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1 January 2017 CFA Institute Journal Review

Is Price Support a Motive for Increasing Share Repurchases? (Digest Summary)

  1. Lee M. Dunham

Companies may use share repurchases to support their shares when they are overvalued. Using changes in short interest as a proxy for overvaluation, the authors find that regression results are consistent with the notion that a significant motive for increasing share repurchases is to support overvalued equity.

How Is This Research Useful to Practitioners?

Share repurchases have become the dominant method of payout, mainly because of their flexibility when compared with “sticky” dividends. Other explanations have been put forth to explain the increase in the popularity of repurchases, including the ability for managers to opportunistically time their repurchases and to increase earnings per share. The authors examine evidence consistent with another explanation: Managers use repurchases to support their overvalued shares.

The finding that changes in repurchases are positively related to changes in short interest has interesting implications for practitioners. This result suggests that managers may not be acting in the best interest of shareholders when repurchasing shares—that is, repurchasing more shares when they are likely overvalued. Finally, given that stock returns on average are positive in the eight quarters following “price support” quarters (i.e., quarters in which both repurchases and short interest increase), traders and portfolio managers may consider devising appropriate trading strategies around such price support quarters.

The authors also examine insider trades relative to repurchase activity using insider trade data from SEC Forms 3, 4, and 5. Results indicate that when companies increase share repurchases, insiders trade differently by not selling their shares and insider trades are not related to changes in short interest. They suggest that this pattern is due to the insiders’ overconfidence that the current share price will be maintained.

How Did the Authors Conduct This Research?

Data on repurchases, short interest, and a host of control variables are collected from various sources (Compustat, CRSP, and Thomson Reuters) for the 2003–14 period. The authors exclude financial institutions and other regulated entities, which usually require regulatory permission to repurchase shares. In a series of regressions, changes in quarterly share repurchases (scaled by total assets) are regressed on changes in quarterly short interest and the control variables. Regression results indicate a statistically positive relationship between changes in repurchases and changes in short interest, and this result survives a series of robustness tests with respect to the measurement of share repurchases and short interest. The authors interpret this result as being consistent with the notion that a significant motive for increasing share repurchases is to support overvalued equity.

Subsample analyses are also performed. Regressions omitting quarters where no repurchases were made, where accelerated repurchases were excluded, and by time of year all yield similar results. In addition to the pooled regressions, the authors run annual regressions, and they find the relationship between the two variables is positive and significant in every year.

In subsequent analyses, the authors examine stock price and operating performance around price support quarters. On average, despite the fact that return on assets declines significantly over the subsequent eight quarters after a price support quarter, earnings per share remain relatively flat, and stock returns (both raw and abnormal returns) are positive over that same time. Therefore, price support via repurchases is deemed successful because the stock prices paid in the price support quarter are below their observed prices over the subsequent eight quarters.

Abstractor’s Viewpoint

The finding that changes in repurchases and changes in short interest are positively and statistically related is an interesting result. If managers were acting in the best interest of shareholders, the opposite result would be expected. As the authors indicate, this motive of price support for repurchases is based on averages, so it may not apply to all firms. The fact that the authors’ main result survives a series of robustness tests suggests that it warrants further research. An interesting follow-up study might examine the relationship between repurchases and other proxies for valuation, such as price multiples or enterprise value multiples, to see if the same results hold. Practitioners also could closely consider executive compensation structures of companies that incentivize managers to prefer repurchases over dividends.

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