Explaining the Share Repurchase Puzzle
The Share Repurchase Announcement Puzzle: Theory and Evidence
BHATTACHARYA, Utpal | JACOBSEN, Stacey
Review of Finance, Volume 20, Issue 2, 1 March 2016, Pages 725–758
When firms announce they will repurchase shares, the market tends to see this as good news and responds positively – even though there is no requirement on the firm to actually repurchase. In fact, a number of firms never do so. So why does the market react as it does?
Researchers Utpal Bhattacharya and Stacey Jacobsen think they have an answer: the announcements may be signalling to the market that the firm is undervalued. By announcing a share repurchase, firms can attract more scrutiny from speculators, who then discover the true value of the firm, buy shares and help boost the stock price.
“An undervalued firm may separate from an overvalued firm by just announcing share repurchases and attracting scrutiny; the overvalued firm will not always mimic this because it will not gain from being discovered.”
If the above is the reason, why don’t all undervalued firms just announce and never repurchase? The answer the authors give is that this trick is not going to work for highly visible firms. Highly visible firms, like Google, who already have so much attention on them, will not attract more attention. Further, such highly visible firms will not have much mispricing. Therefore, highly visible firms like Google, with not much mispricing, have to announce share repurchases and have to repurchase. These firms will have to put their money where their mouths are.
To demonstrate this phenomenon, they developed a model and applied it to 7,602 U.S. firms that announced share repurchases between 1985 and 2012. Some 24 per cent did not repurchase a single share in the fiscal year of the repurchase announcement, including 13 per cent that did not repurchase within four years or before dropping out of Compustat (the source of their data).
Potential stock mispricing of firms was admittedly tricky to determine, so the authors used a basket of proxies that included a stock’s delay in responding to market-wide information, its slowness in incorporating information into its trading costs, the number of analysts following the firm, and investor attention and recognition as measured by market capitalisation, institutional ownership, number of shareholders, number of employees and advertising expense. Together, these proxies indicated how well the stock was known and whether the most up-to-date and accurate information was circulating about it.
“We find firms which announce but do not repurchase have shares which react slower to information, have lower transaction costs, have smaller information production by intermediaries, and have less investor attention and recognition. Such characteristics are typical of firms that tend to have high deviations of prices from their intrinsic value,” the authors said.
They found that speculators were more likely to buy and trade stocks with large under-pricing than small under-pricing, leading to profitable price corrections – with the result that the firm itself did not need to repurchase. “If the under-pricing is low, the firm will not be able to attract attention from speculators, so it will have to put its money where its mouth is and buy shares,” they said.
As further evidence that the beneficiary firms were under-priced, they also looked at the short window around the repurchase announcements and found that abnormal returns and abnormal trading volumes were significantly higher for firms that did not repurchase than those firms that did repurchase.
“These results imply that the magnitude of mispricing corrections is higher for firms that did not repurchase shares than those that did, and that trades by speculators moved prices toward fundamental values in the non-repurchasing firms,” they said.