Bet on Oracle over J.P. Morgan Chase6/20/12 12:01 AM ET (MarketWatch)
CHAPEL HILL, N.C. (MarketWatch) -- Buybacks are back in the news. But are they as reliable a signal of outperformance as they used to be?
That's because the software company announced earlier this week that it was adding $10 billion to its already existing stock buyback program. J. P. Morgan Chase, in contrast, recently announced that, in the wake of its huge trading losses attributed to the "London Whale," it would be suspending its share repurchase program.
What do the data show about such companies?
Consider one of the first major academic papers on share buybacks, which appeared in 1995 in the prestigious Journal of Financial Economics.
Entitled "Market Underreaction to Open Market Share Repurchases," its authors were three finance professors: David Ikenberry (University of Colorado), Josef Lakonishok (University of Illinois at Urbana-Champaign), and Theo Vermaelen (INSEAD, the French business school).
The professors found that, between 1980 and 1990, the average company with a buyback program outperformed the broad market over the four years following the initial announcement of that program -- by 2.5 percentage points per year on an annualized basis.
Making these results particularly compelling was that exploiting them was quite simple and straightforward, since it required nothing more complicated than paying attention to which companies announce buyback programs.
Furthermore, pursuing a buyback strategy did not require day trading or minute-by-minute following of the market, since the companies involved in buybacks tended to continue their market-beating performance for up to four years following the public announcement.
There were skeptics, however. Some worried that, because so many investors and advisers began trying to exploit this phenomenon, its growing popularity would kill the goose that laid the golden egg.
Others worried that unscrupulous companies might try to trick investors into bidding their stocks upward by dinsingenuously announcing buyback programs that they had no intention of actually following through with -- in the process, causing the buyback effect to lessen or even disappear.
The proof of the pudding is in the eating, however.
Consider first the returns of an advisory service called The Buyback Letter, edited by David Fried, which was inaugurated soon after the study from Ikenberry and his co-authors was published and which invests in companies that have announced buyback programs. According to the Hulbert Financial Digest, its average model portfolio since the beginning of 1997 has beaten the broad market by 4.5 percentage points per year on an annualized basis.
Or consider the performance of a fund that Ikenberry helped to create several years ago based directly on his research into buybacks, and for which he continues to act as a strategic adviser: The Cozad Small Cap Value fund. From inception in July 2007, through the end of this year's first quarter, the fund beat its benchmark -- the Russell 2000 Value Index (IWN) -- by 4.4 percentage points on an annualized basis.
In both cases, there is no evidence that the buyback effect is any less pronounced today than it was several decades ago.
To be sure, these results are based on averages of many stocks over many years, and not all individual companies lived up to the overall pattern. So there is no guarantee that Oracle will outperform J.P. Morgan over the next couple of years.
But at least, based on the historical research and recent results, that would appear to be a good way to bet.