Share Repurchase: Potential Signal of Undervaluation and Outperformance

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September 2013 Share Repurchase: Potential Signal of Undervaluation and Outperformance

Share repurchases occur when companies buy back their own stock that was previously issued Scott Offen on the open market. Such stock buybacks are commonly viewed as increasing shareholder Portfolio Manager value. We analyze this proposition by looking at companies in the S&P 500® Index from Emma Baumgartner, CFA December 31, 1990 through July 31, 2013. Mega Cap Research Analyst

For this analysis, we define share repurchase as a decrease in common share count over the past KEY TAKEAWAYS 12 months—a measure that takes into account share issuance due to mergers and acquisitions but excludes preferred share transactions. This allows us to clearly illustrate whether a company is a net • Based on historical analy- share issuer or repurchaser. sis of S&P 500 companies before and after buybacks Since 1990 through July 2013, the median company in the S&P 500 (based on share repurchase) since 1990, we find that was a net issuer (see Exhibit 1, below). On average, only 42% of S&P 500 companies were reducing management tends to repur- their share counts. chase shares after periods of relative underperformance.

• Companies have generally EXHIBIT 1: From December 1990 through July 2013, the median S&P 500 company has been a delivered positive absolute net issuer, although repurchases have become more common during the past two years. and relative returns after buybacks, with particularly strong results among those PERCENTAGE CHANGE IN SHARE COUNT that completed large share MEDIAN STOCK IN S&P 500 INDEX repurchases.

1.0 • Our multiple regression Issue analysis indicates that the 0.5 forward outperformance of share repurchasers cannot 0.0 be explained by other factors such as valuation and price –0.5 momentum. –1.0 • While all large buybacks tended to generate future

Last Months 12 –1.5 outperformance, infrequent Repurchase –2.0 repurchases produced better relative returns than serial % Change in Common in % Change Count Share –2.5 repurchases. • This evidence supports the Jul-11 Jul-98 Jun-10 Oct-01 Apr-95 Jan-92 Apr-08 Jun-97 Jan-05 Aug-12 Feb-93 Mar-07 Mar-94 Feb-06 Aug-99 Nov-02 Sep-00 premise that companies use Dec-90 Dec-03 May-96 May-09 share repurchases to signal Monthly data from Dec. 31, 1990 to Jul. 31, 2013. Source: Standard & Poor’s, S&P Capital IQ/Compustat. the undervaluation of their shares, and the forward outperformance suggests that this message has been successfully communicated to investors. EXHIBIT 2: Net share repurchasers have tended to underperform EXHIBIT 3: Net share repurchasers have tended to deliver the S&P 500 Index 12 months before their buybacks. positive absolute returns 12 months after their buybacks.

RELATIVE TOTAL RETURN 12 MONTHS BEFORE BUYBACKS TOTAL RETURN 12 MONTHS AFTER BUYBACKS NET SHARE REPURCHASERS IN S&P 500 INDEX NET SHARE REPURCHASERS IN S&P 500 INDEX 20 100 Average 12-month forward absolute return = 13.64% 10 80 60 0 40 –10 20 –20 0 Total Return (%) Return Total –30 –20 Relative Total Return (%) (%) Return Total Relative 12 months12 prior to repurchase –40 months12 following repurchase –40 Average 12-month relative return = –1.95% –50 –60 Jul-95 Jul-06 Jan-12 Oct-92 Oct-10 Apr-98 Jan-01 Feb-11 Oct-03 Mar-10 Apr-09 Jun-07 Jun-96 Apr-07 Apr-93 Oct-96 Dec-12 Oct-03 Nov-91 Mar-99 Apr-00 Jun-01 Sep-93 Feb-00 Dec-01 Aug-94 Jun-94 Dec-11 Aug-05 Nov-02 Sep-04 Dec-90 Jun-08 Feb-92 May-97 Feb-99 Feb-06 Aug-95 Dec-97 May-08 Aug-02 Aug-09 Dec-90 Dec-04

Monthly data from Dec. 31, 1990 to Jul. 31, 2013. Relative returns are Monthly data from Dec. 31, 1990 to Jul. 31, 2013. Past performance is calculated by taking the average 12-month return of all stocks in the no guarantee of future results. Source: FactSet, Standard & Poor’s, S&P portfolio and comparing them with the average return of all stocks in the Capital IQ/Compustat. S&P 500 Index. Hypothetical portfolios are rebalanced monthly. Source: FactSet, Standard & Poor’s, S&P Capital IQ/Compustat.

Companies tended to repurchase shares after poor relative centage points over the next 12 months. Those repurchasers performance that bought back more than 5% of their share counts delivered What is the typical performance of companies before they buy even better results, with a 12-month forward relative return of back shares? When we consider the relative returns of hypotheti- 4.79 percentage points (see Exhibit 4, below). And a hypothetical portfolios of net share repurchasers during the 12 months cal portfolio of large repurchasers outperformed the market prior to their buybacks, we find that these companies generally during 72% of months—more frequently than a hypothetical underperformed the market—represented by the equal-weighted portfolio of all repurchasers (57%). In addition, this outperfor- S&P 500 Index—by 1.95 percentage points (see Exhibit 2, above mance continued beyond 12 months. During the 12–24 month left). This result supports the theory that companies repurchase period after their buybacks, the relative returns of large repur- their shares as a means of signaling to the market that their stocks chasers averaged 0.75 percentage points. are undervalued.

Companies generally delivered positive returns after share repurchase EXHIBIT 4: Net share repurchasers have tended to outperform How do the stocks of share repurchasers perform after buybacks? the S&P 500 Index 12 months after their buybacks, and large Looking at S&P 500 companies that repurchased shares between repurchasers have delivered better relative returns. December 31, 1990 and July 31, 2012, we find that they generally 12-Month % of Months # of Stocks delivered positive absolute returns over the 12 months following Forward Relative when Portfolio as % of Total Return Return > their buybacks (see Exhibit 3, above right). Hypothetical portfo- S&P 500 lios of net share repurchasers produced positive 12-month total (%pts) Market Return Repurchase returns during 85% of the observed buyback months, with an 4.79 72% 9% More than 5% average return of 13.64% across all observations. To put this into All Repurchasers 0.83 57% 42% perspective, stocks without repurchases produced lower average returns of 12.12% during a lower percentage of months (79%). Monthly data from Dec. 31, 1990 to Jul. 31, 2013. Relative returns com- pare the average 12-month forward return of all stocks in the hypothetical portfolio with the average 12-month forward return of all stocks in the Along with producing positive absolute returns, companies that S&P 500 Index. Hypothetical portfolios are rebalanced monthly. Source: repurchased shares also outperformed the market by 0.83 per- FactSet, Standard & Poor’s, S&P Capital IQ/Compustat.

2 EXHIBIT 5: Multiple regression analysis indicates that share EXHIBIT 6: Infrequent share repurchasers subsequently repurchase can explain subsequent outperformance, even after delivered the highest outperformance relative to the market. accounting for valuation, size, and price momentum. AVERAGE OBSERVED ALPHA Statistically Independent Coefficient Significant DECEMBER 1990 TO JULY 2013 Variables Interpretation at 5% Level 7 High Repurchase N=5,934 % Change in Shares Yes 6  Higher Alpha Cheap Valuation Valuation (Book Yield) Yes 5  Higher Alpha N=11,298 Small Market Value Size (Market Value) Yes 4  Higher Alpha N=5,269 Price Momentum (12-Month High Price Momentum Yes 3 Trailing Price Return)  Higher Alpha 2 Annual data from Dec. 31, 1990 to Dec. 31, 2012. Relative return, or alpha, compares a stock’s 12-month forward return with the average 12-month 1 forward return of all stocks in the S&P 500 Index; 10,729 data points are included. Source: FactSet, Standard & Poor’s, S&P Capital IQ/Compustat. 0 Average Alpha (%) Over Following 12 Months Over 12 Following (%) Alpha Average All > 5% Repurchasers Consecutively Did Not in the Last 12 Months Repurchased Consecutively Post-buyback outperformance is not fully explained by Stock During Repurchase Stock Prior 3 Years During Prior 3 Years other factors Is the outperformance of repurchasers attributable to share buy- Subsets of All > 5% Repurchasers backs, or are other factors also involved? With multiple regression, Monthly data from Dec. 31, 1990 to Jul. 31, 2013. Past performance is we can test whether repurchase is still predictive of future relative no guarantee of future results. Relative return, or alpha, compares the returns after controlling for valuation (measured by book-to-price 12-month forward return of each stock in the subsets with the 12-month forward return of all stocks in the S&P 500. Source: FactSet, Standard & yield), size (measured by market capitalization), and price momen- Poor’s, S&P Capital IQ/Compustat. tum (measured by the 12-month trailing price return). Based on our regression analysis, share repurchase is still statistically sig- points over the following 12 months. The second group did not nificant after accounting for these attributes. Factors such as valu- consecutively repurchase and outperformed by 5.81 percent- ation, size, and momentum can help explain—but not fully—the age points on average (see Exhibit 6, above right). This suggests relative return of 4.79 percentage points. In other words, there is that unlike the serial repurchasers, infrequent share repurchasers something unique about companies that repurchase shares. And surprised the market with their buybacks and subsequently experi- we can confirm that the higher the share repurchase, the higher enced the highest 12-month forward outperformance. the subsequent outperformance (see Exhibit 5, above left). Investment implications Infrequent repurchasers tended to perform better than Share repurchase is a powerful tool, and its signal should not be serial repurchasers ignored. Historically, companies underperformed the market prior We find that share repurchase—and especially large share repur- to completing a buyback and then outperformed following the chase—has typically preceded forward outperformance. However, buyback. This outperformance cannot be explained by valuation, some companies continually repurchase their shares, while others company size, or price momentum. Forward outperformance do not. Do these serial repurchasers perform differently? To answer was amplified if the repurchase was large and infrequent. This this question, we divide companies with large share buybacks into evidence adds support to the theory that companies can use two groups based on their repurchase decisions during the previ- share repurchase as a signal to the market that their shares are ous three years. The first group consecutively repurchased shares undervalued, and their subsequent outperformance illustrates the during that period and delivered relative returns of 3.19 percentage successful communication of that message.

Authors

Scott Offen Emma Baumgartner, CFA Portfolio Manager Mega Cap Research Analyst Scott Offen is a portfolio manager at Fidelity Investments. Emma Baumgartner is a research analyst at Fidelity Investments. Mr. Offen manages equity dividend–oriented portfolios for Fidelity. Ms. Baumgartner specializes in mega cap equities.

Fidelity Thought Leadership Vice President, Senior Investment Writer Jennifer Carter, CFA, provided editorial direction for this article.

3 Methodology Hypothetical portfolio construction methodology The following methodology was used for the quantitative analysis: All portfolios and benchmarks are equally weighted for the purpose of calculating returns. All portfolios and benchmarks are Time period rebalanced monthly, and annual buy-and-hold returns are used Dec. 31, 1990 to Jul. 31, 2013 for hypothetical portfolios in all calculations. Returns include reinvestment of capital gains Dec. 31, 1990 to Dec. 31, 2012 for multiple regression and dividends, if any, but do not reflect any fees or expenses.

Universe Multiple regression methodology S&P 500 Index Relative return, or alpha, is calculated by comparing a stock’s return versus the return of the equal-weighted benchmark. Each Data sources variable is capped at the 2nd and 98th percentiles to reduce FactSet for security prices and returns; Standard & Poor’s for the effect of outliers and data errors, then normalized to create a index constituents; and S&P Capital IQ/Compustat for finan- “z-score” representing the difference between each observation cial data such as book value, shares outstanding, and market and the variable’s mean, in units of standard deviation. This value. Performance data sourced from and calculated by facilitates comparison across time. FactSet’s AT3 backtesting application. Techniques to overcome look-ahead and survivorship biases Factor definitions Historical S&P 500 constituents are retrieved at the beginning of Share repurchase = percentage change in shares outstanding each period and thus include companies that no longer exist today. over the past 12 months Quarterly book values per share from S&P Capital IQ/Compus- Book yield = book value per share divided by the stock price tat are lagged by 45 days and annual book values per share are Price momentum = 12-month trailing price return lagged by 90 days to allow for the normal procedure of reporting Size = stock’s market value results, with some delay after quarter end and year end.

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