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| | The Speculator
Buy companies buying their own stock
We crunched the numbers and found that companies that repurchase their own stock almost always go on to smash the S&P averages. Here's why -- and 13 stocks you may want to get started with.
By Victor Niederhoffer and Laurel Kenner
Just 13 companies enshrined in the S&P 500 index have announced plans to repurchase their shares so far in 2002 -- the slowest pace for corporate stock buybacks in half a decade.
But if our research into the fate of buybacks in 2000 and 2001 is correct, they are going to be a very lucky 13.
| 2002 Buyback Announcements | | Company | Symbol | Date | # shares (mill.) | Total outstanding (mill.) | | Aflac | AFL | 12-Feb | 25 | 518 | | BB and T | BBT | 27-Feb | 40 | 461 | | Biomet | BMET | 26-Mar | 30 | 268 | | Bear Stearns | BSC | 8-Jan | 20 | 100 | | Health Mgt Assoc | HMA | 21-Feb | 5 | 242 | | Johnson & Johnson | JNJ | 13-Feb | 80 | 3,047 | | Lehman Bros | LEH | 25-Jan | 78 | 244 | | Lexmark | LXK | 21-Feb | 4 | 129 | | MGIC Invest Co | MTG | 24-Jan | 5.5 | 106 | | Royal Dutch Petrol | RD | 7-Feb | 1.5 | 2,127 | | Tenet Healthcare | THC | 14-Feb | 10 | 326 |
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Before we explain our view, let us point out that there is every reason in the world to be bullish about a company when it announces that it will repurchase its shares. Academics have identified at least 30 of them, usually divided into the following classes.- Signaling. If a board authorizes the purchase of its shares, it would likely be signaling to its shareholders that it feels its stock is undervalued.
- Cash flow. Corporations these days are beset by skeptics who fret they will use their cash to build castles in the sky, such as skyscrapers or, in the case of Enron, create a horn of plenty for employees such as free Starbucks coffee (see our article of 12/13/2001, On Wall Street, pride signals a fall.) Distributing wealth to stockholders by reducing available shares diminishes the potential for waste.
- Better income ratios. The reduced number of shares, other things being equal, will improve earnings per share and return on equity.
- Substitutes for dividends. In recent years, the amount of buybacks has been running at or above the level of dividends. There are tax reasons at both the corporate and stockholder level that buybacks are preferable. Also, a one-time stock repurchase does not permanently increase dividends, so that if a mishap occurs in the future, there is no reputational disadvantage to their elimination.
- Lack of sufficient investment opportunities: When a company perceives that the rate of return in their own business is less than that which their stockholders could achieve, they should prudently distribute the money to shareholders.
The classic study on this last subject was published in 1995 in the Journal of Financial Economics by David Ikenberry, a professor at Rice University. He concluded that companies that buy back their own shares perform some 4% a year better than the averages. The differences rise to some 15% a year for value stocks. His studies have set off a cottage industry in academic studies. Confirming evidence has been provided for companies in India, Australia, England and Canada for various selected years and samples.
New data has cast these conclusions into doubt, however. For example, studies by two professors at Curtin University in Australia, John Evans and James Gentry, have concluded that the performance of companies that repurchase shares is worse than average. The effect is particularly pronounced for small companies. The idea here is that the small companies hurt their cash flow by repurchasing shares. If they are willing to do it, then they must be running out of investment opportunities.
A brilliant reconciliation of these results has been achieved by Edward Zajac and James Westphal at Northwestern University. They point out that regime shifts occur that make repurchase strategies good in one period and bad in another. In the1980s, they suggest, the dominant ideology was to honestly signal an intention to get good returns to shareholders and not to waste assets. But in the 1990s, many companies used repurchases to create a faade of stockholder awareness, with not much intention of actually completing the repurchase.
The situation is complicated by the biased nature of the samples that have been used. Many of the studies use data published in newspaper indexes. These data are then cross-referenced with financial data files -- with incomplete records thrown out.
The situation is unfortunately yet another example of the use of spurious correlations and the selective eyeballing of data that often riddles academic research.
It is best illustrated by the documented fact that there is a high observed correlation between the number of storks and human births in Germany.
An ingenious explanation that won the 1998 Purdue University Spurious Correlation Contest underscores the pitfalls. The study is based on the observed high correlation between the number of storks sighted and population of Oldenburg, Germany, over a six-year period. It seems that Oldenburg has attracted a large number of immigrants to study the works of the great German philosopher Immanuel Kant. Needless to say, the preferred diet there is wurst. A diet of wurst clogs up the arteries and leads to slowness in mental acuity. But this decline leads to a serious misinterpretation of Kants work, called unkantverstehenlassenhummel. Written discourse about the error leads to disorders of the eyes just from having to read such a long word. The double vision that results creates spurious sightings of storks with data reported at least double the actual numbers involved.
To prevent double vision, we interviewed David Fried, publisher, chief bottle-washer and cook at the Buyback Letter. Fried is riding a wave right now. His newsletter has been ranked as tops at picking stocks by Hulbert Financial Digest, the arbiter of such matters. This is poetic justice since it was a Hulbert article based on the Ikenberry work that inspired Fried to start his service in the first place. The Buyback recommended portfolio is up some 8% this year and some 86% since inception six years ago.
Fried gets around the common problem of companies not actually following through on announced buybacks by waiting until a quarterly report confirms they have reduced shares outstanding. He filters those observations with his studies, then pulls the trigger. In addition to his letter, Fried says he manages some $20 million for clients. The current recommendations of the letter are SuperGen (SUPG, news, msgs) and General Motors (GM, news, msgs). They join 28 other standards purchased from as early as 1995 such as Philip Morris (MO, news, msgs). The average holding period of the 30 stocks in the portfolio is at least three years. As to when to sell these, the decision seems in the main to be based on waiting until the number of shares increases.
Fried has an unusual background for a stock market letter writer; two decades ago, he said, he founded a company that makes schmattas, which is Yiddish slang for apparel, in case youve never shopped on Orchard Street in New York. Despite his success, we believe his work does not take into account the possibility of regime shifts as described by Zajac and Westphal. Nor are we thrilled with the paucity of his recommendations or the scant methodology behind the sells.
It seemed to us that what the doctor ordered was for the speculators to put on their bifocals and take out the proverbial pencil and envelope to do some calculations of their own. We compiled a list of every company in the S&P 500 ($INX) that has announced a buyback since the beginning of 2000. We tracked the performance of these companies, including dividends, for the year relative to the S&P 500. The buy date was the close the day after the announcement. The sell date was one year later. We wanted to include a full years performance so we cut off all announcements after March 30, 2001 for this study; 224 companies qualified.
Guess what? The results show that these companies outperformed the S&P index by 30 percentage points a year. Four-fifths of them went up more than the S&P 500 during the comparable period. The average superior performance was more than six normal deviations away from zero during this period, a result thats literally a 1-in-a-100 million shot by chance alone. More important, theres a 95% probability that during this period, the average return for companies of this nature fell between 24% and 36%.
This is a truly striking result that shows that during the current regime, S&P 500 companies that buy back shares are signaling above-average prospects of return. Were convinced and we plan to buy all 13 stocks mentioned at the beginning of this column.
A final note
We have reported on many aspects of the hubris phenomenon in our previous articles as well as the difficulties we had in garnering an interview with General Electric (GE, news, msgs). The two came together in a press release dated April 15, 2002 relating to concerns about the opacity of their financial statements which read, in part: Weve addressed these issues calmly, with explanations of our results, activities, culture and processes. We understand that being the best makes one a lightning rod, and we accept that level of scrutiny.
Dare we speculate that our inability to garner an interview from GE was in some way related to the 25% decline in price this company has suffered since the beginning of this year? Kindly give us your thoughts on hubris, buybacks and how we can improve, by e-mailing us. Information is so diffuse and so dynamic these days that the only way two mere columnists can do a good job is to get guidance and feedback from our readers. Well be happy to send you the complete worksheet of our 220-plus S&P buybacks as a reward.
At the time of publication, neither Victor Niederhoffer nor Laurel Kenner owned or controlled shares in any of the equities mentioned in this column.
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