216 InManagersWeTrust
signaling confidence and giving the appearance of reliability, are ei-
ther strange or disingenuous.
We should give credit to boards that use a more rigorous ap-
proach for setting dividend policy, an ideal set forth by Warren Buf-
fett. The test distinguishes between restricted earnings, those which
must be reinvested in a business just to maintain its competitive
position, and unrestricted earnings, which should be retained only
when there is a reasonable prospect that for every dollar retained,
at least one dollar of market value will be created for shareholders;
otherwise, the dollar of earnings should be paid out.^16 Microsoft fol-
lows this policy pretty well, never having paid a dividend and gen-
erating great returns on the reinvested capital.
Boards can justify retaining earnings under this test only if the
capital retained produces incremental earnings at least equal to the
return generally available to the shareholders. For companies that
can reinvest earnings in this manner, dividends should not be paid
and boards should ignore any negative signals this policy sends, such
as lac kof confidence or unreliability (though they should pay atten-
tion to the resulting tax advantages to shareholders).
The smartest thing a company can do with undervalued stoc kis
to buy it back. Obviously, if a stock is selling in the market at half
its intrinsic value, the company can buy $2 in value by paying $1 in
cash. You rarely find better uses of capital than that. Stoc krepur-
chases usually give a stockholder a slight tax advantage. Dividends
on common stoc kare taxed as ordinary income at rates as high as
39.6%, whereas income generated by the repurchase of stoc kheld
longer than a year is treated as capital gains at rates no higher than
20%.
Stoc kbuybac ks are not always what they seem. They reduce the
number of a company’s shares outstanding, thus increasing earnings
per share. The typical result is that investors buy more of that stock
and thus bid the price up, mistakenly believing that the repurchases
are a managerial signal that the company’s stoc kis underpriced. Of-
ten, however, the repurchase program is a cognate of a stoc kissu-
ance program to offset shares issued upon the exercise of stoc kop-
tions. The increased stoc kprice, after all, means increasing the value
of stoc koptions on that stoc k. When a repurchase program and an
issuance program are run simultaneously, you should be more dis-
criminating in your judgment of what management is doing.
It is possible that this effect could lead management (with many
stoc koptions at its feet) to prefer buybac ks even if that were not