As always, I have saved the best for last. All week I have been crunching numbers on share buybacks searching for what does and does not work when considering this as part of an investment strategy. It makes a lot of sense to do this as companies that repurchase their shares at attractive valuations are adding value to the corporation and ultimately (we hope) the stock price.
The trick is to avoid those being done at bad prices or for bad reasons. Buying back stock at high valuations or to manage earnings and disguise executive compensation can actually destroy value.
So far this week we have looked at using P/E (price/earnings) and EV/EBIT (enterprise value/earnings before interest and taxes) ratios to identify companies buying back stock at low valuations. Both strategies have delivered strong returns that beat the market, and a key part of the outperformance was that the approach plays great defense in bad markets.
But I saved my favorite metric for today. I have done well over my career buying stocks trading at less than book value and my study shows that corporations that repurchase their shares below book have also done well -- for the company and shareholders.
Using the same approach as the previous tests, I find that using book value to find undervalued companies that are buying back stock outperforms the other metrics by a wide margin. It also makes sense to drop the F-score requirement, as by itself buying back stock below asset value seems to act as a safety check. Using Piotroski F-scores (a measure of financial strength) produces a very small number of stocks, although it is worth noting that those it does find have very high returns. That's not to say that the list without using it finds a ton of stocks, as the average portfolio size is just 29 names.
This approach outperforms in both up and down market cycles and, like the others, does particularly well in bear markets. We can also gather a little predictive data from the model. If the number of qualifying stocks drops to single-digits it is time to be extraordinarily cautious. If you find 50 or more stocks that fit the book value, buyback criteria it is time to be bullish. If there are more than 100 stocks on the list it is time to break out margin, sell furniture, pets, your spouse's car, all your sports memorabilia not signed by Johnny Unitas or Brooks Robinson -- whatever it takes to raise cash and buy stocks.
The current portfolio has 40 stocks (see below), with an average market capitalization of $2.8 billion. The average buyback rate is 12.2% and CFOs are getting bargain prices as the average price-to-book value is just 75%.
This is a fantastic portfolio. Twenty-five percent of the portfolio is invested in "trade of the decade" community bank stocks. There are also several real estate-related companies that are activist targets with significant upside potential. One of my favorite long-term ideas is single-family REITs and Silver Bay Realty Trust (SBY), one of my favorite long-term single-family REITs, is in the book value buyback portfolio right now. Investment brokers have been hard hit this year and is another group I believe will see consolidation. There are handful of these names in the portfolio, too. It is an attractive mix of very cheap stocks.
My studies this week have shown that when companies buy back stock at low valuations based on earnings, cash flow and asset value, shareholders are very well rewarded. Stock buybacks are no different than any other stock purchase. Valuation matters and the cheaper you buy, the higher the potential returns.
One big surprise is that given the thousands of stocks on the various exchanges and the massive number of announced share repurchases there are actually very few buybacks done at attractive prices. All too much of this activity is to appease investors and manage earnings and I don't think that ends well for long-term shareholders.
I did run a combination test to conclude my buyback study. If you stuck to just purchasing stocks in companies that were buying back stock, and had either low P/E or EV/EBIT ratios or traded below book value with an F-score of 5 or higher you would be one of the top-performing investment managers around. In an average year you would have a portfolio that averaged 130 stocks. You would have positive returns in 15 of the last 17 years and outperformed the index in 12 of 17, including four of the last five.
Today, you would own a portfolio of 116 stocks with an average market cap of $6.9 billion, so you could actually run a decent-sized fund with this approach.