Beating the Market through Share Buybacks

This article was originally published in CFA Institute website

The “buyback anomaly” is a global phenomenon whereby long-term investors can generate significant alpha through a structured investment strategy, says Theo Vermaelen, professor of finance at INSEAD, during the recent CFA Institute Middle East Investment Conference. Vermaelen gave an analysis of the U.S. market and provided insight on how, when, and which companies can maximize their returns using buybacks.

Vermaelen explained that there are four primary ways to buy back shares. In a fixed-price tender offer and a Dutch auction tender offer companies typically would have to pay a premium to buy back shares and so these types of transactions are rarely used. The private repurchase method is used when a large shareholder wants to sell their shares and approaches the company. The most common and widely used buyback method is the open market repurchase. In an open market repurchase, when a company announces it will buy back its share, it does not translate into a firm commitment on the company’s end, and there is no premium to be paid.

Vermaelen says that in recent years the buybacks in the rest of the world started catching up with the United States because of changes in regulation and tax laws that provided greater shareholder value. But he believes the most important reason is the adoption of executive stock option plans.

Vermaelen argues that there could be a number of reasons for a stock price increase after a buyback and highlighted that the most likely motivation for initiating a buyback is related to the market’s perception of undervaluation of stocks. He said that if the market is efficient and reacts to the buyback announcement, the stock price will increase, meaning that the stock is no longer undervalued and in the open market, there is no firm commitment on the part of the management to exercise the announced buyback. In reality, 90% of such open market–announced buybacks are seen through to completion.

Vermaelen says that the most important aspect to remember is that it takes 36 to 48 months to notice substantial gains after a buyback is announced. So buybacks are for those who want to follow a buy-and-hold strategy rather than short-time money making speculators. He added that share buybacks are generally used by companies that have low market-to-book value, small-cap companies, companies that believe their stocks are undervalued, and/or companies that have been beaten up.

Based on his research and analysis, he noted that it takes three years on average to adjust the stock price to reflect the benefits of buybacks. One reason for such a long period is that analysts focus on short-term return and thus downgrade stocks that buy back as they result in poor earnings. Another reason is associated with the negative momentum of buyback stocks. The key takeaway for investors here is to go long on buyback stocks and short on equity issues, as buybacks generate positive excess returns whereas equity issues generate negative excess returns. Vermaelen added that a fund with a portfolio of buyback options should have buy-and-hold strategy for three to four years to realise effective gains.

In conclusion, Vermaelen looked at the rest of the world and emphasised that Japan, Canada, and Australia are the most important buyback markets. In comparison with the United States, he considers that these other markets do not get as excited about buybacks after buyback announcements with an average of only 2% stock price increase are noted. In the long run, he stated that, on average, buyback firms earn excess returns of around 20% during the first four years, which is more or less similar to returns in the United States.

Professionalism more important than regulations

This article was originally published in Arab Times

The financial reforms that are in full swing around the world will remain incomplete and ineffective if they do not also fundamentally improve the behavioural norms of those working in finance and investments. Yet, the signs are that an unbalanced emphasis on new regulations and industry structures risks neglecting the equally important need to improve the values and conduct of practitioners. Nitin Mehta from CFA Institute and Raghu Mandagolathur from CFA Society Kuwait discuss the need for behavioural change for finance and investment professionals.

Happily, the template for a solution already exists: professions have long regulated their members' behaviour for the ultimate benefit of society. Of course, it was not always so. In earlier times, there were no restrictions to practise as a doctor, lawyer or an accountant. But frequent experiences of malpractice led to an inevitable realisation that controls were required to establish standards of practise in order to protect the public.

Today, most of us would not consult a doctor for our health unless she was properly certified, current in her expertise, and followed an ethical code. Yet, many readily entrust their savings to those who do not have these qualifications. After the recent crisis, it seems high time that what we expect from healthcare is also demanded from 'wealthcare'. Greater professionalisation of workers in finance should be sought as a remedy which complements new regulations.

Society  rightly demands  more  from  a  profession  and  its members  than  it  does  from  a  trade and its craftsmen.  In return for status, self-regulated autonomy, and often rich rewards, a profession extends a public warranty that it has established conditions of entry, standards of fair practice, disciplinary procedures and continuing education for its members. In doing so, the profession improves the quality of its practitioners for the benefit of their clients. While the most conscientious employers and practitioners join professional associations and adopt their standards, many more do not. A lack of consistent regulation is usually the cause of such a state of affairs.

The GCC region is initiating major regulatory reforms as a swift response to the financial crisis and its aftermath. Celebrated cases of corporate failures, restructurings, defaults and other impediments are sought to be remedied through establishment of new regulatory structures (like ESCA in UAE or the Capital Markets Authority (CMA) in Kuwait) or through new strictures. However, this is not an assurance to prevent recurrence of similar problems or emergence of new problems. The money management industry in the GCC should progress on professionalism as much as it progresses on regulatory reforms. Recruitments to key positions involving financial advice both at institutional and retail level sill happen based on networking skills and language proficiency rather than professional skills as measured by relevant global qualifications combined with multi-disciplinary experience. As the region goes through the next phase of massive government expenditure, it is imperative that regulatory progress is accompanied by a realization of the need to professionalize the workforce especially at a decision making level. 

The recent crisis revealed how serious flaws had developed in the culture of finance. Over recent decades, secular shifts in values resulted in too much emphasis on profits and not enough on professionalism;  an excessive celebration of innovation and entrepreneurship, and not enough of ethics; an unhealthy focus on building a career, instead of character and competence. In other words, a swing in favour of business success and away from professional values. If this arc is not reversed and trust restored, there may not be much of a business left.

Much needs to be done urgently. Regulators should drive broader professionalisation of the financial sector; greater emphasis on professionalism must properly complement and balance the regulatory and industry overhaul reshaping finance. At the same time, employers should require their most valued employees to actively seek professional status as a condition of employment; long-term competitive advantages and investor confidence could be built in this way.  And individual practitioners should adopt the higher standards and obligations of a profession, transforming their work into a vocational calling. Nothing less than such co-ordinated action will reshape the future of finance and protect the laity. 

Keeping up with Knowledge-The Key to Success!

This article was originally published in Indians in Kuwait

The profile of Indian expats in the Gulf is slowly changing from a purely blue collar workforce to a balanced workforce with executive positions in the middle and senior level in several banks and other companies. Today, we can see several professionals like doctors, chartered accountants, engineers, etc. working in respectable positions in various industries, earning reasonably well and yearning to grow and achieve even greater heights.


A key question here is, how are we performing when it comes to honing our knowledge and qualifications. Further enhancing one’s qualification is a great idea – especially if it can lead to some good MBA or other related post-graduate attainments from reputed universities. Such qualifications can help Indian professionals in the Gulf to grow either organically (within the organization) or inorganically (finding another better job). Besides, more important is to continuously keep oneself updated about various trends in the professional space. This will enable one to perform better in the job and help achieve growth and impress the seniors.

In today’s technological world, there are several ways in which one can keep up with knowledge. It is a commonplace to see newspapers as a good starting source for knowledge acquisition, as it provides instant information in a very interesting form. Magazines will be the next additional step and here the choice gets wider as well. There are general business magazines as well as professionally oriented magazines that can provide excellent source of knowledge. The next higher step for knowledge gathering will be reading good blogs. Blogs are a key source of knowledge within the social media space and offer excellent breadth and depth of choices. A further step in the process is to cultivate the habit of reading latest books on topics of one’s interest and professional relevance. The choice can be either the printed books or e-books that one can download and read in devises such as Kindle.

On the other hand, knowledge acquisition can also happen through informal mediums of interaction with colleagues, friends, business associates and thought leaders. Office colleagues form the first leg since we interact with them on a daily basis. But sometimes competition can hold back colleagues from genuinely sharing all knowledge that they may have. Friends are the next best source of knowledge. However, the context of discussions amongst friends mostly happens to be social and entertainment issues rather than professional issues. Business associates can be very productive when it comes to knowledge sharing as it can also lead to money making. Finally, interacting with thought leaders (like Mr. Narayana Murthy of Infosys when he recently visited Kuwait) can be a completely different experience. Thought leaders can teach you in 45 minutes what it will otherwise take months to gather and understand. But such opportunities are rare. There are several webcasts that are available (www.ted.com) which can provide free opportunities to listen to several such thought leaders.

At the end, it is a combination of formal and informal channels that need to be used to acquire and enhance one’s knowledge. It is essential to realize the importance and measure oneself on this parameter to attain higher success. Here is a simple chart to see where you stand regardless of your age, experience and position in the company.

 

 

Global trends in the fee-for-service model in wealth management

This article was originally published in Arab Times

The Retail Distribution Review (RDR) in the U.K. and the Future of Financial Advice (FoFA) Act in Australia are examples of a new regulatory regime that embraces the fee-for-service business model in wealth management.  They could well be the precursor of a new regulatory movement toward making the fee-based model much more important in the industry globally. Wendy Guo, Tom Robinson from CFA Institute and Raghu Mandagolathur from CFA Society Kuwait discuss the fee-for-service model in the wealth management landscape.

 

What is behind the changing regulatory trends since the Global Financial Crisis?

 Prior to 2009, there were numerous cases of mis-selling of investment products by commission-incentivized wealth management service-providers involving subprime mortgage products, collateralized debt obligations, mini-bonds, accumulators, and various other products that are questionable in their design or simply not suitable for the client’s objectives and circumstances. The “Occupy Wall Street” movement, which spread around the world, is one manifestation of the public’s loss of trust in the industry and its professionals that has arisen as a result of this type of behaviour.  Regulatory authorities are finding that eliminating the conflict of interest inherent in the compensation paid to wealth management service providers and requiring greater transparency are becoming front and center elements of their regulatory agenda. 

How prevalent is the fee-for-service model?

Following the RDR which has been in progress in the U.K. for several years and slated for implementation at the beginning of 2013, the FoFA Act was introduced in Australia in July 2012, and the government is currently consulting with industry on its implementation. The Act introduces a fee-based regime and a ban on “conflicted remuneration” (including any payments from products and platforms to advisers).  It also bans certain insurance product commissions, “soft dollar benefits” to advisers, and asset-based fees where the client has borrowed to finance the product’s purchase.

The fee-based mandate is a main feature of the private banking heritage in Europe. The U.S. has around 27,000 independent registered investment advisors and it is slowly increasing in acceptance in Asia Pacific. Apart from Australia, rapid growth in the number of independent financial advisors in India in recent years signals a gradual shift away from a product-centric model. Japan’s smaller private wealth management firms typically earn advisory fees rather than trading commissions. In Singapore, the Association of Independent Asset Managers was formed in 2011 to set their members, who follow a fee-based model, apart from the conventional asset managers.

In the GCC statistics on managed accounts are relatively sparse compared to co-mingled funds or mutual funds. Fee-based service models have generally made a  slow start with most money managers  based in banks focusing on a transaction based fee model.

 

How are the wealth-owners in the GCC different from those in other part of the world?

The wealth created in the GCC region by private investors is primarily through inheritance and income thanks to consistently high oil revenues over generations. This may explain the high levels of risk taking appetite which may go down progressively as the second and third generation wealth owners may change the structure more from inheritance to investment performance.

The wealth management business model for GCC will take some global and some domestic characteristics. This is based on their deployment of their wealth which is estimated to be biased more in favor of global investments due to lack of local absorptive capacity. While for the global segment, they tend to follow the traditional fee based outsourced model, for the domestic they tend to prefer commission based self-directed investment decision making process. GCC high-net worth clients enjoy a high development index when it comes to their global investments. They get the privilege of full product suite including mainstream and alternative products. Hence, GCC high net worth individuals are acutely familiar with asset based fee concept as well as transaction based fees for their global investments.      However, the same cannot be said about their regional investments where fee based service model is prevalent in the managed accounts segment of the fund management business, which can either be discretionary or non-discretionary. Also, fee based business is practiced for custody accounts which is quite popular service.

Is the fee-for-service model the panacea? 

Compared with a transaction-based commission-led brokerage model that tends to be more short-term and opportunistic, a fee-for-service model allows an advisor to take on a long term view and provide differentiated and relevant value-added service to investors. With fee-based service, the incentive design eliminates much of the conflict of interest. There is no guarantee that the service is always satisfactory under any model. A recent mystery shopping survey conducted by the Monetary Authority of Singapore found almost one-third of the product recommendations were viewed as being unsuitable, as they were inconsistent with the client’s objectives or circumstances. Ultimately quality of advice and professional ethics are the key to the long term success of the industry. 

Where is the Correlation?

This article was originally published in Gulf News 

It is well known that oil revenues - and by default oil prices - are what drive GCC economies, despite efforts by individual GCC states to diversify their economies. Hydrocarbon GDP continues to dominate the economic structure, and consequently, periods of high oil prices and high economic growth, have fed into the stock market through increased liquidity and petrodollars. However, this relationship seems to be breaking, with oil price no longer driving stock market performance. From 2005 to date, crude oil and the S&P GCC Index have had a correlation of only 12%, a relatively  low figure. Since 2008, crude oil price increased by 19% while S&P’s GCC index fell by 46%. So why is this correlation diverging and is it likely to return?

Figure 1: Oil Price and S&P GCC Composite Index

Source: Reuters Eikon

Reason #1: The Oil Price-Economy-Stock Market link broken thanks to Banks

Bank lending has always been the conduit through which petrodollars have made their way into the stock market. The oil revenues feed into the citizens’ coffers through wages and social allowances, which are then placed with banks and are subsequently lent out. Roughly 10% of loan portfolios are for the purpose of stock market investing. In the past (especially 2005-2008) bank lending was growing at a frantic pace of 33% a year while in the subsequent period that average fell to a muted 5%.

Lending has considerably slowed over the last few years as GCC banks have exercised greater prudence and heightened risk aversion in the face of highly leveraged corporates and individual retail clients. Banks have been unwilling to lend as they have worked towards shoring up capital, increasing provisions and coverage of non-performing loans in addition to maintaining existing credit lines. On the other handmany retail investors have been deleveraging and therefore cannot procure the means to fund their activities in the stock market.

 

Reason #2: Increased Government Spending

Encouraged by the strong oil price and oil revenues and coupled with the need to shore up infrastructure on the back of demographic changes, GCC governments are investing heavily in infrastructure and other social projects, to the  extent that this is crowding out a weak private sector, which is mostly represented in the stock market. Also, some of the big family houses that are direct beneficiaries of this government spending are not represented in the stock market, leading to the lack of transmission mechanism between oil price and stock market performance.

 Reason # 3: Fear Factor

 The aftermath of 2008 global financial crisis has left deep wounds on the psyche of many corporates, high net worth individuals and retail investors. Many regional investors had substantial investments abroad and faced losses due to this. This has caused risk aversion and a fear factor that prohibits them from taking risk. In the past, the smooth transmission mechanism between oil revenues and stock market created the needed Feel Good Factor (FGF) that enabled investors to take risk and infuse confidence. The fear factor is doing exactly the opposite thing, leading to a disconnect between oil price and stock market. The fear factor is also exacerbated by the political developments in the form of “Arab Spring”

Reason #4: A “dependent” monetary policy

Most of the GCC governments peg their currency to the USD, forcing them to mirror US monetary policy even though the economic settings are not as nearly synchronized as it should be for the peg to function logically. This causes needless friction in terms of inflation and other side effects. For eg., even though the GCC region is growing well economically, thanks to high oil price, it has to have a loose monetary policy in line with US. However, this does not result in increased borrowing due to risk aversion both on the part of lenders and borrowers. In normal times, such low interest rates should encourage borrowers to borrow and seek higher yields in the stock market.

Reason #5: Increasing global connect

The GCC region is today more interconnected with the outside world than before, thanks to increasing trade. This means that events outside the region will have an increasing impact on the local economy. Lack of growth in inter-trade among GCC countries also forces this situation.

Why is the correlation important?

The GCC region is oil dependent and will continue to be oil dependent for the foreseeable future. Economic progress need not translate instantly into stock market riches as we have seen with many countries including China. However, it has to eventually catch up and reflect especially in predominantly one-product economies like those in the GCC. Hence, sooner or later, oil wealth should resonate in stock market success aided by regulatory reforms, institutional participation and bank strength. Also, oil price strength on account of improving global demand may enable return of confidence while oil price strength on account of supply fears may hinder confidence. While continued bank distress may delay the transmission process for the moment, correlation is bound to come back - at least in the medium term if not short-term.  This is a good thing and good for the region’s economic growth.