Open market share repurchases seem to be driven by the self-interests of managing insiders. Companies with poor prior performance and those with low debt levels appear to be more likely to engage in stock repurchases. Shareholders of repurchasing firms experience positive, albeit small, stock price reactions to the repurchase announcements.
The authors examine the motivations behind and effects of open market repurchases for corporate insiders and shareholders. Firms with greater free cash flows, poor recent performance, and less financial leverage are found to be more likely to engage in repurchases. Shareholders of firms announcing the repurchase of a large percentage of shares and those of firms with poor preannouncement performance experience positive abnormal returns during the repurchase announcement period. Furthermore, the authors find that, overall, insiders at repurchasing firms tend to decrease selling and increase buying of their firms’ shares prior to the repurchase announcement.
How Is This Research Useful to Practitioners?
Open market repurchases are becoming an increasingly popular way to distribute unneeded cash among shareholders without tying the company to firm commitments. Share repurchases are more attractive than dividends because the selling shareholders are subject to lower capital gains taxes. Shareholders who do not sell but hold the stock for a longer time experience capital appreciation with deferred taxes.
Although binding fixed-price tender offers or Dutch auctions have been known to lead to significant increases in share price, the authors find that open market repurchases also benefit shareholders. Using share repurchase data for the period of 1995–2007, they find that repurchase announcements are associated with about a 3% increase in the share prices of the purchasing firms around the announcement.
Repurchasing firms’ poor preannouncement performance indicates that managers perceive their stock to be undervalued. Managing insiders, in contrast to nonmanaging insiders, appear to take advantage of the mispricing by engaging in reduced net selling of shares during the preannouncement period, up to two weeks before the repurchase announcement. They become net buyers during the last two weeks before the announcement.
How Did the Authors Conduct This Research?
The authors use the Securities Data Company (SDC) database to find 1,949 exchange-traded companies that made a repurchase announcement between January 1995 and December 2007. For each company in the sample, they match a similar nonpurchasing firm. They find that the repurchasing firms have significantly greater cash flows, less debt, and lower prior returns than the matched firms. Dividend payout and prior period returns appear to negatively, but not significantly, influence the likelihood of a repurchase.
The event study reveals that the repurchasing firms’ daily cumulative abnormal returns (CARs) turn strongly positive after the announcements; this positive effect continues, albeit at a slower rate, for 15 days after the announcement. On average, purchasing firms’ shares experience a positive announcement effect, CAR, of about 3% during the two-day announcement window (Day 0 to Day +1).
The authors find that the larger the percentage of shares repurchased, the greater the positive stock market reaction. They contend that a large repurchase indicates that managers think their stock is significantly undervalued. The dividend payout appears to negatively impact the decision to repurchase, but when shares are repurchased, the market response increases as the typical payout increases.
Next, the authors compare the net selling activities of insiders of repurchasing firms and matched firms. During the last two weeks before the repurchase announcement, matched firms’ insiders continue to engage in net selling but repurchasing firms’ insiders engage in significant net purchasing activities. There is no difference in the two groups’ net selling after the announcement.
Furthermore, when the insiders are broken into managing and nonmanaging groups, the authors find that managing insiders’ net selling falls dramatically during the period from three months to two weeks before the repurchase announcement. They become net buyers during the last two weeks before the announcement. In contrast, nonmanaging insiders remain net sellers during the entire preannouncement period. This pattern indicates that managing insiders have market-timing abilities, which they exploit to earn extra profits during the preannouncement period.
Share repurchases are a well-recognized means for companies to distribute extra cash to shareholders in a tax-efficient manner. Share repurchases also avoid the risk of unintended signaling effects that an extra dividend or an increase in regular dividend might involve. In addition, they can be used effectively to alter a firm’s capital structure. The authors add to the literature by showing that in anticipation of, and in response to, repurchase announcements, managing insiders change their selling and buying activities to benefit personally. This study confirms that managing insiders have private information and they use it to derive benefits for themselves.