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.

► However, Peyer and Vermaelen show that the buyback effect is still alive and well.
James Montier
+44 (0)20 7475 6821 Between 1990-2005 the average firm carrying out a buyback in the US has seen
james.montier@dkib.com 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
companies, all relevant disclosures are available on our website
Bloomberg: www.dresdnerkleinwort.com/research/disclosures or by contacting the Dresdner
DKIB1<GO> Kleinwort Research Department at the address below.
Dresdner Kleinwort Securities Limited, authorised and regulated by the Financial Services Authority and a Member Firm of the London Stock
Exchange. PO Box 52715, 30 Gresham Street, London EC2P 2XY. Telephone: +44 20 7623 8000 Telex: 916486. Registered in England
No. 1767419. Registered Office: 30 Gresham Street, London EC2V 7PG. A Member of the Dresdner Bank Group.
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
Announced
600000

500000
Completed
400000

300000

200000

100000 Net

-100000
1987

1988

1989

1993

1994

1998

1999

2003
1990

1991

1992

1995

1996

1997

2000

2001

2002

2004

2005

2006
Source: Dresdner Kleinwort Macro research

Buybacks raise total yield to over 5% (%)

6

Dividend yield
4 Total yield

2
Net repurchase yield
1

-1
1991

1992

1994

1995

1999

2001

2002
1987

1988

1989

1990

1993

1996

1997

1998

2000

2003

2004

2005

2006

Source: Dresdner Kleinwort Macro research

Buybacks used to distribute temporary earnings (%)

50 3
40
Earnings relative to trend (l.h.scale) 2.5
30

20 2

10
1.5
0

-10 1

-20 0.5
-30
0
-40 Net repurchase yield (r.h.scale)

-50 -0.5
Jan-94

Jan-95

Jan-97

Jan-98

Jan-04

Jan-05
Jan-87

Jan-88

Jan-89

Jan-90

Jan-91

Jan-92

Jan-93

Jan-96

Jan-99

Jan-00

Jan-01

Jan-02

Jan-03

Jan-06

Source: Dresdner Kleinwort Macro research

2
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 Value

25
All Firms
20

15

10
Growth
5

0
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%.

2
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

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 Worst past performance

30
Best past performance
20

10

-10

-20

-30

-40

-50
-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 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

-0.01

-0.02

-0.03

-0.04

-0.05 Year 1 Year 2 Year 3 Year 4

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

5
 Global Equity Strategy 21 March 2007

Disclaimer
This report has been prepared by Dresdner Kleinwort, by the specific legal entity named on the cover or inside cover page.

United Kingdom: This report is a communication made, or approved for communication in the UK, by Dresdner Kleinwort Securities Limited
(authorised and regulated by the Financial Services Authority and a Member Firm of the London Stock Exchange). It is directed exclusively to
market counterparties and intermediate customers. It is not directed at private customers and any investments or services to which the report
may relate are not available to private customers. No persons other than a market counterparty or an intermediate customer should read or rely
on any information in this report. Dresdner Kleinwort Securities Limited does not deal for, or advise or otherwise offer any investment services to
private customers.
European Economic Area: Where this report has been produced by a legal entity outside of the EEA, the report has been re-issued by
Dresdner Kleinwort Securities Limited for distribution into the EEA. Dresdner Kleinwort Research GmbH is authorised and regulated by the
Federal Financial Supervisory Authority (‘BaFin’) by the laws of Germany.
United States: Where this report has been approved for distribution in the US, such distribution is by either: (i) Dresdner Kleinwort Securities
LLC; or (ii) other Dresdner Kleinwort companies to US Institutional Investors and Major US Institutional Investors only ; or (iii) if the report relates
to non-US exchange traded futures, Dresdner Kleinwort Limited. Dresdner Kleinwort Securities LLC, or in case (iii) Dresdner Kleinwort Limited,
accepts responsibility for this report in the US. Any US persons wishing to effect a transaction through Dresdner Kleinwort (a) in any security
mentioned in this report may only do so through Dresdner Kleinwort Securities LLC, telephone: (+1 212) 429 2000; or (b) in a non-US exchange
traded future may only do so through Dresdner Kleinwort Limited, telephone: (+ 11 44) 20 7623 8000; or (c) in a banking product may only do so
through Dresdner Bank AG New York Branch, telephone (+1 212) 969 2700.
Singapore: This research report is being distributed for Dresdner Kleinwort in Singapore by Dresdner Bank AG, Singapore Branch, purely as a
resource and for general informational purposes only, and is intended for general circulation. Accordingly, this research report does not take into
account the specific investment objectives, financial situation, or needs of any particular person and is exempted from the same by Regulation 34
of the Financial Advisers Regulations ("FAR") (as required under Section 27 of the Financial Advisers Act (Cap. 110) of Singapore ("FAA")).
Hong Kong: This report is being distributed for Dresdner Kleinwort in Hong Kong by Dresdner Kleinwort Securities Limited. Unless permitted to
do so by the securities laws of Hong Kong, no person may issue or have in its possession for the purposes of issue this report, whether in Hong
Kong or elsewhere, which is directed at, or the contents of which are likely to be accessed or read by, the public in Hong Kong, other than with
respect to the securities referred to in this report which are or are intended to be disposed of only to persons outside Hong Kong or only to
"professional investors" within the meaning of the Securities and Futures Ordinance (Cap.571) of Hong Kong and any rules made thereunder,
and to persons whose ordinary business is to buy and sell shares or debentures.
Japan: Where this report is being distributed in Japan, such distribution is by either (i) Dresdner Kleinwort (Japan) Limited Tokyo Branch
(registered and regulated by the Financial Services Agency and General Trading Participant of TSE, Regular Transaction Participant and Transaction
Participant in Futures Transaction of OSE, Participant of JASDAQ) to Japanese investors excluding private customers or (ii) other Dresdner Kleinwort
companies, to entities falling within Article 2, Paragraph 1 of the Enforcement Order for Law Concerning Foreign Securities Firms act. Any Japanese
persons not falling within (ii) wishing to effect a transaction through Dresdner Kleinwort in any security mentioned in this report may only do so through
Dresdner Kleinwort (Japan) Limited Tokyo Branch, telephone: (+ 813) 6230 6000.
Australia: Neither Dresdner Bank AG ("DBAG") nor Dresdner Kleinwort Securities Limited holds an Australian financial services licence. This
report is being distributed in Australia to wholesale customers pursuant to an Australian financial services licence exemption for DBAG under
Class Order 04/1313 or for Dresdner Kleinwort Securities Limited under Class Order 03/1099. DBAG is regulated by BaFin under the laws of
Germany and Dresdner Kleinwort Securities Limited is regulated by the Financial Services Authority under the laws of the United Kingdom, both
of which differ from Australian laws.
This report contains general information only, does not take account of the specific circumstances of any recipient and should not be relied upon
as authoritative or taken in substitution for the exercise of judgment by any recipient. Each recipient should consider the appropriateness of any
investment decision having regard to their own circumstances, the full range of information available and appropriate professional advice. The
information and opinions in this report constitute judgment as at the date of this report, have been compiled or arrived at from sources believed to
be reliable and in good faith (but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness)
and are subject to change without notice. Dresdner Kleinwort may amend, supplement or update the contents of this report in such form and in
such timescales as Dresdner Kleinwort deems appropriate. Recommendations and opinions herein reflect Dresdner Kleinwort's expectations
over the 12 month period following publication from the perspective of long-only investment clients. Dresdner Kleinwort reserves the right to
express different or contrary recommendations and opinions for different timescales or for other types of investment client. This report does not
constitute or form part of, and should not be construed as, any offer for sale or subscription of, or any invitation to offer to buy or subscribe for,
any securities, nor should it or any part of it form the basis of, or be relied on in any connection with, any contract or commitment whatsoever.
Dresdner Kleinwort accepts no liability whatsoever for any loss or damage arising from any use of this report or its contents. Whilst Dresdner
Kleinwort may provide hyperlinks to websites of entities mentioned in this report, the inclusion of a link does not imply that Dresdner Kleinwort
endorses, recommends or approves any material on the linked page or accessible from it. Dresdner Kleinwort accepts no responsibility
whatsoever for any such material, nor for any consequences of its use. This report is for the use of the addressees only, is supplied to you solely
in your capacity as an investment professional or knowledgeable and experienced investor for your information and may not be reproduced,
redistributed or passed on to any other person or published, in whole or in part, for any purpose, without the prior, written consent of Dresdner
Kleinwort. Dresdner Kleinwort may distribute reports such as this in hard copy, electronically or by Voiceblast. Dresdner Kleinwort and/or any of
its clients may undertake or have undertaken transactions for their own account in the securities mentioned in this report or any related
investments prior to your receipt of it. Dresdner Kleinwort specifically draws recipients attention to the disclosures contained in the Disclosure
Appendix but notes that, excluding (i) Dresdner Kleinwort Securities LLC and (ii) the research analyst(s) responsible for this report unless
specifically addressed in the "Disclosures under US regulations": (a) Dresdner Kleinwort and its directors, officers, representatives and
employees may have positions in or options on the securities mentioned in this report or any related investments or may buy, sell or offer to buy
or sell such securities or any related investments as principal or agent on the open market or otherwise; and (b) Dresdner Kleinwort may
conduct, solicit and/or engage in other investment and/or commercial banking business (including without limitation loans, debt securities and/or
derivative, currency and commodity transactions) with the issuers or relating to the securities mentioned in this report. Accordingly, information
may be available to Dresdner Kleinwort, which is not reflected in this report or the disclosures. In this notice “Dresdner Kleinwort” means
Dresdner Bank AG and/or Dresdner Kleinwort Securities Limited and any of their affiliated or associated companies and their directors, officers,
representatives or employees and/or any persons connected with them. Additional information on the contents of this report is available at
www.dresdnerkleinwort.com/research and on request.
© Dresdner Kleinwort Securities Limited 2007

6 [F:14254 G:155179]