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Economics & Finance

Buyback investing: time to come in from the ‘cold’?

Urs Peyer and Theo Vermaelen |

Many investors are wondering: is it time to take the plunge and go back into stocks? While no one can predict the future, it is generally accepted that company insiders know more than outsiders. So, one way to check whether insiders have confidence is to check net insider buying data (insider purchases minus insider sales). However, such a signal is likely to be noisy, as in many cases insider sales are driven by personal reasons such as the need to sell stocks to finance consumption or pay off debt.

An alternative way to examine insider confidence is to look at share buybacks. Academic surveys show that the main reason for repurchasing stock is “undervaluation” – firms believe that the market is overly pessimistic about the company’s prospects.  The most recent evidence of market timing is reported in our paper 'The nature and persistence of buyback anomalies' published in The Review of Financial Studies, April 2009. In this paper we show that a strategy that invests in companies that announce repurchase programmes motivated by undervaluation, outperform risk-adjusted benchmarks by 50 per cent after three years. The probability that a buyback is driven by undervaluation is measured by an undervaluation index. This index is based on the stated motivation in the press release, market-to-book ratios, past price behaviour and market capitalisation.

Why did such a free lunch exist for 25 years? Our research shows that the anomaly is a result of the short-termism of the analyst community. Although the value of a company is the present value of cash flows from now until infinity, analysts pay excessive attention to short-term performance, perhaps as a result of simplistic valuation methods such as valuation based on earnings multiples. As managers have a long-term perspective, they are better able to take advantage of mistakes induced by short-termism, at least on average.

This still then leaves us with the question why investors don’t exploit this anomaly by setting up buyback funds. Perhaps the strategy is too simple. It is based on common sense, not on sophisticated quantitative models which are often the result of “torturing the data until they speak”. If a strategy is too simple, investors may be reluctant to pay management fees to portfolio managers who don’t seem to work very hard.

Stock market crashes and buybacks

Occasionally stock markets overreact and crash without fundamental reasons and firms react to this by buying back their own stock. Two examples: the October ‘87 crash and the crash of 9/11.  Figures 1 and 2 show the level of the S&P 500 and the number of daily buyback announcements reported by Security Data Corporation in the period surrounding the crashes. It is obvious that buybacks increased dramatically after these crashes, especially after October 19, 1987 where more than 500 firms announced buyback programmes during the following week.

Things are quite different today. Figure 3 shows the S&P 500 and the daily repurchase announcements starting June 2, 2008 until April 21, 2009. Obviously the crash of the fall of 2008 is not followed by a drastic increase in buyback activity. Actually, we are currently in an extremely “cold” buyback period. During the first three weeks in April, only seven buyback announcements were made by US firms. It is difficult to find such a cold period during the last 20 years. So if companies are not buying their own shares, why should we? It seems that they believe the worst is still to come.

One counter-argument could be that perhaps companies believe their shares are undervalued but because their financial leverage is above their target, they want to de-lever, rather than to lever up through a buyback. Indeed, buying back shares makes sense if you have excess cash or debt capacity. Perhaps very few firms are in that position today.

Alternatively, the decline in repurchase activity may have well been the result of the fact that, viewed today, repurchasing stock in 2007 and early 2008 looks like a big mistake. Many companies who bought back shares because they thought they were cheap (including Lehman Brothers who announced a buyback for 19 per cent of its shares in January 2008) are today licking their wounds and are less confident about their ability to time the market. 

Picking a buyback portfolio in April 2009

The lack of buyback activity in general makes us reluctant to call the “bottom” of the market. However, some firms with excess cash may believe they have hit the bottom and are buying back stocks to take advantage of this undervaluation. We are putting our money where our research is, and on March 31, 2009 we invested a significant fraction of our wealth in 24 stocks that announced buybacks during the first 3 months of 2009 and appear to be driven by undervaluation, using our undervaluation index methodology.

Table 1 lists the firms, followed by their ticker symbol and market capitalisation. Except for two firms, most companies have market capitalisations in excess of $ 100 million, with an average market cap of $ 500 million. The fact that the firms are small is not surprising as our research shows that performance is negatively related to market capitalisation: it is more likely that small firms are undervalued than large firms.   Consistent with our expectations 18 out of the 24 firms have negative debt, that is, their cash holdings exceeds their financial debt. One outlier: Capital Source has a very high debt-to-equity ratio because it is in the banking industry.

We had a good start. Three weeks after portfolio formation, on April 24, the portfolio was up by 20.6  per cent which is higher than the results obtained by investing in the S&P 500 (8.6  per cent), the Nasdaq (10.8  per cent) as well as the Russell 2000 (13.2 per cent). The performance was not due to only a few outliers, as 22 out of the 24 stocks increased during the three week period. Whether this is indicative of the long term performance - only the future will tell.  We plan to keep you updated as history unfolds.

 

Theo Vermaelen is Professor of Finance at INSEAD and Urs Peyer is an Associate Professor of Finance at the school.

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