This post is a quick survey of recent literature regarding share repurchases. We look at who repurchases shares, why they do it, and whether repurchase activity affects the price or liquidity of equities.
Who Repurchases Shares?
Pacheco (2007) studied first-time share repurchasers:
“initial repurchase firms are younger, have lower leverage and operating risk, and higher payouts, operating cash flows, profitability and market-to-book than matched non-repurchase firms. Compared to secondary or seasoned repurchase matched firms, these initial repurchase firms are also younger and have higher cash, profitability, sales growth and market-to-book, as well as lower payouts, leverage and retained earnings.”
Why Do Firms Repurchase Shares?
Dittmar (2000) finds firms repurchase stock “throughout the sample period to take advantage of potential undervaluation and distribute excess capital. Firms also repurchase during certain periods to alter their leverage ratio, fend off takeovers, and counter the dilution effects of stock options.”
Pacheco (2007) finds “support for the free cash flow and risk reduction signaling hypotheses and the flexibility motivation for conducting stock repurchases,” while finding no support for “undervaluation signaling, timing, tax effects, and options and dilution hypotheses.”
Blouin et al. (Did firms substitute dividends for share repurchases after the 2003 reductions in shareholder tax rates?, 2007) find mixed conclusions regarding tax effects.
“We find that firms undertaking ASR programs are significantly larger than those undertaking OMR programs, and that ASR programs have larger median deal values than OMR programs. Further, ASR firms have significantly smaller cash holdings, higher dividend payout ratios, higher pre-announcement leverage ratios, similar probabilities of being takeover targets, and smaller equity based compensation for their CEOs compared to OMR firms. Finally, firms undertaking ASR programs have lower pre-announcement market valuations conditional on firm insiders’ private information, more positive announcement effects, and better post-announcement operating and stock return performance, compared to those undertaking OMR programs. Overall, our results are consistent with the predictions of the undervaluation hypothesis but inconsistent with the predictions of the distribution of excess cash, the target leverage-ratio, the takeover avoidance, or the management compensation hypotheses.”
“We examine the impact of stock market liquidity on managerial payout decisions. We argue that stock market liquidity inﬂuences payout policy through a ﬁrst-order effect on the share repurchase decision, and a second-order or residual effect on the dividend decision. Managers compare the tax and ﬂexibility advantages of a repurchase against its liquidity cost disadvantage. All else equal, higher market liquidity encourages the use of repurchases over dividends. Our empirical results conﬁrm that stock market liquidity plays a signiﬁcant role in repurchase and dividend initiations, as well as in recurring payout decisions. Unlike previous
studies that measure liquidity changes following the repurchase decision, we examine liquidity levels prior to the payout decision. We show that managers condition their repurchase decision on a sufﬁcient level of market liquidity, consistent with Barclay and Smith’s theoretical analysis and Brav et al.’s CFO survey results. Repurchases have recently become the payout decision of choice in part because of rising stock market liquidity.”
“stock repurchases are viewed as financing rather than investment decisions. While the desire to change the capital structure was the most frequently expressed motivation, a majority of the responses were consistent with the signalling hypothesis. This finding suggests that signalling may indeed be as important as suggested by prior theoretical and empirical work.” “Most repurchases are accomplished through open-market transactions and are financed in a majority of cases with available cash balances. Low stock price is the circumstance most often precipitating repurchases.”
Rosenthal (2011) finds that repurchases
- are a costly way to give money to shareholders;
- tend to be bigger when CEOs more exposed to stock price;
- often do not increase shareholder value;
- may be used to defend against mergers;
- may be used to reduce debtholder value;
- are less likely when firms hold more debt; and, thus,
- are a possible channel for asset stripping
How Do Firms Repurchase Shares?
Baker 2003 finds that repurchasing fewer shares than announced (though illegal if done intentionally) is a common practice.
Cook (2004) finds in the US:
- Repurchase programs vary widely across firms. That is, program length, speed of completion, and timing vary widely in our sample. For example, one firm completed its announced program on one trading day, while another repurchased on 288 of 387 trading days following the program’s announcement.
- We find evidence that firms decrease repurchasing activity around firm-specific information announcements. Thus they appear to take care to avoid trading on short-term information.
- We find that many firms repurchase following price drops. On the NYSE, daily repurchase volume is related to contemporaneous and lagged price changes and trading volumes. Nasdaq firms’ repurchase volumes are unrelated to both lagged excess return measures and contemporaneous price changes.
- Trade execution appears to be influenced by market structure (specifically, the use of limit orders) and firm size. On the NYSE, 38.9% of repurchase trades are executed at the prevailing market bid, consistent with the use of a limit order. On the Nasdaq, only 8.1% of trades are similarly executed.
- We show that repurchase trading contributes to market liquidity through narrower bid-ask spreads on repurchase days than on adjacent non-repurchase days, and that order imbalances move prices less when repurchasing firms are active in the market.
- From a cost perspective, we find that NYSE firms pay significantly less compared to several naive accumulation strategies. In contrast, Nasdaq firms pay more compared to these same strategies.
Do Repurchases Affect Liquidity?
Brockman (Managerial timing and corporate liquidity: evidence from actual share repurchases, 2001)finds in Hong Kong for OMR that “consistent with the information-asymmetry hypothesis, bid-ask spreads widen and depths narrow during repurchase periods.” Hong Kong is unique in that firms must disclose repurchase transaction details.
Cook (On the timing and execution of open market repurchases, 2004) in contrast, finds for OMR that “repurchasing contributes to market liquidity by narrowing bid-ask spreads and attenuating the price impact of order imbalances on days when repurchase trades are completed.” They continue:
Our evidence indicates that repurchase activity coincides with narrower bid-ask spreads relative to three different benchmark periods: (i) prior to the repurchase announcement; (ii) on non-repurchase days immediately before days with repurchase transactions; and (iii) on non-repurchase days immediately after days with repurchase transactions. We argue that the documented spread narrowing is consistent with the notion that, at the time of a repurchase transaction, the corporation on average competes with market makers to provide liquidity on the bid side of the market. Overall, we find convincing evidence that repurchase trading confers at least local liquidity advantages to those trading the corporation’s equity.
Do Repurchases Affect Share Price?
Agency theory suggests that positive share price reaction may stem from investors’ belief that managers may invest in negative-NPV projects if doing so can produce individual gain, so returning surplus capital can add value. Signaling theories suggest managers purchase shares when firm earnings are expected to rise or become less risky, and thus before prices are expected to rise.
Grullon (2004) finds
Contrary to the implications of many payout theories, we find that announcements of open market share repurchase programs are not followed by an increase in operating performance. However, we find that the systematic risk and the cost of capital of these firms decline after these events. Further, we find that the market reaction to share repurchase announcements is more positive among those firms that are more likely to overinvest. Taken together, our results suggest that the market reacts positively to share repurchase announcements because these events are associated with a reduction in the agency costs of free cash flows. Finally, while the initial reaction is positively related to the reduction in the cost of capital associated with the repurchases, we find evidence to indicate that investors underreact to repurchase announcements because they initially underestimate the decline in cost of capital.
Our empirical findings do provide support for Jensen’s (1986) free cash flow hypothesis. We find that repurchasing firms reduce their current level of capital expenditures and R&D expenses. Furthermore, we find that the level of cash reserves on their balance sheets significantly declines. Finally, we find that the market reaction to share repurchase announcements is stronger among those firms that are more likely to overinvest. These findings, combined with the evidence on profitability, indicate that, as implied by the free cash flow hypothesis, firms increase their cash payouts in response to a deterioration in their investment opportunity set.
The evidence corroborates the free cash flow hypothesis along these dimensions. In examining the six-year period around the repurchase announcement, we find that repurchasing firms experience a significant reduction in systematic risk relative to non-repurchasing firms. The changes in systematic risk translate to an economically significant decline in risk premium of 1.5% a year. Moreover, we also find that those firms experiencing a larger decline in risk also experience a larger decline in capital expenditures and R&D expenses, consistent with the impact of a transition to a lower growth stage.
But then a question remains: If investment opportunities decline after share repurchase announcements, why would the market react positively to such events? Clearly, a reduction in investment opportunity set is not good news. Jensen (1986) explains the positive market reaction to such events by alluding to the notion that the market is already aware of the reduction in profitable investments, and it reacts positively to share repurchase announcements because these events reduce the amount of free cash flows at management’s disposal.
Lie (2005) finds
“the capital market responds favorably to earnings announcements after the program announcements. Further analysis reveals that both the operating performance improvement and the positive earnings
announcement returns are limited to those ﬁrms that actually repurchase shares during the same ﬁscal quarter. A subsample of ﬁrms that initiate the repurchases in quarters following the program announcements experience improvements after the initiation quarter, suggesting that actual repurchases, and not announcements per se, portend future performance improvements.”
Wang 2008 finds
We examine the market reaction to announcements of actual share repurchases, events that cluster both within and across firms. Using a multivariate regression model, we find that the market reacts positively to the events, indicating that these announcements provide additional information to that contained in the initial repurchase intention announcements. Further, the market response is especially favorable for firms with overinvestment problems as measured by Tobin’s q, and is not related to signaling costs as measured by the size of the repurchase. Our findings generally support the hypothesis that share repurchases reduce the agency costs of excessive free cash flow.
Jin (2011) finds “most studies focus on the average positive reaction; however, 30% of repurchasing firms experience negative abnormal returns at announcement. Market reaction is determined by firm-specific factors. The results are consistent with conventional signaling models and agency theories.” They partition firms by whether the cumulative abnormal return (CAR) was Negative or Positive:
Negative CARs occur when “the benefits of repurchase are likely to be small and the costs, such as reduction in financial slack, tend to be big” Group N firms have
- larger size
- less volatile earnings
- higher leverage
- larger institutional investor holding
Ben-Rephael (2012) note “as of the beginning of 2004, US firms are required to report detailed information about their repurchase activity in their quarterly financial reports”; they find
“smaller firms repurchase less frequently than larger firms, and at prices which are significantly lower than average market prices. Their repurchase activity is followed by a positive and significant abnormal return which lasts up to three months after the repurchase. These findings do not hold for large S&P 500 firms. Consistent with these findings, we show that the market response to the disclosure of actual repurchase data is positive and significant only for small firms, and that insider trading is positively related to actual repurchases. “
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