To return cash to shareholders, firms choose between issuing dividends and repurchasing share. There are many reasons to choose to repurchase rather than issue dividends. For one, dividends are believed to be sticky, in that a dividend cut is taken as a sign of weakening fundamentals and often leads to a sell-off in the market. Few companies follow a dividend policy that mimics corporate earnings or free cash flows. Second, when executives believe their company’s share price to be unrealistically low, they can use a repurchase program to take advantage of the market’s pessimism and reward shareholders that stick with the company.
To the extent that the second rationale is correct, one might believe that a good investment strategy could be formed by purchasing shares of companies that have recently begun repurchasing their own shares. This is similar to tracking the transactions of insiders such as the CFO or CEO. Is this a good strategy?
In a new study published on SSRN, Israeli researchers analyzed share repurchases among companies included in the S&P 500. They sought to determine whether these repurchases can be used as signals for future news and possibly lead to abnormal returns.
Here’s the abstract (emphasis added):
Using new data we investigate open-market repurchase execution of S&P 500 firms. We find that smaller firms repurchase less frequently than larger firms, and at prices which are significantly lower than average market prices. Their repurchase activity is followed by a positive and significant abnormal return which lasts up to three months after the repurchase. These findings do not hold for large S&P 500 firms. Consistent with these findings, we show that the market response to the disclosure of actual repurchase data is positive and significant only for small firms, and that insider trading is positively related to actual repurchases.
This is the first study to look at actual repurchases, rather than simply the announcement of a repurchase program. As I have long bemoaned, many companies announce repurchase programs, only to sit idle for months or years and even then only making nominal repurchases.
The authors conclude that small firms do repurchase at lower prices (though, the term significantly used in the abstract relates to statistical significance, rather than the magnitude; the amount is less than 50bp below the actual prices). Further, statistically significant returns could be earned by following these companies (emphasis added):
While all firms increase their repurchase activity following price drops, we find that only for the small firms in our sample is actual repurchase activity followed by a positive and significant abnormal return that lasts up to three months. For large firms, the abnormal return is negative and insignificant. In fact, we show that a short-term strategy that focuses on the actual repurchase activity of the small firms can earn a monthly abnormal return of 0.9%, which is significant at the 1% level. We did not find positive abnormal returns in longer-term horizons (we considered returns for up to two years following the repurchase).
Read the full paper here.
What do you think of this research?
Author Disclosure: None