Thursday, May 12, 2016

The Effects of ETF Cash Flows on Equity Values

My response by email to Mr. Zweig yesterday -

I have been convinced that the ETF funds exercise a significant influence on equity valuations and your recent column on low volatility stocks gave me an opportunity to prove it - to my satisfaction anyway.

The first graph is the dollar volume for the large ETF, iShares MSCI USA Minimum Volatility (USMV) showing a clear run-up that you described. (Yahoo Finance: Monthly, $ millions.)

Inline image 2

This chart below shows the relative performance of 50  of the larger stock holdings in the USMV. The index is the relative performance of these stocks compared to the average of our universe of close to 500 equities. It shows a gain of 25% from the low in the summer of 2014.

Inline image 3

Finally, this is the average Valuation Return/Risk (VR) of these stocks, again relative to our universe. From a high of +5%  in early 2014, the average Risk is now -15%. (VR is the projected price change between the current price and the price at which it would equal its inherent value)

Inline image 4

My theory is that purchasing ETFs does not involve valuation analysis as individual stock selection would and it appeals to Momentum buyers.  As such it becomes a source of inefficiency in equity pricing.

(c) 2016 Robert L. Colby

Wednesday, May 4, 2016

30 Stocks with significant buybacks between 2008 and 2015

Thirty equities with significant buyback programs in the last 7 years show that their average EPS grew at 9.9% pa while Net Profit gained only 4.9% (Median numbers are 8.1 vs 1.7%.)  Using the averages, the give up is 5.0% pa which is an enormous  difference in the amount of cash generated.
Our analysis is based on the Net Profit Test which asks the question:  what rate of return is required on investing the buyback funds to grow the Net Profit and EPS at the same rate as the Earnings per Share (EPS) grew due to the buyback. The answer is not very much.  The average for the 30 stocks is 5.8% and the median 5.4%.

This give up in Net Profit is directly attributable to the size of the buyback program as shown in this chart.  On the x-axis we have the size of the reduction in shares outstanding from 2008 to 2015.  On the y-axis, we show the give up in the growth of EPS and Net Profit.  The correlation between the two is 0.94.  In plain English, the larger the buyback program, the greater the penalty as measured by cash generation.

There are two main reasons for this apparent anomaly.  One, the price paid for the shares is too much to compete with alternative investments (the average P/E for all stocks is 15x for the period).  An example of this is given in the paper “The Net Profit Test: Comparing Buybacks to Investment”.  Secondly, the correlation between each equities annual percentage of total buyback and average annual price is very a positive: it averages 0 .48 and the median is 0.59.   The exceptions are ANTM (-0.60), CSCO (-0.03), GPS (-0.33), TMK (-0.12) AND TRV (-0.16).

Ranked from the bottom in terms of Required Return to equal EPS growth we have BOBE (-0.7%), MCD (2.3%), LM (2.9%), KO (3.7%), DRI (3.8%), KMB (2.9%), VAR (4.3%), FOSL (4.3%), CAKE (4.5%), OMC (4.8%), AAPL (5.0%), ALL (5.1%), TXN (5.1%), PH (5.2%), SHW (5.3%) and DE at 5.4%.

Correl  is the Correlation between average stock price and the %age of annual buyback to total buyback from 2009 to 2015.  There is a definite positive correlation between the size of the annual buyback and the price.
Shares O/S is the %age contraction from 2008 to 2015
Cost (B$) is the cost in Billions of total shares bought back from 2009 to 2015
% Growth in EPS and NET PRF is the % annual growth in Earnings per Share and Net Profit from 2008 to 2015
Give up is the difference between the growth in EPS and growth in Net Profit. 
Required Return ADJ and NOM.  The nominal required return is the % growth applied to the buyback cost to equalize the growth in net profit to earnings per share growth.  ADJ is the adjusted required return to reflect that our method of calculation of buyback cost  is less than actual cost (using last 4 years of data)
Average  Prc/Bk (Price/Book Value) and Ave P/E (Average Price to Earnings ratio) are based on 2009-2015
©2016 Robert L. Colby                                                                         
May 4. 2016                                                                                          

Friday, April 15, 2016

The Net Profit Test: Comparing Buybacks to Investment

The Net Profit Test asks the question: what rate of return is required on investing the buyback funds to grow the Net Profit at the same rate as the Earnings per Share (EPS) grew due to the buyback.  If it can be shown that a low rate of return would equalize the growth between Net Profit and EPS, then the probability is high that the company would earn more money by investing.

The return that a shareholder receives when a company buys back its stock occurs at the time of purchase and only then.  It is because the Net Profit is being divided by a fewer number of shares (i.e. decimating the denominator).  This is contrasted to investing the same funds (i.e. enhancing the numerator).
In this example, the company is assumed to have bought back 10% of its shares at 10x earnings. With 10% fewer shares, the EPS is increased by 11% at the outset.
The alternative use of the buyback funds is assumed to be an investment that earns 3% in the first year, 8% the second and 10% thereafter.  As shown in the graph, the annualized returns crossover occurs in the second year and from that point on the investment is the better asset allocation decision.

Surprisingly, the return generated by buybacks is independent of the price paid for the shares. Instead, the cost of the decision is measured by what the funds could otherwise have achieved if invested. In the above example, if the buyback was done at $7.20 a share, the Net Profit under the two scenarios would be equal after 8 years. However, with the buyback at $10.00, the investment would have generated 40% more in Net Profit.
(As a corollary, the higher the investment return, the lower the buyback price that can be justified.)
Our analysis of 25 companies with aggressive buyback programs from 2008 to 2015 shows an average P/E of 15x earnings.  It is also evident that most companies spend more on buybacks when their P/E’s are at the upper end of their range suggesting a higher dollar weighted P/E.
My conclusion is that few buybacks in recent years come even close to meeting the Net Profit Test. Given that S&P 500 companies alone have bought back over $2 trillion of their stock since 2009, you have to be in awe by the scope of this misallocation of corporate assets and its consequences for the economy.

© 2016 Robert L. Colby
April 13, 2016

Monday, April 11, 2016

1st Quarter Performance 2016

The results for the 1st quarter favored value stocks as shown in the table.

(c) 2016 Robert L. Colby

Friday, April 1, 2016

March 31st Screens for Undervalued and Overvalued Equities

This month marks the addition of 2017 estimates to our analysis which accounts for some of the turnover.

(c) 2016 Robert L. Colby

Thursday, March 31, 2016

Email from Len Sherman, Adjunct Professor, Columbia Business School

Robert, I read with great interest your recent blog post demonstrating the relatively low ROI's  required to replicate EPS growth from equivalent share buybacks.  Your analysis suggests profound flaws in the two most common rationales corporate executives give for their share buyback programs
1.     Our actions reward shareholders by making their shares more valuable 
2.     Our stock is undervalued. Our actions reflect management's confidence in our growth potential
The first argument may be true for EPS, but not for long term stock price appreciation. The second argument is even more galling, as your analysis suggests exactly the opposite.  Given your results, the only logical explanation to go ahead with an aggressive buyback program is that management actually doesn't  believe it can generate even modest returns on its cash from current operations.  Or said another way, management is in essence saying they are giving money back to shareholders because they have run out of ideas on how to generate attractive returns within the company.  Or course, the more likely explanation for share buybacks is  management bonus kickers based on EPS.  So much for CEO's and boards acting in the best interest of shareholders.

I teach business strategy in the MBA program at Columbia Business school where I share a perspective that effective capital allocation is one of the most important responsibilities of the CEO.  To illustrate the point, I point to IBM who has skewed its use of capital (including debt financing) towards share buybacks at the expense of value-creating investments in R&D and capex.  As a result, IBM's R&D lags its technology peers, and not surprisingly (despite aggressive acquisition activity), its revenues have declined for 15 straight quarters.  The attached figure graphically depicts these trends.

HP is another case of the folly of favoring share buybacks over R&D in the tech industry.  Carly Fiorina is often criticized for her disastrous acquisition of Compaq, but her successor Mark Hurd also deserves notoriety for slashing HP's R&D expenditures while sizably expanding HP's share buyback program.

Shareholders who maintained their investments in both of these companies through their periods of substantial share buybacks have not fared well. 

I'd be curious to learn whether you've done any analysis tracing the stock price performance (relative to the S&P 500) of companies who have been most active in stock buybacks.  Has management unwittingly practiced buy high/sell low?!

Len Sherman
Columbia Business School
Attachments area
March 27th 2016

Thursday, March 3, 2016

February Results

The Undervalued Screen was up an average of +2.9% while the Overvalued were down -0.6% relative to the S&P 500 in February.  This represents quite a change from January.

The gains and losses of those stocks leaving the screens are even more dramatic.  Stocks leaving the UV gained 8.2% relative while those leaving the Overvalued declined by 9.3%.

© 2016 Robert L. Colby

Saturday, February 20, 2016

Turn around in the equity market appreciation of value.

There has been a significant change in the market's appreciation of value in equities this month.   As noted below in January's results, the Overvalued had outperformed the Undervalued list by 4.7%. This has now reversed and the December Undervalued list is now 2.0% ahead.

This is also reflected in the Screens from January 31st where the Undervalued has outperformed its opposites by 4.9% this month.  This indicates a definite change in the tone of the market.

Thursday, February 11, 2016

Cost-benefit analysis of the stock buyback programs

The goal in buying back shares in a company is to increase the growth rate of the earnings per share.  However, there is no benefit accruing to the growth in Net Profit which is unaffected.  This analysis calculates the after tax return on the funds used in the buyback program that would be necessary to grow the Net Profit at the same rate as the EPS.  Clearly this is a desirable goal and the rates required are surprisingly low which suggests that the buyback programs are a poor use of resources.

Imagine if the shareholders of Bed Bath & Beyond were asked a question in 2008.

“Would you prefer to have growth in Net Profits of 9% or 17% in the next seven years, assuming that the growth in earnings per share would be the same?"

Surely they would have elected the higher net profit (i.e. more money) and you would think that management would too but you would be wrong.

In the period between 2008 and 2015, BBBY bought back 38% of their outstanding stock at a cost of over $6 billion dollars. (That turns out to be equal to the total net profit during the entire period.)  We calculate that the company would only have needed to earn 6.9% after tax on those funds to grow their Net Profit at the same rate as the earnings per share which was 17.3%.  In 2015, the difference in Net Profit would have been $1,300 million vs $800 million.  That is $500 million more in one year (over 60% and growing!) if management  successfully reinvested the funds at under 7% instead buying their own  stock.

Here is the calculation[1] -

I should point out here that I don’t think that BBBY is a bad company but rather one of many that are following a very bad practice.

As shown in the following table, BBBY is not alone.   Most of these companies[2] would only have to earn a fraction of what they achieved to have made significantly more money for their shareholders.  This is shown in the last column (MP/NP) where the range of missed profits is from 8 to 101% of Net Profits in 2015.

Home Depot (HD) is another good example.  They bought back 27% of the shares outstanding in 2008 at a cumulative cost of $29 billion.  EPS grew at 16.8% while Net Profit grew at only 12.5%.  Had they reinvested those funds at 6.3% after tax, they would have had grown their Net Profit at the same 16.8% and earned close to $2 billion more in 2015 Net Profit.  That is close to a third more than they actually earned.

One possible explanation is that management is motivated to increase their incentive remuneration by increasing the growth of earnings per share without risk. However these companies justify their buyback programs, it is clear that most would need only a small ROI to enhance the shareholders’ real returns.  Seven out of these 12 examples have a required return to balance EPS growth of under 7 % with Allstate (ALL) and Kimberly-Clark (KMB) being the lowest.

Alternatively, in cases like some Banks, the reason might be that they can’t re-invest at even the minimum required return.  However, this explanation would be just as detrimental to the stock.

I recently was with the CEO of an international firm that employees 70,000 persons world-wide, has a market cap of $24 billion and whose stock gained 330% in the last 7 years.  I asked him if his company had bought any stock back and his answer was:  “Non - it is better to finance growth which will generate long term returns.”
© 2016 Robert L. Colby

Gretchen Morgenson's NY Times article on this research report

[1] Data: Value Line
[2] These companies were selected from the holdings of the Buyback ETF (SPYB) for their consistent buyback programs during the period of 2008-2015.

Monday, February 1, 2016

January Results and Screens

January wasn't a good month for value as the Overvalued outperformed the S&P 500 by 1.0% while the Undervalued underperformed by 3.7%.

The changes to the screens are summarized here:

The current Undervalued Screen is shown below with Sector weighting and without.

The overvalued screen:

(c) 2016 Robert L. Colby

Sunday, January 3, 2016

Wednesday, November 11, 2015

Efficient Market Analysis in relation to a measure for Quality

Stocks with a Value Line Safety Rank* of 3, 4 & 5 contribute to our performance measures for the Under- and Overvalued stock screens.  Stocks with a Rank of 1 or 2 do not contribute to any appreciable amount. The latter are characterized as having above average market capitalization and yield.  They account for 35 % of the observations  in our monthly analysis of 500 equities over the last 11 years. 

Using the quartile rankings for Valuation Return/Risk (VR) and the ratio of Estimated earnings/ Normalized earnings (E/M),  we compare the average of next month's Relative Strength for quartiles 1,1 (Overvalued) vs 4,4 (Undervalued).  As shown in the first example, the average Undervalued stock outperforms the S&P 500 by 44 basis points while the Overvalued underperform by 6 bp. The resulting spread of 49 bp translates into an annual 6.10%.


Screening for Safety Rank of 1 and 2 only reduces the spread to only 0.01% or 0.13% pa. This strongly suggests that, on average, these stocks are more efficiently priced. 

Screening for Safety Rank of 3, 4 and 5 only improves the spread  to 0.57% or 7.03% pa.  The rank of 3 alone, which has 58% of the observations, has a spread which is even higher at 0.63% or 7.84% pa suggesting that the middle ground, in terms of quality is the most inefficiently priced. 

Robert L. Colby
November 11th 2015

* The Safety Rank is computed by averaging two other Value Line indexes the Price Stability Index and the Financial strength Rating. Safety Ranks range from 1 (Highest) to 5 (Lowest).  - Value Line

Thursday, October 15, 2015

10 year results to September 30th 2015

The returns from the Undervalued and Overvalued lists are compared to the 10 year returns in the Globe & Mail univerese of US equity funds.  Without income or management fees the average annual returns of +9.29% and +4.89% would have ranked in the 97th and 42nd percentiles for a spread of 55.

This compares to the 99th and 39th percentile ranks respectively  for 10 year results a year ago.