Companies that have more money than they need to operate or expand can return that cash to shareholders in two ways: dividends or stock buybacks.

A dividend distributes those excess profits proportionally between all shareholders. I love dividends because they allow an investor to reap rewards from his or her investment without having to sell some or all of that investment. For that reason, I buy and hold dividend growth stocks (issued by companies I respect) so I can profit more by owning more shares. I rarely sell stocks.

Stock buybacks were uncommon 40 years ago, but the popularity of the practice has skyrocketed, and the value of buybacks have grown to exceed dividend payments in some years.

Source: Compustat, via Aswath Damodaran

A stock buyback is a transfer of value from one party to another. I don't like stock buybacks because they can pit investors in the same company against one another, or they can reward the executives of a company at the expense of all shareholders. Stock buybacks are also a perverse incentive if you buy shares in companies that you love (like I do) because an investor may have to relinquish his or her shares to realize the greatest benefit of the buyback.

I don't believe that stock buybacks are part of an evil conspiracy and, despite the headline of this article, I am not an advocate of "class warfare" (many fine Seeking Alpha readers and contributors are, indeed, wealthy). The point that I hope to make is that long-term investors should greet stock buybacks with skepticism.

Let's Immediately Address the Hole in My Argument

The S&P 500 Buyback Index, a list of 100 companies that have repurchased the highest ratio of their outstanding shares, has performed shockingly well over the last decade. The index has crushed the S&P 500 and has even eked out a win against my beloved Dividend Aristocrats (an index of S&P 500 companies that have raised dividends for 25 consecutive years or more).

Source: S&P Global

To me, the outperformance of both the Buyback Index and the Dividend Aristocrats Index suggests that silly acquisitions and wasteful spending are the worst evils that an investor faces. Better for a company's management to issue a dividend or repurchase its shares than to squander investor money.

But why has the buyback index outperformed the index of companies with growing dividends? I can offer three possible reasons:

My argument (to follow) is objectively wrong; The last 10 years are a peculiar time for markets because of unprecedented manipulation and intervention; or The size of the companies within these indices favors the buyback-focused fund.

The median market capitalization of the companies within the Dividend Aristocrats Index is 43% greater than the median market capitalization of the Buyback Index. I think this plays some role in how each index performs. On a long enough timeline, small-cap companies tend to grow more than mid-cap companies, which tend to grow more than large-cap companies.

How Stock Buybacks Can Transfer Shareholder Money to Executive Brokerage Accounts

Whether a company buys back shares in the open market or allows shareholders to tender their shares back to the company, the total number of outstanding shares is reduced. So, even if the company's earnings remain constant, earnings per share (EPS) will increase (i.e., the same earnings spread across fewer shares equals higher EPS). And yet, many companies award bonuses to their executives for increasing EPS. Sound fishy? It gets worse.

Companies don't always retire those shares that they bought back. Sometimes, they record those shares as treasury stock that can be repurposed later to fulfill a grant of restricted stock units (RSUs), used for compensation. So, the shares that the company bought back, that increased EPS and triggered bonuses for executives, might be paid out to those same executives as RSUs. Still, it gets worse.

Not every management team that wants to buy back stock has the cash on hand to do so: Some of them borrow money. So, the executives who borrow money in the company's name use it to buy back shares, that increase EPS, that trigger bonuses for those executives, and that are paid out using those repurchased shares. Meanwhile, the long-term investor is stuck paying back a loan.

(Investors may take some comfort knowing that interest payments on debt may lower the company's tax bill.)

The situation I describe above is an extreme one: RSUs are a less popular way to compensate employees than stock options are. And I've never seen a company that solely uses EPS as a bonus metric. But you needn't look further than the Dow Jones Industrial Average to find a company whose shareholders are at least partially exposed to this questionable compensation arrangement.

(I'm not going to name individual companies here because it would arbitrarily invite criticism of them, despite the practice being widespread. I wouldn't be surprised if some executive teams adopted certain buyback and compensation policies only because their competitors did.)

How Stock Buybacks Benefit Large Investors (Sometimes, at the Expense of Small Ones)

Small investors rarely have trouble buying and selling stock in a large company; however, large investors have a much harder time buying or selling stock without driving the price of the shares up higher or down lower. (I know the manager of a small hedge fund who once had trouble exiting his position in General Electric (GE)!)

That's why I take it with a grain of salt when an activist investor is on CNBC agitating for a company to deliver value by repurchasing its shares. These individuals may have the best interest of all shareholders in mind, but not necessarily. A company that repurchases billions of dollars of its own stock may unwittingly (or complicitly) serve as a trading partner with a large investor who wants to lighten, or completely exit, his or her position.

This reminds me of when Yahoo! was hunting for a new CEO. Hedge fund manager Dan Loeb was adamant that Marissa Mayer was the right choice to deliver long-term value. Mr. Loeb got his wish, and the stock popped higher, but he didn't stick around long after. Yahoo! repurchased more than $1B of his shares, helping Mr. Loeb lock in a tidy profit.

I realize that this real world scenario isn't exactly like the hypothetical one I describe above. Nevertheless, it shows how a buyback arrangement can appear tailored to a single, large shareholder.

Stock Buybacks and Shareholder Dilution

Some companies (particularly, tech companies) issue huge blocks of stock options to their employees as part of compensation packages. When these options are exercised, an existing shareholder's stake in the company is diluted. A company might offset these new shares by repurchasing and retiring existing shares, but shareholders are still being diluted in a way, because the company has less cash. This phenomenon is similar to when a can of coffee drops in weight from 1 lb. to 14 oz., then to 12 oz., then to 10.5 oz. - but the price of the can stays the same. Frustratingly, many investors (and consumers) don't realize they're getting less in return for what they pay.

Silly Things That People Say

I've heard many CEOs talk about their buyback plans using phrases like "We're so confident in our business, we're investing in ourselves." Nonsense. A company invests in itself by investing in its people, products, processes, plants and property. (Unfortunately, many companies squander shareholder money, as discussed above.)

You'll also hear people on television talk about the "mechanical" effect of buybacks on stock prices, as if a stock's price is mathematically guaranteed to rise when the number of shares is lessened. That's not how buybacks work. True, the company is reducing the number of shares outstanding, but the company has also reduced its cash on hand (which counteracts the reduction in shares).

Some investors may believe the line that the company is investing in itself, and pay a higher price for its shares. The stock may also trade higher because the company's purchases temporarily cause a scarcity in tradable shares, thus allowing the dynamics of supply and demand to kick in. But these impacts on a stock's price are psychological, not mechanical.

I can only think of one way that a buyback would have an immediate mechanical impact on a stock's intrinsic value. Let's pretend that a company has $20 of net, liquid assets per share, but those shares are only trading for $15 in the open market. Every repurchased share would lock in a $5 loss for those who sold their shares, and the claim on those cash assets would immediately be distributed across the base of existing shareholders. On the other hand, situations like this hypothetical one haven't been common in the U.S. since the 1930s (when companies sold for less than they were worth throughout the Great Depression).

Revisiting the Hole in My Argument

I first admitted that the S&P 500 Buyback Index has outperformed the S&P 500 Dividend Aristocrats Index over the last decade, but just barely. Both of these indices have trounced the S&P 500 over that same period. The good news for investors is that these specialized indices are investable via exchange-traded funds (ETFs).

The SPDR S&P 500 Buyback ETF (SPYB) and the ProShares S&P 500 Dividend Aristocrats ETF (NOBL) have the same expense ratio (0.35%) and almost identical dividend yields (1.78% and 1.74%, respectively). Both of these funds seem like fine investments for investors who want a turnkey way to invest in companies that return cash to shareholders.

But for enterprising investors who like to choose their own stocks, dividend growth investing offers something that buyback-chasing cannot: the incentive to cherry-pick the index.

The S&P 500 Buyback Index "turns over" almost all of its stock holdings each year. This would cause big tax consequences and high trading costs for anyone who tried to rebalance his or her portfolio to mirror part of the index each year. (Thankfully, the Buyback ETF shields investors from these costs.) Nonetheless, the Dividend Aristocrats Index has a much lower turnover by its nature.

I won't buy the Dividend Aristocrats Index ETF because I can't stomach the annual expenses. I'd rather buy 15 to 20 of the best stocks within the index and hold them indefinitely. That way, the only expense that I pay is the upfront cost of buying the stocks (and that expense grows smaller and smaller, relative to the portfolio's value, over time). I've been able to outperform both the Dividend Aristocrats Index and the S&P Buyback Index this way, and I don't think my results are hard to recreate.

Opposing Views and Final Thoughts

NYU professor Aswath Damodaran, a man who is much smarter than I am, believes that stock buybacks are preferable to dividends. I disagree, but I encourage you to read his thoughts on the subject and come to your own conclusion. If you are keen on companies that buy back their own stock, one final caution that I'll offer is to be wary of stocks with rising EPS and a falling net income. I can't be sure, but I think professor Damodaran would agree that this is a red flag.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.