Wednesday, January 9, 2013

Repurchases: Part 2 The Positive Side

On our last post, Repurchases: Part 1 Shareholders Beware Joe pointed out some concerns about repurchases.  These are good cautions, but I'm an empiricist and I need to point out that the empirical evidence on repurchases is much more positive.  In the paragraphs below,  I'll first outline some theories about share repurchase and then discuss some empirical evidence.  

We generally assume one of six things is going on with a share repurchase.  First, a firm could feel that its stock is undervalued and the repurchase signals positive news to the market about this inside view.  In this case, we'd expect to see the stock price rise on the announcement of a repurchase.  Second, the firm could use repurchases as an efficient tax-advantaged way to return excess cash to shareholders.  It is efficient and tax advantaged since capital gains are taxed at a lower rate than dividends.  Third, the repurchase signals that management is not going to squander excess cash on things like unproductive acquisitions.  Both of these are positive effects and the stock price should rise upon announcement of a repurchase.  Fourth, an in contrast to the previous item the repurchase could signal a lack of growth opportunities for the firm.  In this case, we'd expect the stock price to decline at the announcement of a repurchase.  Fifth, since repurchases reduce the equity position in a firm, they change the capital structure producing less cushion for debt holders.  If true, debt holders would lose upon announcement of a repurchase; equity holders would gain.  Sixth, firms sometimes repurchase shares to fund executive options. One can imagine other motives, some of which Joe outlined in his post.  I'll return to that in a moment.  

The empirical evidence on repurchases is strongly consistent with a positive impact to shareholders and generally supportive of the first three hypotheses mentioned above: signaling, tax efficiency, and the return  (rather than squandering)  of excess cash.  The fourth and fifth hypotheses ( a lack of growth opportunities and wealth transfers from bondholders)  find less support.  On the sixth hypothesis, Kahle (2002) also provides compelling evidence on the use of repurchases to fund executive options.  This is not, by itself detrimental, but has clouded some empirical tests of the other hypotheses.  (For an elaboration on this see Share Repurchases see our article in the Journal of Corporate Finance, Share Repurchases Executive Options and Wealth Changes to Stockholders and Bondholders.) 

So the empirical evidence is overwhelmingly positive and I find myself more optimistic about repurchases than Joe.  This does not mean that shareholders shouldn't be concerned with the cautions that Joe notes.   The empirical results we discuss in this post are statistically significant tendencies.  Individual firms could still be using repurchases for less than desirable reasons.  Indeed, some of the items Joe notes (use of repurchases to mechanically raise earnings per share, for example), have no empirical justification.  Concerns about firms overpaying shareholders who tender make sense.    Other items like repurchases to alter option values suggest fruitful additional ideas for additional analysis.    These things may exist in a subset of the data.  The wise investor or board member can take comfort from the positive evidence about repurchases, but should sprinkle this with healthy skepticism for possible abuse.  


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