Tim Collard:  As value equity investors we want to better understand shareholder yield, more specifically capital that’s returned via dividend relative to capital returned via share repurchases. I’m Tim Collard, portfolio manager at Boston Partners, and on this edition of Entry Points we will discuss capital allocation.

Within the three circle framework, capital allocation is a key component of the fundamental circle and capital allocation should be specific to each company’s opportunity. Provided there’s excess capital after reinvestment in the business and M&A will not drive attractive returns and assuming the balance sheet is in good standing, there’s really two options thereafter for shareholders dividends and share repurchases. And there’s certainly pros and cons to both.

Specific to dividends on the positive side. As a shareholder, there’s certainty of income. It’s lowering your reinvestment risk. You’re effectively pulling forward free cash flow and lowering your investment basis. There are negatives to dividends. It’s a fixed commitment by management in a company that may or may not be the best allocation of capital at that time. In a perfect world, management should have total autonomy to deploy capital to the highest return opportunity both in the short and the long term. You also have things like double taxation, taxing the dividend both at the corporate level as well as the individual level. And then there’s reinvestment risks for shareholders as it relates to that dividend income. On the other side, stock buybacks can create long term shareholder value.

If a company is reasonably consistent as it relates to earnings and cash flow and has excess capital shareholder returns will benefit from share repurchases. Another benefit – if you own stock in a business that repurchases 5% of their shares every year for five years, your ownership is going to increase 30% without doing anything. That math actually gets quite a bit more compelling the longer the time frame. If you look at the Russell 3000 on any sort of reasonable time frame, one, three, five, ten years, the companies that return capital both with dividend and share repurchases, have outperformed those that have only paid dividends in each of those time frames.

A company like AutoZone, which we’ve held at Boston Partners for a number of years, they’re really the poster child for share repurchases. In 1998, they recognized there were limited capital needs within the business outside of modest store openings. So at that time, they decided they would return all capital to shareholders via repurchases with no dividend. Over that 25 year time frame, they’ve reduced the shares outstanding by over 90%. And that’s on a net basis since they pivoted to share repurchases they’ve had very consistent growth. And so 20 plus years of straight earnings growth on a 25 year basis, revenues grown just about mid-single digits annually. Net incomes grown about 10% annually, but because of the share repurchases, they’ve compounded earnings at 20%. Resulting in an 85 fold cumulative gain.

Capital allocation is a key component of the fundamental circle, and each opportunity set is specific to the underlying company. But to the extent there’s excess capital, the valuation of the stock is reasonable- we’d prefer to align ourselves with companies and management that recognize the long term compounding nature of consistent share repurchases.