A Better Buyback Strategy
Repurchases, Reputation, and Returns
- Alice Bonaime
- A recent version of the paper can be found here.
This paper examines whether a firm’s reputation is a determinant of repurchase completion rates (the ratio of actual to announced repurchases) and whether the stock market discounts announcements made by less reputable firms. Prior completion rates are positively correlated with current completion rates and announcement returns, suggesting consistency in repurchases and implying a reputational effect. Further, a nascent literature regarding accelerated share repurchases finds them to be more credible than open market repurchases. I show that the probability of announcing an accelerated share repurchase is greater for firms likely to be concerned about reputation because of low past completion rates.
The author uses the Securities Data Corporation (SDC) database for data on buyback announcements, CRSP for return data, Compustat for various financial data and the Institutional Brokers Estimates System (IBES) for earnings forecast and reporting data. The sample period is 1986 through 2004 and any firms not indicating the level of their intended repurchase are omitted.
When dealing with academic research, earlier drafts of papers are often more informative on the trading front than newer versions (dissertations, good; published article, bad). This is how the not-so-scientific approach to academic research typically works:
- First, a hard-charging PhD student finds some anomalous results after painstakingly hand collecting a dataset.
- An initial draft of the paper comes out with an emphasis on the amazing returns and results surrounding a trading strategy. Nobody reads it, and the results are often buried in the dissertation that sits on the shelf of a library.
- Next, the PhD student must develop a fancy economic model or theory to “fit” the odd data and appease the academic community’s desire for mental stimulation.
- The next draft of the paper is released and emphasizes some economic theory or details that few outside of academics care about.
- The published paper is released, with a strong emphasis on an economic theory, followed by some empirical results that the author already knows will fit the economic theory. Voila, a published academic paper.
The paper we are dealing with here is a perfect example of this process.
Alice started off with a paper outlining a stunning investment strategy. She even emphasized the results in the original abstract (relevant stuff is highlighted):
“Though open market repurchase announcements are generally viewed as positive signals and are associated with positive abnormal returns, they are not binding commitments. This paper examines whether the market incorporates a firm’s reputation when evaluating the credibility of an announcement to buy back stock. I find weak evidence that ex ante indicators of managerial credibility are reflected in announcement returns. Empirical results support the theory that announcements made by firms that consistently meet or beat analysts’ expectations are viewed as more credible, but announcement returns are unrelated to prior completion rates, accruals, or insider trading during the prior repurchase program. However, high prior repurchase plan completion rates are associated with greater abnormal long-run returns. For the subset of firms in the lowest quintile of returns following the prior announcement, I identify three-year cumulative abnormal buy-and-hold returns of 29.8 percent on average for firms whose prior completion rates were high.”
Alice then went on the typical academic track and eliminated all the great information on a cool trading strategy and wrote an article tailored for an academic audience. Now it looks like Alice will get her article published in the JFQA–very well deserved I might add.
“This paper examines whether a firm’s reputation is a determinant of repurchase completion rates (the ratio of actual to announced repurchases) and whether the stock market discounts announcements made by less reputable firms. Prior completion rates are positively correlated with current completion rates and announcement returns, suggesting consistency in repurchases and implying a reputational effect. Further, a nascent literature regarding accelerated share repurchases finds them to be more credible than open market repurchases. I show that the probability of announcing an accelerated share repurchase is greater for firms likely to be concerned about reputation because of low past completion rates.”
Noticed how I didn’t highlight much in the new absract? Well, there was nothing relevant to the trading strategy returns–she took them all out!
Anyway, that was a longer than expected rant trying to get a simple point across: read research early or you’ll often miss the boat.
On to the strategy…
The author of this paper dissects the buyback anomaly originally discussed in “Market Underreaction to Open Market Share Repurchases.” The summary of that paper is best described with a picture:
The main point is that there is evidence that firms who buyback stock tend to outperform on a risk-adjusted basis in the future.
Can we make this anomaly more powerful?
Ingredient 1: Reputation
Investors react positively to the announcement of share buybacks because they interpret it as a positive signal as explained above. But such an announcement does not bind the company to doing anything. Some companies therefore may fail to follow through on the plan to buy shares back. Stephens and Weisbach (1998) find that firms on average repurchase only about 74-82% of what they say they are going to. One angle Alice takes is to see if firm buyback reputation, or firms who say they’ll do a buyback and then actually do a buyback, earn higher abnormal returns than those who are not credible.
Ingredient 1: Past Performance
Prof. Bonaime splits her sample of repeat buyback companies into quintiles based on the abnormal return to the stock following the previous buyback. Q1 is previous losers, Q5 is previous winners.
Combining ingredient 1 &2
- Repurchase reputation affects long-term abnormal returns–9.64% vs 6.66%
- Stock performance following the previous repurchase affects long term returns–23.77% for losers vs 4.85% for winners.
- A strategy that focuses on firms with high reputation AND who have had poor performance following their previous repurchase do extremely well–29.76%
It appears that stocks that had low returns following their previous buyback, but a high completion rate, see amazing returns following their next buyback.
- Observe historical data for companies with past share buybacks and record the stock return and rate of buyback completion.
- Segregate the sample in to five groups based on previous return.
- Within the lowest previous return group identified in step 2, break the sample in half based on prior completion rates.
- When a subsequent buyback is announced, buy stocks that fall in the low previous return, high past completion rate subset.
- Do this as often as possible to create a diversified portfolio of returns that seem to do well in the future.
This strategy is fairly compelling based on the numbers, but the logistics are quite intensive. Nonetheless, the paper emphasizes a very important point: not all buybacks are created equal. Often, market commentators mention buybacks as a panacea of everything great in the world–the reality is quite different. Some firms never actually do what they say.
Another point to ponder is where the extreme returns in the ‘lowest prior return’ decile are coming from. In the original repurchase anomaly paper, Market Underreaction to Open Market Share Repurchases, the authors find some insane abnormal returns associated with ‘value stocks’ that engage in share repurchases (the three year abnormal returns are north of 30%). I wonder if Alice is essentially picking up this same effect with here ‘previously poor performance’ measure. It would make sense to me that firms who have underperformed the market will likely end up being classified as “value” in the near future. So in the end, Alice is may simply be emphasizing a larger point regarding stock repurchases: focus on repurchases among “cheap” stocks.
I know what all the fundamental investors are thinking: “D’uh.”
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