Theo Vermaelen: Beating the Market through Share Buybacks

Theo Vermaelen, professor of finance at INSEAD

The “buyback anomaly” is a global phenomenon whereby long-term investors can generate significant alpha through a structured investment strategy, says Theo Vermaelen, professor of finance at INSEAD, during the recent CFA Institute Middle East Investment Conference. Vermaelen gave an analysis of the U.S. market and provided insight on how, when, and which companies can maximize their returns using buybacks.

Vermaelen explained that there are four primary ways to buy back shares. In a fixed-price tender offer and a Dutch auction tender offer companies typically would have to pay a premium to buy back shares and so these types of transactions are rarely used. The private repurchase method is used when a large shareholder wants to sell their shares and approaches the company. The most common and widely used buyback method is the open market repurchase. In an open market repurchase, when a company announces it will buy back its share, it does not translate into a firm commitment on the company’s end, and there is no premium to be paid.

Vermaelen says that in recent years the buybacks in the rest of the world started catching up with the United States because of changes in regulation and tax laws that provided greater shareholder value. But he believes the most important reason is the adoption of executive stock option plans.

Vermaelen argues that there could be a number of reasons for a stock price increase after a buyback and highlighted that the most likely motivation for initiating a buyback is related to the market’s perception of undervaluation of stocks. He said that if the market is efficient and reacts to the buyback announcement, the stock price will increase, meaning that the stock is no longer undervalued and in the open market, there is no firm commitment on the part of the management to exercise the announced buyback. In reality, 90% of such open market–announced buybacks are seen through to completion.

Vermaelen says that the most important aspect to remember is that it takes 36 to 48 months to notice substantial gains after a buyback is announced. So buybacks are for those who want to follow a buy-and-hold strategy rather than short-time money making speculators. He added that share buybacks are generally used by companies that have low market-to-book value, small-cap companies, companies that believe their stocks are undervalued, and/or companies that have been beaten up.

Based on his research and analysis, he noted that it takes three years on average to adjust the stock price to reflect the benefits of buybacks. One reason for such a long period is that analysts focus on short-term return and thus downgrade stocks that buy back as they result in poor earnings. Another reason is associated with the negative momentum of buyback stocks. The key takeaway for investors here is to go long on buyback stocks and short on equity issues, as buybacks generate positive excess returns whereas equity issues generate negative excess returns. Vermaelen added that a fund with a portfolio of buyback options should have buy-and-hold strategy for three to four years to realise effective gains.

In conclusion, Vermaelen looked at the rest of the world and emphasised that Japan, Canada, and Australia are the most important buyback markets. In comparison with the United States, he considers that these other markets do not get as excited about buybacks after buyback announcements with an average of only 2% stock price increase are noted. In the long run, he stated that, on average, buyback firms earn excess returns of around 20% during the first four years, which is more or less similar to returns in the United States.

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