Dear Fellow Investor

Imagine the addition of one simple number, easy to calculate using simple arithmetic, to your existing method of evaluating companies, substantially increasing your stock market returns.

As you know I am constantly on the lookout for research papers with a brilliant insight that, when implemented lead to substantial index beating performance over long periods of time.

In 2008 I discovered exactly such a paper, published in October 2006, called Contrarian Investment, New Share Issues and Repurchases.

The three authors were onto something remarkable.

Apart from finding, once again, that a value (buying undervalued companies) beats a growth (buying expensive companies) based investment strategy, they also did something else.

They wanted to see if net share buybacks by companies had any impact on the share price returns in subsequent years.

And here is where they really stumbled onto something.

They tested this insight over a period of 30 years from May 1972 to April 2002 to make sure it works.

The paper is a typical academic research paper that is not always easy to read and understand and is filled with jargon and statistical language, but here is the essence of the study.

The authors started with the assumption that management knows when the shares of the company they work for are undervalued and overvalued.

It thus follow that if a company’s shares are overvalued it would be advantageous for the company to issue shares and if the shares are undervalued management would be more likely to buy shares back.

The issuance or repurchase of shares by companies is thus a signal by management that the company is over- or undervalued.

In the study they tested this line of thought with remarkable results.

The study uses the previous year’s net share issuance (shares issued minus shares repurchased) as an indication of management’s actions. A negative net issuance number indicates net share buybacks.

The paper tested a number of value strategies all with the same remarkable results.

In the example below I used only one of the value strategies they tested, buying low price to book (“P/B”) ratio companies.

The researchers looked at the returns of a low P/B investment strategy over 30 years. They then sorted these companies into two groups, net issuer or net repurchaser of equity.

The following graph shows the performance of this low P/B strategy over 30 years. And shows the average returns for one to four years after the shares were purchased.

As you can see the results are really significant, with companies buying back shares substantially outperforming a simple value strategy of buying low P/B companies. And the effect continues for four years after the shares were purchased.

Even more important though is that low price to book companies that were net issuers of shares substantially underperformed the simple value strategy.

If the difference in performance do not look significant to you remember that these results were measured over a 30 year period.

To illustrate, the first year returns of net buybacks companies outperformed the low P/B strategy by 3.6% on average over the 30 years.

If you invested $1,000 in the low P/B strategy if would over 30 years grow to $139,770. However if you invested only in the companies that bought back shares your $1,000 would have grown to 344,579… nearly 2.5 times more.

Call me conservative but I think this is significant.

The study also tested other value strategies such as low price to cash flow and low price to earnings strategies. In each case just buying the companies that have bought back shares would have substantially boosted your returns.

I am not a growth investor but should you be the study has good news for you too as it found exactly the same for growth companies. Only investing in companies that have bought back shares would have substantially increased your returns.

I know plodding through studies like these is not much fun but their results are significant.

They are the only objectively tested results that something you think may work in investing actually does.

If you thus put all the studies that have shown significant index outperformance over time together you have an

extremely high probability of generating outstanding returns and substantially outperforming the markets.

This is what I have done when developing my investment strategy, I looked at all the academic studies that have shown excellent results over long periods of time (in up and down markets) and combined them into one strategy that substantially increases my probability of generating outstanding returns.

I use the results from these studies to identify possible investments, which I then analyse further and invest in along with my subscribers.

Profitable investing

Tim du Toit

P. S. You simply have to invest when you find a good company in the software industry.

Here’s why.

A software company, once its development and fixed costs are covered, generates just about pure profit on each additional sale as the cost to produce an additional CD is virtually zero.

This month I stumbled onto exactly such a company when searching for an investment to recommend to my subscribers.

The company is trading at a price to earnings ratio of under 12. I agree this does not seem like a bargain but remember 2009 was a difficult year for all companies.

The company is even cheaper based on its price to free cash flow (operating cash flow minus capital investment) of 8.7 times. This means the theoretical dividend the company can pay with the cash it generates is nearly 11.5%.

The only valuation measure (I look at 7) the company is not cheap on is its dividend yield of only 2.1%. This is due to it using cash to pay down debt taken on to pay for an acquisition.

But as the debt is nearly all repaid there is a lot of room for a substantial increase.

To find out how you can also get ideas like this monthly click here.