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

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

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Macro research

Equity Strategy | Global
21 March 2007

Global Equity Strategy
When to catch a falling knife, or, repurchases and special situations
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.
James Montier +44 (0)20 7475 6821
james.montier@dkib.com

► 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 price

to 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 don’t hold water. For instance, some argue that repurchases are a management signal of improved future operating performance. However, the evidence is sadly lacking. There doesn’t 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 Global Investment Strategy
Research 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

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.

Online research: Please refer to the Disclosure Appendix for all relevant disclosures and our www.dresdnerkleinwort.com/research disclaimer. In respect of any compendium report covering six or more Bloomberg: DKIB1<GO>

companies, all relevant disclosures are available on our website www.dresdnerkleinwort.com/research/disclosures or by contacting the Dresdner Kleinwort Research Department at the address below.

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Global Equity Strategy

21 March 2007

When to catch a falling knife
One 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)
700000 600000 500000 400000 300000 200000 100000 0 -100000 1987 1988 1989 1993 1994 1998 1999 2003 1990 1991 1992 1995 1996 1997 2000 2001 2002 2004 2005 2006 Net Completed Announced

Source: Dresdner Kleinwort Macro research

Buybacks raise total yield to over 5% (%)
6 5 4 3 2 Net repurchase yield 1 0 -1 Dividend yield Total yield

1991

1992

1994

1995

1999

2001

2002

1987

1988

1989

1990

1993

1996

1997

1998

2000

2003

2004

2005

Source: Dresdner Kleinwort Macro research

Buybacks used to distribute temporary earnings (%)
50 40 30 20 10 0 -10 -20 -30 -40 -50 Jan-94 Jan-95 Jan-97 Jan-98 Jan-04 Jan-05 Jan-87 Jan-88 Jan-89 Jan-90 Jan-91 Jan-93 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-06 Jan-92 Jan-96 Net repurchase yield (r.h.scale) 0 -0.5 1 0.5 Earnings relative to trend (l.h.scale) 3 2.5 2 1.5

Source: Dresdner Kleinwort Macro research

2

2006

Global Equity Strategy

21 March 2007

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 Vermaelen 1. 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 haven’t 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 (%)
35 30 25 All Firms 20 15 10 Growth 5 0 Value

12M

24M

36M

48M

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.

1

Peyer and Vermaelen (2007) The Nature and Persistence of Buyback Anomalies, working paper

3

Global Equity Strategy

21 March 2007

Let’s 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 style 2). 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 doesn’t 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 doesn’t bode well for the inside information hypothesis. Having ruled out the first three possible causes of the buyback anomaly, we are left with the 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%.

Pastor 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. 3 Grullon and Michaely (2004) The information content of share repurchase programs, The Journal of Finance 4 Erik Lie (2005) Operating performance following open market share repurchase announcements, Journal of Accounting and Economics

2

4

Global Equity Strategy

21 March 2007

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 -6 0 6 12 18 month 24 30 36 42 48 Worst past performance Best past performance

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 analyst’s forecasts and the eventual forecast error 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)
0.02 0.01 0 -0.01 -0.02 -0.03 -0.04 -0.05 Year 1 Year 2 Year 3 Year 4

Average change (low past return) Forecast error after change (low past return)
Source: Peyer and Vermaelen (2007), Dresdner Kleinwort Macro research

Average change (high past return) Forecast error after change (high past return)

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.
5

Global Equity Strategy

21 March 2007

Disclaimer
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