Their research provides insights into why some firms announce share repurchases, but never repurchase any, and why stock prices increase upon announcement. "In our sample, the average abnormal return surrounding the repurchase announcement is 2.5%," says Jacobsen. "So the market views the repurchase announcement as good news, even though the announcement does not commit the firm to follow through with the repurchase program." The authors' research creates both a theoretical framework and empirical evidence to provide resolution to the puzzles.
A good news puzzle?
The authors suggest that the announcement of share repurchases attracts investor attention. An ignored undervalued firm with the potential for a lot of mispricing may separate itself from an overvalued firm by just announcing share repurchases and attracting scrutiny; the ignored overvalued firm will not gain from being discovered. "Popular firms, with a potential for only small mispricing, cannot attract more attention," says Jacobsen. "Such firms, if undervalued, have to use a costly signal – actually repurchasing shares – to credibly signal their undervaluation."
Share buybacks can be costly however. In the first two months of 2014, $11 billion dollars of debt was issued for stock buybacks, with ensuing credit downgrades and negative outlook changes. In 2013, credit ratings agency Fitch downgraded six U.S. companies because of buybacks, the research notes. The Wall Street Journal notes, "U.S. companies announced $141 billion of new stock buyback programs last month [April], the highest level ever for new buyback programs during a single month and an increase of 121% from April 2014," according to Birinyi Associates, analysts of money flows.
Theory and practice
The researchers theoretical model predicts that firms with large mispricing use repurchase announcements to attract scrutiny from speculators who discover their true value. And, firms with small mispricing must announce and actually repurchase shares to signal their true value, they note. The authors analyze 7,602 firms that announced an open market stock repurchase program between January 1985 and September 2012. Findings show that a significant minority of firms -- 40% -- that announce a repurchase program do not repurchase a single share in the fiscal quarter of the announcement; in the entire fiscal year of the announcement, 24% do not repurchase. Interestingly, from the 2004-2012 period of the study, from the study's universe of publicly-listed firms that announce stock buybacks, firms have been buying back shares more than in years past. That is, more firms that announce are repurchasing, or following through, than in the past.
Findings also indicate that firms, which announce but do not repurchase, have a higher potential for deviations of prices from their intrinsic value. These firms' shares react slower to information; have higher transaction costs; have smaller information production by intermediaries such as analysts; and have less investor attention and/or recognition. Abnormal returns and trading volume surrounding the announcement are significantly higher for such firms relative to firms that follow through with the repurchase program.
The repurchase announcement attracts attention to firms that announce but do not repurchase shares. Jacobsen offers, "For non-repurchasers, the mere announcement of an open market share repurchase attracts scrutiny from speculators, who search and discover the under-pricing, trade, and these trades lead to price corrections."
The paper "The Share Repurchase Announcement Puzzle: Theory and Evidence" by Stacey Jacobsen, Cox School of Business, Southern Methodist University and Utpal Bhattacharya of Hong Kong University of Science and Technology was recently published in Review of Finance.
Written by Jennifer Warren.