The New Science Of Stock Analysis

Why Buyback Stocks beat the market

As a first step to understanding the buyback phenomenon, let's look at The New Issues Puzzle. Among other things, this study compared how an investor would have fared buying stock in a company that made a seasoned equity offering versus buying stock in similarly capitalized non-issuing firms. (A "seasoned equity offering," as it is used here, simply refers to a sale of additional stock by a company whose shares are already publicly traded.)

Loughran and Ritter studied 2,680 companies that sold additional shares from 1970 to 1990. These companies actually made 3,702 such offerings, since some had multiple offerings. In fact, fifteen firms issued new shares five or more times. (Did I hear anyone mention P.T. Barnum?) Each company that issued shares was compared to a company of equal market capitalization that did not. As a result, two portfolios were created each with the same number of companies and a similar market capitalization. The only difference was that one portfolio was made up of stock-issuing companies, while the other, the reference portfolio, consisted only of non-issuing companies.

The average annual return of the issuing companies was a measly 7% a year. The non-issuing companies averaged a return of 15.3% annually. In each case, the time frame studied was the five years following the date of the seasoned offering. The year-to-year breakdown of Louchran and Ritter's results is as follows:

The preceding graph shows that $10,000 invested in the companies which issued more stock would have grown to $13,903 (a gain of 39%) in five years, but the same $10,000 invested in non-issuing companies would have grown to $20,357 (a gain Of 103%).

Playing devil's advocate with their own study, Loughran and Ritter wondered if the poor performance of the issuing companies could have been due to something other than the fact that they had issued more stock. After all, the stock issuers' share prices had run up about 72%, on average, in the year preceding the second stock offering. Perhaps the subsequent slump merely evened out their returns.

To test for this, the authors compared the issuing firms with a select group of non-issuing firms that had enjoyed similar price run-ups prior to the initial study. The results were similar: The non-issuing firms had an additional appreciation of 98% in the five years after the one-year run-up, or almost as much as the 103% gain for all of the non-issuing companies in the reference portfolio. To quote the authors, "What matters for future returns is not the previous year's return, but whether or not a firm has issued stock." The strength shown by the stock of the issuing companies in the year prior to their seasoned stock offering, the study showed, proved to be temporary. Investing in firms issuing stock," Loughran and Ritter concluded, "is hazardous to your wealth."

To get a more complete picture of the impact that a changing number of outstanding shares has on share price, let's examine the study Market Underreaction To Open Market Share Repurchases. This project compared the stock performance of 1,290 companies listed on the New York Stock Exchange, the American Stock Exchange, and the NASDAQ Stock Market who announced open-market buyback programs from 1980 to 1990. In the interest of fairness, the authors did not include buyback announcements made after the 1987 crash, since the subsequent strong performance of the stock market would have biased the study in favor of buyback companies. During the fourth quarter of 1987, a whopping 777 firms announced either new or increased stock repurchases totaling over $45 billion. Their buying proved timely, since the market quickly rebounded from the crash.) Here's what the researchers found:

Now, before you ask yourself why we are going through so much trouble to understand a 12.14 percent performance difference over a four-year period, let's take a closer look at these figures.

The statistics in the preceding graph apply to the entire universe of buyback stocks included in the study. But look what happens after the authors divided the buyback companies into five segments defined by their book-to-market ratio (their book value divided by their stock price). We'll refer to the group with the lowest book-to-market ratio as glamour stocks (group #1). We'll refer to the group with the highest book-to-market ratio as value stocks (group #5). When we examine their performance in this fashion, the results are eye popping:

Translation: $10,000 invested in value companies, which did not buy back any stock, would have grown to $19,062 in four years. The same $10,000 invested in value stocks that made buyback announcements (remember, this study deals with announced buybacks without regard to completion) would have grown to $23,591, an average annual increase of approximately 24% .

If you'll refer back to The New Issues Puzzle, you'll remember that its reference portfolio of nonissuing companies appreciated approximately 15% per year, or about the same as the reference portfolio of non-buyback companies in the second study. Using a four-year reference frame for both studies, we can see the following: A $10,000 investment in a portfolio of companies that issued additional stock would have been worth approximately $13,100 after four years, representing a 7% growth rate compounded annually. The same $10,000 invested in a portfolio of companies which neither issued nor bought back stock, and had an average book-to-market ratio, would have been worth approximately $17,490, or a 15% rate of growth compounded annually. A portfolio of value companies, which neither issued nor bought back stock would have been worth approximately $19,000, representing a 17% rate of growth compounded annually. But a portfolio of value companies that announce buybacks would have been worth approximately $23,900 after four years, for a 24% rate of growth compounded annually.

Two findings of these studies are striking. First, the reference portfolio for each study yielded an almost identical 15% per year. More interestingly, the issuing firms under-performed the reference portfolio by 8% annually in the first study, while the "value" buyback firms in the second study outperformed their reference portfolio by 9% a year. Those two figures are virtually mirror images of each other.

All well and good, you may say, and academic studies are great but I want to invest real money. What about the real world? Fortunately, the Ford Investment Review has published statistics appropriate for our needs based on a universe of approximately 2,600 stocks. Ford studied their share prices for 12 months following real changes in the number of shares outstanding, either due to the issuance or repurchase of stock. This is what they found for the twenty-year period from December 1974 through December 1994:

The returns in the Ford study are higher than we might have expected, for two reasons. First, the study began after a period of depressed prices, and second, it screened out companies in poor financial health. Nonetheless, the survey proved the general academic theory that the supply of outstanding shares impacts share prices in the real world.

Now that we are convinced that we can increase our returns by investing in buyback companies, which buyback firms should we invest in? Answering this question for you is our purpose here at The Buyback Letter.

Buybacks, we have learned, are not as straightforward as they seem, for a variety of reasons. Sometimes, companies don't follow up on their buyback announcements with actual share repurchases. And while one company's motivation for repurchasing shares may be to use them for the exercise of stock options, another firm may be repurchasing because it feels its shares are under priced and represent a good investment. In fact, 90 percent of buyback announcements do not disclose the reason or the motive behind the announcement.

Even if you know why a company is buying back its stock, you may find it difficult to know when it is buying. Many firms, particularly small and mid-size companies, will not say when they are buying back their stock because they do not want to tip their hand to the rest of the marketplace. (If investors knew a company was trying to buy its shares, they could drive prices higher, costing the company money.) In such cases, we only know for certain that a buyback has taken place by looking at a company's quarterly and annual reports. Additionally, companies do not generally announce that they are canceling a buyback plan. And finally, only high-profile companies like IBM or Chrysler gets headlines when they announce a buyback plan. Other companies' buyback announcements are buried in the news or not reported on at all. Only The Buyback Letter does this detective work necessary to track down this kind of information for you.

They key to profiting from buybacks is to know who is making the buyback announcement, why, and whether they are or are likely to go through with it. At The Buyback Letter , we divide companies that make buyback announcements into three basic categories. One consists of firms that never follow through with their announced plans; they make buyback announcements to "signal" that they believe their shares are undervalued. These companies are not among the companies we recommend for purchase.

The second group consists of companies that buy back stock only if and when their shares are bargain priced. An example of this type of company is SkyWest Airlines. SkyWest repurchases shares when the market price of its stock is close to its book value. If the price rises significantly beyond that level, the company abstains from open-market repurchases. Companies such as SkyWest provide us with opportunities to profit over a two- or three-year period if we can purchase shares at or near the price that the company repurchases its shares.

Our third group is made up of companies committed to long-term buyback programs as a means of building shareholder value. This group can be counted on to fulfill their promise when they make a repurchase announcement, and it is this group that holds the most appeal for long-term investors. A prime example is Coca-Cola, perhaps the ultimate buyback company. Since beginning its buyback program in 1984 it has repurchased 966 million shares (adjusted for splits). The company states in its annual report that it has "always viewed its stock as a consistent bargain for long-term holders." During the past 12 years, the stock buyback plan at Coca-Cola has turned 14% annual gains in profitability into 18% annual growth in per-share earnings.

Needless to say, The Buyback Letter is the first and only publication of its kind. Each month, we will separate the buyback contenders from the pretenders for you. Many Of our buy recommendations will have a low price-to-earnings multiple, and a low book-to-market ratio. All will poses excellent growth possibilities. Of course, these are just the first few factors in our "buyback screen," for which an extensive set of additional criteria, both subjective and objective, must be satisfied before we recommend that our subscribers buy a stock. The point is, a buyback announcement alone isn't sufficient reason to buy a stock. You need to know more. You need the kind of information The Buyback Letter can uncover.

On average, we expect to hold our stocks for about three years. However, we will not hesitate to sell a company that does not follow through on its repurchase announcement. Conversely, we will not be afraid to increase our position in a stock that has gone down, if we can verify that the company is buying with us at bargain prices.

How do you outperform the Market by 388%? Earlier we stated that value companies that announced buybacks returned about 24% annually. Lets reduce these return figures by 1% to 23% and compare to the 15% average annual increase in the S&P over the last 20 years. The following table shows the compounded growth in the value of $10,000 invested at these two rates of returns over a ten-year period:

Rate of return 15% 21.2% Cumulative
Year 1 $11,500 $12,300 8%
Year 2 $13,225 $15,129 19%
Year 3 $15,208 $18,608 34%
Year 4 $17,490 $22,888 54%
Year 5 $20,113 $28,153 80%
Year 6 $23,130 $34,628 115%
Year 7 $26,600 $42,592 159%
Year 8 $30,590 $52,389 218%
Year 9 $35,178 $64,438 293%
Year 10 $40,445 $79,259 388%

In closing, let me stress that at The Buyback Letter , we don't select stocks as much as they select us. We think the management of a company knows better than anybody outside the company when its stock represents a good value, and that management will signal this when it announces a buyback plan. What would you rather invest in–a company whose management puts its money where its mouth is, or one that doesn't? The answer, we think, is obvious.

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