Market Underreaction to Open Market Share Repurchases: 9/10

Investment Potential Rating:
9/10 (1 worst, 10 best)

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OVERVIEW:
Market Underreaction to Open Market Repurchases
David Ikenberry
University of Illinois
Josef Lakonishok
University of Illinois
Theo Vermaelen
INSEAD

Journal of Financial Economics 39 (1995) 181-208
http://ideas.repec.org/a/eee/jfinec/v39y1995i2-3p181-208.html
Abstract:
We examine long-run firm performance following open market share repurchase announcements, 1980–1990. We find that the average abnormal four-year buy-and-hold return measured after the initial announcement is 12.1%. For ‘value’ stocks, companies more likely to be repurchasing shares because of undervaluation, the average abnormal return is 45.3%. For repurchases announced by ‘glamour’ stocks, where undervaluation is less likely to be an important motive, no positive drift in abnormal returns is observed. Thus, at least with respect to value stocks, the market errs in its initial response and appears to ignore much of the information conveyed through repurchase announcements.

Data Source:
The dataset examined consists of 1239 open market repurchase announcements between Jan 1980 and December 1990 by firms who traded on the NYSE, ASE, or NADSDAQ.

Data Specification:

Open market repurchases can mean a lot of things to many people, but the primary reasons a company may do a open market repurchase are to readjust capital structure, have stock to pay off stock option compensation agreements, as a use for excess cash, as a substitute for dividends, and finally--to signal to the market that the shares are undervalued and the best use of cash is to buy stock on the cheap.

This paper doesn't try to tackle the question of why management engages in share repurchase, but instead focuses on the market reaction to share repurchases.

Theoretically, if the market were perfectly efficient, when a company announced a share repurchase the stock would adjust to reflect this signalling from management. Of course, if the market thinks the share repurchase is not a signal that the shares are undervalued, then it may not react to the announcement. Because of the confounding issues surrounding the motivations for implementing a share repurchase, investors have a tough time figuring out where to price shares after an announcement...hence the potential opportunity..


Investment Strategy:

The authors examine a bunch of different strategies and address many theoretical questions that are really only of interest to academics--we just want to figure out how to make money! The strategy I will speak to here addresses the intersection of value stocks and open market repurchases.

Specifically, the authors take all value firms (top 20% b/m) that announced a market repurchase in a certain month and formed an equal weight portfolio of these companies in the following month. They then hold this portfolio for a specific time period (1 year up to four years). This is a relatively straight forward method to form a portfolio.


Results:

The results from the portfolio of "value stocks announcing stock repurchases" gets the investment juices flowing. The authors report the following abnormal returns:

1yr abnoral: 4.66%
2yr abnormal: 6.36%
3yr abnormal: 34.29%
4yr abnormal: 45.29%

It seems the market really starts to agree with the managers repurchasing decision around year 3 and 4, which makes sense to me. Usually the market is looking 1-2 years out (on its 'long term' days, usually the focus is one quarter out), whereas solid managers are looking 3+ years ahead.

The abnoral returns are calculating after stripping out the returns of their respective benchmark portfolio. The benchmark portfolio they focus on is a portfolio that matches the same size and book to market ratio of the 'share repurchasing portfolio' under question. This controls for the size and value factors described in Fama & French's paper on the cross section of stock returns. If you ran this strategy as a long/short much of the market risk factors out there would vaporize and you would be left with pure alpha.


Implementation Issues and Remarks:

This paper shows that the market tends to underreact to a public signal from management that shares are undervalued. Not surprisingly, this effect is most pronounced in 'value' firms, where the potential market misvaluation is probably greatest.

There are no real hoops to jump through when trying to implement this strategy. If you are narotic and want to trade this month to month, the authors describe a method of doing this. If you are more concerned with taxes, trading costs, and lowering your time spent in front of a trading terminal, the buy and hold methods are proven to work as well.

There has been some recent literature that says that open market repurchases are merely a way for companies to buy stock so they can fulfill their stock option compensation obligations--I think its all bogus. In the end, value works because investors fail to appreciate diamonds that haven't been polished. When managers signal that they may have a diamond that will be polished in the next few years, it is probably a good time to load up on the shares.
I give this a 9/10 for its simplicity, intuitive appeal, and solid performance.


WRG