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 the February 1st comment on 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.

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

corequity.blogspot.com

robertlcolby@gmail.com

Gretchen Morgenson's NY Times article on this research report

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[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.

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

robertlcolby@gmail.com

2015 Results and Current Screens

Our results for the end of 2015 our summarized as follows -

Current Screens

November 30th 2015 Screens for Value

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

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.

Valuation of stocks with aggressive buyback programs

Stocks with aggressive buyback programs have little or nothing to show for the money they spent.

Many public companies continued to buyback their shares at a very high level as indicated in this Factset chart

http://www.factset.com/websitefiles/PDFs/buyback/buyback_9.21.15

We compared the stocks in the S&P 500 Buyback ETF (SPYB), of which we cover 66 out of 100, to our universe of  approximately 500 stocks to evaluate what they achieved for the money they have spent.

The bottom line is that it appears that the buyback programs have bought very little benefit, if any.

This table compares the median values of the SPYB stocks to our Universe.

First, the SPYB stocks are undervalued by 7% as indicated by VR or Valuation Return/Risk.  What is the point of spending money to goose your stock price if your stock is remains undervalued ?

Their growth rate (RR, or Reinvest Return) is a percentage point better than average but this likely is entirely attributable to the deductions from book value due to buying back shares above book value (its called 'decimating the denominator' and is good for executive compensation bonuses).

Not shown in the table are the median P/Es which are 13.1x vs 15.1x for the universe!

The result of the higher return and lower P/E is a shorter Payback (PB) for the Buyback stocks, i.e.8.0 vs 8.5 years.  These stocks are cheaper!

It is interested to note that the median target Payback (NM) for all stocks is 103% of the S&P 500's while the Buyback stocks' target is only 95% which suggests lower long term valuations. 

Finally, it is worth noting that the median market cap of the buyback stocks is double that of the and is just over the line into the 4th quartile.  As shown in the preceding post, the 4th quartile market caps have a slightly negative VR so it can't be argued that the lack of demonstrable benefit from the buyback programs is attributable to being big caps.

In short there is no evidence here that they have achieved any benefit from spending all that money on buying back their stock.

October 29th Addendum: Performance

One argument in favor of buyback programs is that the reduction in shares leads to higher eps growth and, hopefully, higher stock prices.  However, this isn't working right now.  This Yahoo graph shows that the SPYB ETF has underperformed the S&P 500 by close to 6% in the last 6 months.

WHERE IS THE VALUE ?

Growth is undervalued by the market today.  The lowest quartile in Reinvestment Return (RR) has a median VR of - 9% while the top quartile median is +11%.  There is little difference across the Yield quartiles but when added to RR, we get an even higher discrimination over the combined IR (Inherent Return) which is RR + YLD

Low Payback shows the best disparity in value of +54% vs +31% for IR

The ratio of Estimate/Normalized earnings  (EM or E/M) shows the best values at the least attractive end of the range while the small Market Caps are more undervalued that Large Caps by 7%.

NB Quartile ranks go from low to high.

Value by Sector is summarized in this table -

The best values are in  Basic Materials, Financial and Industrial Sectors while the worst is the Utilities.

September 30th 2015 Screens for Value

by Sector

By Sector

Performance Update: Value is working !

Value has been driving the equity market for a while now. The Undervalued are comprised of the top quartile of both the Valuation Return (VR) and the Estimate/Normalized Earnings (EST/MPEPS or E/M or 4,4). They are in a positive trend of +4.3% pa, relative to the S&P 500, while the Overvalued's (1,1) downtrend is 3.9% pa for a spread of 8.2%. The spread is even higher using the Universe as the standard. 

(Click here to learn about valuation model and terms used)

In May, the UV stocks were up 4.5% while the OV declined 1.1% for a spread of 5.6% in one month.

So far in June (to June 24th intra-day), there has been a reaction to last month's gains and the Overvalued are up 2.5% relative to the market.  The Undervalued are down fractionally.

For a list of the screens, email robertlcolby@gmail.com

Recent Performance Anomolies

I was asked recently to explain more fully what caused the most recent performance anomalies of the Under- and Overvalued screens.

The chart below shows the performance of the Undervalued and Overvalued screens relative to our universe of approximately 500 equities. The Undervalued are comprised of the top quartile of both the Valuation Return (VR) and the Estimate/Normalized Earnings (EST/MPEPS or E/M).

(Click here to learn about valuation model and terms used)

Since inception in 2004, the Undervalued have outperformed the universe by 2.30 % points pa while the Overvalued under-performed by 3.23 % for a spread of 5.53% pa*.

However, there are three anomalous periods where investing in value bore a cost.  The first is the sub-par performance of the Undervalued from May 2008 to December 2008 (months 43 to 50). The second, also affecting the Undervalued, started in January 2012 and lasted until April 2013 (months 88 to 103).  Finally, the third anomaly is the superior performance of the Overvalued which took place between September 2011 and February 2014 (83-112).

The following is an analysis of the causes of the two most recent periods of sup-par performance.

Undervalued (88-103)

This table shows the undervalued stocks which were screened in months 88-103.  The column on the right shows the cumulative Relative Strength to the S&P that the individual stocks contributed over the 15 month period.  The worst 6 equities, 12% of the total number,  account for 84% of the decline of 18% relative.

Click here to open file

The column on the right above is shown in the graph below.  It illustrates that relatively few stocks accounted for the poor performance.  This is also shown by the median of all of the cumulative relative returns which is close to zero.

Looking at the performance by Sectors, Basic Materials is overweighted and is also had the worst performance.  Technology has an equal weighting but is also a major contributor.



Looking at the individual stocks, a common characteristic is the secular (vs cyclical) decline in the estimated earnings in the months following being screened.  Where this occurs, it shows up as a decline of  the normalized earnings (MPEPS - red line).  The following individual equity graphs show the Estimated earnings (EST), normalized earnings (MPEPS) and the implied earnings (IEPS).  The green  bars indicate the months that the equity was screened.

CAT is an exception in that there is little decline in the normalized earnings suggesting the decline in estimates was more cyclical.  The majority suffered a secular decline in earnings.

Overvalued (83-112)

The superior performance of the Overvalued screens in months 83-112 somewhat overlaps but has a substantial positive median return.  Here the median  cumulative Relative Strength of all stocks screened is  +5.7%, or an average of 0.74% per month.

The top and bottom screened equities by total Relative Strength are shown here (the file below is complete)

Click here to open file

Sector weighting and performance is shown here and it is clear that Consumer Cyclicals had a lot to do with the positive performance of the Overvalued screens.  They had twice the weighting and strongly positive relative strength.

As it turns out, there was (and is) a huge bet on Home Building and Building Supplies.

Examples of the top contributors are:

KBH's estimates do rise to the level of Implied Earnings.  This is the only one  where the earnings estimates rose to the level of implied earnings when screened although normalized earnings remains well below implied.

LEN has rising earnings estimates but implied earnings remain well above.

In this instance, the majority of these stocks benefited from expectations that failed to materialize, some of which persists to the present.


* The Universe did 2.18% pa better than the S&P 500, very similar to an unweighted S&P 500 return.