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8/9/2019 When to Catch a Falling Knife or Repurchases and Special Situations 032107 - James Montier
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21 March 2007
Global Equity StrategyWhen to catch a falling knife, or, repurchases and special situations
Macro researchEquity Strategy | Global
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James Montier
+44 (0)20 7475 6821
james.montier@dkib.com
Global Investment StrategyResearch Analysts
Global Asset Allocation
Albert Edwards
+44 (0)20 7475 2429
albert.edwards@dkib.com
Global Equity Strategy
James Montier
+44 (0)20 7475 6821
james.montier@dkib.com
The buyback anomaly was first documented 12-15 years ago. However, it still
exists today. So much for the markets arbitraging anomalies away. Buying stocks
that have repurchased equity is a good idea. To really increase returns, the stocks
to look for are those with a poor recent price performance that then repurchase. It
appears corporate insiders behave as contrarians... if only investors did!
One can hardly have failed to notice the sheer scale of the buyback bonanza that has
occurred in the US over the last couple of years. Net repurchases (after issuance) added
the equivalent of 3.3% to the dividend yield in the US in 2006.
However, as we have previously noted, buybacks tend to be used to distribute temporary
earnings. As such, the high level of buybacks may well tell us more about the state of the
earnings cycle than anything else.
But what use is this to a fund manager? The answer may well lie in a new paper by Peyer
and Vermaelen. They update the original buyback studies from 12-15 years ago. The
high priests of market efficiency would have us believe that anomalies are quickly
arbitraged away by investors.
However, Peyer and Vermaelen show that the buyback effect is still alive and well.
Between 1990-2005 the average firm carrying out a buyback in the US has seen
cumulative abnormal returns of around 3% over 12 months. But the rewards to patience
are significant; the four year abnormal return is 24%.
Value firms (low price to book) benefit more from buybacks than growth stocks (high priceto book). The four year cumulative abnormal return to a value stock conducting
repurchase is nearly 30%. For a growth stock it is only 13%. This confirms ideas that we
have explored before suggesting that value strategies can be significantly enhanced by
the use of repurchase/issuance data.
There are many potential reasons why the buyback anomaly has proved so persistent.
However, most of them simply dont hold water. For instance, some argue that
repurchases are a management signal of improved future operating performance.
However, the evidence is sadly lacking. There doesnt appear to be any significant
improvement in the long-run operating performance of firms conducting buybacks.
The most likely explanation is that managers conduct repurchases when they feel the
market has gone too far (i.e. overreaction). This view argues that the best returns should
be seen from firms that repurchase after a marked price decline. This is exactly what
Peyer and Vermaelen find. The average stock in the worst past performance decile
witnessed a decline of 41% in the six months before the buyback was announced. But
the cumulative abnormal return was 45% in the next four years. In contrast, those firms in
the best past performance decile saw a 21% return in the six months prior to the
buyback, but only a 13% abnormal return over the next four years. Thus buybacks are
most useful after significant price declines they are a signal that it is safe for
investors to catch falling knives.
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When to catch a falling knifeOne can hardly have failed to notice the sheer scale of the buybacks that have occurred
in the US over the last year. Of course, far fewer were actually completed than were
announced, and fewer still were net buybacks (after options related issuance has been
removed). However, net repurchases added some 3.2% to the dividend yield in 2006!
Level of US S&P500 buybacks (US$m)
-100000
0
100000
200000
300000
400000
500000
600000
700000
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Announced
Completed
Net
Source: Dresdner Kleinwort Macro research
Buybacks raise total yield to over 5% (%)
-1
0
1
2
3
4
5
6
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Total yieldDividend yield
Net repurchase yield
Source: Dresdner Kleinwort Macro research
Buybacks used to distribute temporary earnings (%)
-50
-40
-30
-20
-10
0
10
20
30
40
50
Jan-87
Jan-88
Jan-89
Jan-90
Jan-91
Jan-92
Jan-93
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
-0.5
0
0.5
1
1.5
2
2.5
3
Net repurchase yield (r.h.scale)
Earnings relative to trend (l.h.scale)
Source: Dresdner Kleinwort Macro research
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However, as we argued last year (see Global Equity Strategy, 31 August 2006),
buybacks are often a signal of high temporary earnings, and as such the high buyback
level may tell us little more than that the earnings cycle is seriously extended. As the
chart at the bottom of pp2 shows, buybacks and deviations of earnings from their trend
are relatively closely correlated. The high level of buybacks is probably just another
reflection of the peak nature of earnings.
But what use is all this to a fund manager? The answer may lie in a new paper by Peyer
and Vermaelen1. They update the original buyback studies which used data that is now
well out of date. Peyer and Vermaelen argue that if the buyback anomaly still exists then
this is a major blow to market efficiency since it suggests that participants havent jumped
onto the anomaly and arbitraged it away. Unfortunately for fans of the efficient markets
hypothesis (not that I can believe any of them read my work) Peyer and Vermaelen
conclude that the buyback anomaly is still very much alive and well, some 12-15 years
after it was first documented!
They examine the US market over the period 1991-2005, ending up with some 5,348
open market share repurchase announcements. They show that buyback investing
requires a great deal of patience. Perhaps this is the best explanation as to the longevity
of the buyback anomaly as the average horizon for professional investors seems to be
measured in days rather than years. As the chart below shows, stocks with buybacks
tend to outperform (style, size and market adjusted) by around 3% in the first 12 months.
However, as the time horizon extends so the returns increase. By the fourth year firms
with buybacks show a 24% abnormal return.
Looking at the average firm hides a more interesting picture. Peyer and Vermaelen break
down the returns based on price to book. The value firms (low price to book) see
significantly better returns than the average firm, whilst the growth firms (high price to
book) see significantly lower returns than the average firm. This reinforces the results we
flagged up in Global Equity Strategy, 30 November 2006. The returns to value and
growth can be greatly enhanced by using issuance related information.
Cumulative abnormal returns US market, 1990-2005 (%)
0
5
10
15
20
25
30
35
12M 24M 36M 48M
All Firms
Value
Growth
Source: Peyer and Vermaelen (2007), Dresdner Kleinwort Macro research
However, Peyer and Vermaelen go beyond this decomposition to explore other
dimensions of buybacks that might be of interest to investors. They argue that there are
four possible explanations for the long-run outperformance of firms carrying out
repurchases:- (i) risk change hypothesis, (ii) liquidity hypothesis, (iii) the inside
information hypothesis, (iv) the over-reaction hypothesis.
1Peyer and Vermaelen (2007) The Nature and Persistence of Buyback Anomalies, working paper
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Lets examine each of these briefly. First up is the risk change hypothesis. This view
argues that the excess returns reflect changes about future risk. The argument runs that
the repurchase signals a decline in growth prospects (and hence risk). To make up for
this reduced growth, valuations decline and hence returns increase. However, the
argument is confounded by the empirical evidence since the numbers presented above
are already risk-adjusted.
The second hypothesis relates to liquidity. Several papers argue that liquidity is a priced
risk factor within markets (much like size and style2). There is still an active debate
amongst academics over the impact of buybacks on liquidity. Several authors conclude
that repurchases have no impact upon liquidity; some even find evidence of increased
liquidity. In order to test the relationship between buybacks and liquidity, Peyer and
Vermaelen calculate an extra abnormal return model which also includes a liquidity
factor. They find the results are essentially unchanged from those mentioned above. That
is to say liquidity doesnt appear to explain the buyback anomaly.
The third suggestion is the inside information hypothesis. This argues that managers know
the future better than outsiders and as such have a clearer idea of the likely path of future
fundamentals such as earnings and cash flows. They then use this information to time the
market better than other investors. The only snag with this argument is that the evidence on
improved operating performance following buybacks is very mixed to say the least.
For instance, Grullon and Michaely (2004)3
find no evidence of any long run improvement
(up 4 years) in operating performance amongst firms that repurchase equity. Erik Lie
(2005)4
notes Perhaps most importantly, neither this study nor Grullon and Michaely find
evidence of significant performance improvements during the years following the
announcement year, suggesting that any improvement primarily occurs during the
announcement year. This doesnt bode well for the inside information hypothesis.
Having ruled out the first three possible causes of the buyback anomaly, we are left withthe over-reaction hypothesis. This view argues that the buyback is driven by the fact that
management think the market has over-reacted to something in the recent past, and as
such they act as contrarians (that is to say, they act the way investors are meant to do).
Of course, this view argues that past performance should be a strong predictor of future
returns. After all the management will be acting as contrarians when the past price
performance has been poor, but not when the past price performance has been good.
Peyer and Vermaelen test this idea by conditioning buybacks on past price performance.
The results are shown in the chart at the top of pp5. Those stocks that have had the
worst past performance actually see the highest returns over long-time horizons. The
average stock in the worst past performance decile has witnessed a price decline of 41%in the six months before the buyback was announced. However, four years after the
repurchase was announced the average stock was showing cumulative abnormal returns
to the tune of 45%.
In contrast, those firms with the best past performance recorded an average return of
21% in the six months prior to the buyback announcement. However, four years later
their cumulative abnormal return was only 13%.
2Pastor and Stambaugh (2003) is the classic reference. See Liquidity Risk and Expected Stock Returns,
Journal of Political Economy. It is discussed on pp95 of my book, Behavioural Finance.3Grullon and Michaely (2004) The information content of share repurchase programs, The Journal of
Finance4Erik Lie (2005) Operating performance following open market share repurchase announcements,
Journal of Accounting and Economics
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As Peyer and Vermaelen note These findings suggest that managers do not necessarily
repurchase because of private information about the future operating performance of
their company, rather because they disagree with the hammering received in the stock
market. They argue that managers repurchase Because they believe their firm to be
undervalued. However it is not undervalued because future performance is improving,
rather because the market believes, incorrectly, that its performance will decline.
Cumulative abnormal returns by prior return - US market, 1990-2005 (%)
-50
-40
-30
-20
-10
0
10
20
30
40
50
Worst past performance
Best past performance
-6 0 6 12 18 24 30 36 42 48
month Source: Peyer and Vermaelen (2007), Dresdner Kleinwort Macro research
Interestingly, Peyer and Vermaelen find that analysts tend to be most pessimistic about
the stocks with poor past performance that conduct a buyback. Prior to the buyback
announcement, analysts seem to downgrade the stock both in terms of
recommendations and earnings forecasts this is, of course, consistent with analysts
chasing prices (something we have noted on many occasions).
The chart below shows the change in the analysts forecasts and the eventual forecasterror for both the firms that repurchase stocks grouped by prior price performance (all the
variables are scaled by market price). Analysts downgrade the earnings forecasts of both
sorts of stocks, but they end up being too pessimistic about the stocks with poor past
performance, and still too optimistic about the stocks with good past performance!
Analyst forecast changes and forecast errors (all scaled by price)
-0.05
-0.04
-0.03
-0.02
-0.01
0
0.01
0.02
Year 1 Year 2 Year 3 Year 4
Average change (low past return)
Forecast error after change (low past return)
Average change (high past return)
Forecast error after change (high past return)
Source: Peyer and Vermaelen (2007), Dresdner Kleinwort Macro research
The bottom line is that buybacks are most useful after significant declines in share prices
they are a signal that it is safe for long-term investors to catch falling knives. However,they are not anywhere near as important when recent share price performance has been
impressive. Given the performance of equities in the last few years, investors may wish
to be slightly more cautious about the motivation for the buyback bonanza behaviour.
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