When to Catch a Falling Knife or Repurchases and Special Situations 032107 - James Montier

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

[email protected]

Global Investment StrategyResearch Analysts

Global Asset Allocation

Albert Edwards

+44 (0)20 7475 2429

[email protected]

Global Equity Strategy

James Montier

+44 (0)20 7475 6821

[email protected]

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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Global Equity Strategy 21 March 2007

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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


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)



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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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When to Catch a Falling Knife or Repurchases and Special Situations 032107 - James Montier

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