the average small investor. Do you think that even they outperform markets on a regular basis?

It’s possible, but it’s not easy. Usually only the most experienced traders can acheive this consistantly. It’s unlikely that u’d be able to acheive this in your first few months of trading.

Avoiding index funds

Why bother investing in “actively managed” funds at all? Good question. Not only do many actively managed funds fail to outperform the markets (see above), they also tend to charge higher fees. And fees, by the way, can really mess up your portfolio growth over the long run.

It pays to find funds with very low fees, and index funds tend to charge the lowest fees of all mutual funds. Index funds are “set it and forget it” funds, which means that they don’t need an overpaid fund manager to maintain them. If you want to be invested in the markets without thinking too much about which mutual funds you should invest in, then simply invest in index funds. Then go take a long nap or grab a beer.

Keeping too much of your portfolio in illiquid investments

What happens when your rusty old clunker finally requires that transmission replacement that you’ve been putting off for the last two years? Homeowner’s insurance won’t pay for the repairs, and you probably won’t be able to cash out of your mutual fund or stock investments in a hurry. So, always keep some cash on hand just for emergencies. Online banks are good for storing money that you might need to transfer to a checking account quickly. It’s normal for a transfer to be completed in two or three business days.

Believing that “the sky is falling!”

There are always a few “gurus” running around yelling: “buy gold and silver because the major world currencies are going to be devalued and the world will end next week!!!” Please. For thousands of years, there have been people running around yelling that the “end is near”.

(Lately, the Mayan Indians are guilty of this, and heck – they aren’t even around any more. Now, that’s influence!) The world won’t end, the sky is still blue (well – usually), and gold and silver probably shouldn’t take up more than 5% of your portfolio.

You’re going to miss out if you avoid buying stocks or mutual funds that invest in growing companies, because you listen to “end is near” precious metals hucksters. The wealthiest folks in the world didn’t get that way by building bomb shelters and stacking gold bars in them.

Failing to consider your own investing personality

Do you like to go bungee jumping? Do you enjoy hanging out with shadowy criminal types who engage in questionable businesses? Or is your idea of a good time a night in front of the T.V. watching “The Bachelorette” reruns?

Take your own personality into account when you choose your investments. Some individuals can handle wild stock price swings better than others, while others like their investments, well – boring. Ideally, you might consider small investments in exciting and “sexy” companies, while keeping big percentages of your portfolio focused on sleep-inducing businesses. And, reconsider your hobbies if “Bachelorette” reruns really are your favorite pastime. You should get out more.

Face it, you’re reading this post, so you’ve learned something, haven’t you? Oh, yes you have, admit it! Click on your RSS feed and add this blog to your list of subscribed blogs. You’ll continue to learn (and slowly build wealth) by becoming a subscriber. You’re welcome.

How Do Mutual Funds Work?

November 18, 2012 by Karl Leave a Comment

If you’re into investing and want to know more about making money in the markets, you probably have asked yourself at one point this question: “What are mutual funds?” You’re not alone, either; mutual funds easily constitute one of the most popular asset classes for investment in the world.

Here, I will tell you what a mutual fund does, how it works, and talk about the advantages of mutual funds and how they compare to other asset classes.

What is a Mutual Fund?

A mutual fund is a collective investment scheme that takes investment funds from thousands of individual investors and pools mutual funds it together into a pot of money. This pot is then used by a professional fund manager who uses it to buy and sell shares of stocks – or bonds, or commodities, or commercial notes, or other securities.

Put another way, let’s say you want to invest in real estate. You can pick a single home in a city and purchase it. Or, you could pool your money with your friends and give it to a professional real estate investor, who acts as your manager. The manager then takes that much larger pool of money and buys a residential home or two, plus a couple of apartment buildings, a townhouse, a luxury condo, and a couple of office buildings – all located across the city.

You have just created a mutual fund for real estate. In essence, what you’re doing is multiplying your purchasing power and diversifying your holdings at the same time – all while letting a paid professional do the dirty work of investment for you.

How Are Mutual Funds Valued?

The main way a mutual fund is valued is based off its net asset value(NAV), which is calculated by taking the number of shares of the fund that are out in the market and dividing them into the total value of the fund.

Before we go further, though, it’s important to understand the difference between the two different types of funds: open-end funds and closed-end funds.

An open-end fund is a mutual fund that issues shares based on demand. As long as people want shares of the fund, they will be issued – and as long as people want to sell their shares, the funds will buy them back. Most mutual funds are open-end funds.

A closed-end fund is one in which there is a limited number of shares. These are actually very much like stocks, in that they are traded on stock exchanges, except that these are actively managed by professional advisors.

Since open-end funds are what we think of when we think of “mutual fund”, and are the most common type of mutual funds, we’ll focus on that type. The value of an open-end mutual fund is calculated by dividing the value of the assets held by the mutual fund by the number of shares outstanding (i.e. NAV). NAV changes based on the underlying value of the assets in the fund’s portfolio.

NAV is the price at which you can buy shares of a fund. You profit from a mutual fund either by the difference between your purchase price and the sale price of the shares you buy and sell, respectively, or by dividends generated by the fund.

What Types of Funds Are There?

Within open-end funds, there are several types of mutual funds, including:

Stock funds: These are the most common types and feature bundles of stocks either in one industry or sector or spread across several.
Corporate bond funds: These are funds that invest in corporate bonds, which have lower returns on average than stocks but aren’t as risky.
Government bond funds: These funds invest in bonds and notes issued by governments, including the U.S. Treasury. These tend to be the safest funds in the world.
Junk bond funds: Also known as “high-yield bond funds”, junk bond funds invest in bonds that have very high yields, but are very risky – and are more vulnerable to downswings in the economy than other bonds.
Municipal bond funds: These funds invest in municipal bonds, which are bonds issued by cities and local/state governments. Income from these funds are tax-free, which means you can generate higher returns than other types of corporate or government bonds.

Within stock funds, there are several types:

Value funds: These funds invest in stocks that are determined to be undervalued, i.e. currently priced below what they normally should be as judged by the underlying financial strength of the companies represented. Commonly, these are either companies that have had their stock prices beaten down by the market but otherwise are sound, large, and here to stay, or stocks with low price-to-earnings ratios or price-to-book ratios.
Growth funds: These funds invest in stocks that generate higher-than-average earnings and are growing rapidly. You gain more return than with value funds at times, but you also are exposed to more risk.
Income funds: These funds invest in stocks that generate income through dividend. If you want steady, fairly-predictable income, these are your best bets. You can have income produced while also enjoying appreciation in your assets.

You can also find blend funds which combine two or more types into one tradable asset.

How Much Does It Cost to Trade Mutual Funds?

Investing in mutual funds does cost money. With stocks, you pay commissions or flat fees. With mutual funds, you also pay management fees and expenses. Trading stocks with discount online brokerages is generally viewed as less expensive than investing in mutual funds.

One way to avoid this is to find no load mutual funds, which are funds that have no transaction costs. Let’s say you have $1,000 to spend. You choose a load mutual fundthat charges a commission of 5%. You will pay $50 either on the front end or out of your profits for this fund, meaning only $950 is actually used (if it’s a front-end fee).

A no load fund would use the entire $1,000 amount. These are typically used because the investment company that owns the mutual fund issues shares directly, instead of going through intermediaries. If you want to avoid paying a broker or advisor who selects mutual funds for you to choose from, no load mutual funds are the way to go.

Generally speaking, it is better to find mutual funds with the lowest fees and expenses possible. Statistical analysis has shown that load mutual funds do not outperform no load mutual funds. In fact, one study has indicated that no load mutual funds actually outperformed load mutual funds from 2000 to 2002.

Why Invest in Mutual Funds?

The main reason most people turn to mutual funds is diversification. To get the same kind of diversification (i.e. risk mitigation) from a single mutual fund, you would typically pay more to get a basket of individual stocks that accomplishes the same thing. Plus, you’d have to keep up with dozens of individual stocks instead of one, convenient investment vehicle – the mutual fund.

Mutual funds are also great if you have no interest in picking stocks or are not good at it – and many traders aren’t. Plus, if you don’t have the time to play the stock market, a mutual fund will more than adequately suffice. Mutual funds, furthermore, are preferable for beginners who want to get into investing but probably shouldn’t jump right into picking stocks and letting the dice fly.

Finally, mutual funds are good for those who want professionals to pick and manage the assets.

Of course, there are three drawbacks to a mutual fund. The first is cost. Mutual funds are more expensive than individual stocks because they incorporate fees and expenses that are more than your typical stock trade commission.

The second drawback is that you lose control over what assets go into your mutual fund, whereas with a stock portfolio you and you alone have control.

Finally, the third drawback is how mutual funds are priced. The price of a stock changes in real time throughout the day. The price of a mutual fund isn’t assessed until the end of the trading day, with the fund’s closing price. This takes away the real-time trading aspect of stocks. One way to avoid this is to consider trading exchange-traded funds (ETFs), which are mutual funds that trade like stocks.

Mutual funds can be powerful assets to have in your portfolio. Ask your financial advisor for more information.

Dividends vs Stock Repurchases/Share Buybacks

November 14, 2012 by Karl 1 Comment

Both dividends and stock repurchase schemes are ways that a company can boost the returns of its shareholders. However, whilst it is reasonably easy for an investor to understand how the payment of a dividend rewards him, many find the mechanism of stock repurchases more complex, especially when it comes to their benefits to shareholders.

What is a stock repurchase?

A stock repurchase program – also known as a share buyback program – is a mechanism by which a company buys back its own shares.

The company buying back its own shares can do so by either purchasing direct from the market (getting its broker to buy shares on the stock exchange) or it can ask if its shareholders wish to tender their shares at a fixed price.

A stock repurchase program has to be agreed at the annual general meeting, and the agreement will stipulate the amount of the buyback (usually in terms of total value, rather than number of shares) and the period during which the repurchase program may operate.

Why would a company conduct a stock repurchase program?

When a company wants to return cash to shareholders, it can, of course, do so by paying a dividend. However, if the company believes that its shares are undervalued by the market it might decide to undertake a stock repurchase program. The company believes that by taking shares out of the market it will increase the value of the remaining shares.

Often a company will announce the price at which any stock repurchase will take place, and this puts a ‘floor’ under the price of the shares traded on the stock exchange. Understanding how a stock repurchase can help the share price increase, however, is a little more complicated.

The first thing to understand is that the act of purchasing shares does no more harm to a company’s value than paying a dividend. Both methods of returning cash to shareholders take cash off the balance sheet and remove a certain value from the company.

However, in the case of a stock repurchase, because the shares bought by the company are then cancelled, there are fewer shares on the market. The overall value of the company is no different to if the return to shareholders had been made via a dividend payment, but the respective price per share will have increased.

Further, future dividend payments will likely be higher per share, because there are fewer shares for the dividend to be shared between. This will be another push on the share price.

So, share repurchases are a good thing?

This really depends upon the price of the shares and the value of the shares. Price and value are two different things. Just because the company is undertaking a stock repurchase program does not mean the stock is undervalued.

There are many measurements of value, and when considering whether the stock repurchase program is a good event, then an investor should look at ratios such as the price to earnings and fundamentals such as revenue, cash flow, and debt.

Having established the value of the company, perhaps relative to others or in an historical context, the investor will be able to say whether he would reinvest any dividends that would be paid to him, or perhaps commit new capital. If the answer is yes, then the stock repurchase program works in the investor’s favor.

Are there other benefits to a stock repurchase program?

We’ve already discussed the effects that a stock repurchase program may have on the share price, by cancelling stock and seeing the market capitalization of the company supported by fewer shares.

And we’ve seen that the payment of higher dividends will help drive the share price forward.

But there is also a tax advantage for shareholders. If the investor believes that the stock repurchase is being conducted at a good valuation, and would have reinvested his dividends anyway, then he will be gaining because the dividends he would have received would have been liable to tax at his personal rate.

The disadvantage of a stock repurchase program

Instead of buying shares in the market, the company could have paid its investors a higher dividend. This dividend could then have been used in any way the investor cared, including reinvestment, investment elsewhere, and to meet regular expenditure.

When the company buys its own shares, it is removing the capability of the individual investor to make the decision of what to do with dividend cash. Even if the investor would have reinvested, when the company conducts a share repurchase it is deciding when and at what price to do so and the investor has no control over this either.

Dividend payments give the shareholder a wide ranging flexibility of choice, stock repurchase take that choice away.

The attraction of dividends

Most companies pay dividends on a quarterly basis, though some do pay monthly, and this can produce a good regular flow of income for investors.

Those investors who don’t need the income can reinvest those dividends as they please to benefit from a compounding effect. This can greatly enhance investment performance over the longer term.

As a long term investment strategy, investing in stocks that pay a high yield, or those with dividend growth rates above the level of inflation, helps to protect purchasing power against the effects of inflation.

However, dividends are treated as taxable income, and will be liable to tax at the individual’s tax rate.

Stock repurchases or dividends: what’s best?

Stock repurchases should boost the value of shares and mean that dividend payments will be larger on a per share basis in the future. They also negate the tax effect that investors suffer when receiving dividend payments. If they are conducted at a price which would appear to attractively value the company, then most investors would agree that they are good news.

However, for those investors that require income, or want the flexibility to choose what to do with an otherwise higher dividend, the repurchase of shares by the company removes this flexibility.

The choice of whether to stick with the company that conducts a stock repurchase program will depend on the objective of the investment, and the investor’s valuation of the company.