How do you achieve a year-to-date return of more than 31 per cent? “Well, common sense. That is our only strategy. We have no more information than the market. We don’t use a complex box with all kinds of variables”, said Theo Vermaelen, one of the four managers of the Buyback USA Fund.
The strategy is based on multiple academic research and dates back to 1995, when Belgian manager Vermaelen published the article “Market under reaction to open Market Share Repurchases” in the Journal of Financial Economics. In it, based on a sample of 1239 share repurchase announcements in the US, between 1980 and 1990, he argued that these programmes by stock market funds were a source of “abnormal returns”. Those who can muster the patience to allow generally undervalued shares to mature can expect an annual average return of about 12 percent, Vermaelen said (photo: below left).
Cumulative return: 275%
The research results he wrote received media attention, including in the Belgian magazine Trends. Based on this, the professor at the French business school INSEAD was approached by KBC and in 1998 became responsible for the selection and composition of the portfolio of the KBC Equity Buyback Fund America. He was involved in that fund for 8 years.
In 2008, a new initiative was launched by Theo Vermaelen and Urs Peyer (photo: below right), both associated with INSEAD. In 2014, a Luxembourg-registered UCITS fund emerged from this: Buyback USA Fund (LU0630248994). This fund contains 75 names and now has assets under management of around EUR 80 million. The cumulative return over the past ten years is more than 275 percent. This means that the fund beats the benchmark, the Russell Total Return Index, by 66%. Turnover in the fund is 35 per cent a year.
Buybacks are so popular and successful in the US because they are a decision of the board, unlike in Europe where a share buyback is the prerogative of the general meeting of shareholders, which sometimes wants to give priority to more investment in new product lines or more employment.
Fundamental research
The fund’s strategy, which Vermaelen described in a relatively laconic way in an interview with Fondsnieuws, Investment Officer Luxembourg’s sister publication, is based on a meticulous analysis of the actual reasons for an announced share buyback programme. If it is motivated by excessive cash or by manipulating the earnings per share, then investing in such a company is not a good idea, Vermaelen said he believes. But if it is an attempt to profit from the fact that there is undervaluation, that is a signal to get in, he said.
To assess whether a stock is undervalued, the team looks at various parameters: market to book, the size of the company, the earnings and the formulated motivation for a buyback. On this basis, a score is given, which forms the basis for the so-called “Undervaluation Index”. The undervaluation of a share usually occurs when the announcement is made in a period of considerable volatility, i.e. when there is uncertainty about the real value of a share.
The returns that are expected are affected by some anomalies, such as analysts’ ratings being revised downwards when there is negative performance. Usually, a buyback programme is not a direct reason for a higher rating either. Usually, stocks perform poorly in the six months preceding the buyback.
Best positions good for 1000%+
Vermaelen and Peyer’s team pointed out that buybacks among US stock market funds have been a recurring and persistent phenomenon over the past 10 years. That is why they react to such an announced share buyback with a process of fundamental research. If that research shows that managers of those companies no longer believe in the undervaluation of a share and are selling it, then that is also a reason for the Buyback USA Fund to get out.
Sometimes there is a takeover, resulting in a premium of roughly 30 per cent. That usually happens in the fund about six times a year. But according to Vermaelen, that does not explain the outperformance. “Much more important are the best shares in the fund, which in four years sometimes deliver more than 1,000 percent price gain,” said Vermaelen.
The fund invests in a well-diversified value portfolio, which can become growth stocks over time. In principle, the portfolio is equally weighted. The main exposure is to industrials, financials, heath care, semiconductor and hardware. The ten largest positions account for 25 per cent. Companies that belong to the ten now include Shyft Group, Techtarget, Nova, Modivcare and Surgery Partners.
I’m in it with all my money
The fund is relatively small in terms of assets under management, but it is not offered in the US where buyback is a very popular investment theme. The fund is available in the Benelux, France and Switzerland. The fee for the B-shares (clean shares fund) is 100 basis points per year. There is also a high watermark. If this is realised over two years by means of an outperformance of 10 percent compared to the benchmark, then this is the case. The minimum investment is EUR 250,000.
The fund’s management business has been outsourced to Degroof Petercam Asset Services (DPAS) in Luxembourg, which is also responsible for administration, risk management and compliance. The fund managers are both advisors to the sub-fund and members of the board of the SICAV. After consulting with the fund managers and assessing whether all criteria are met, the investment decisions are implemented.
To conclude, when asked if the team also invests in the fund itself, Theo Vermaelen replied: “Yes, we do. I have put all my money into it. I have never sold a single share. I earn more than my annual salary at INSEAD.”