Announcements of stock buybacks by corporations, a signal that in theory relies on market efficiency to disseminate, appear to reveal a market inefficiency, showing investors in practice fail to recognize a real bargain in searching for undervalued stocks.
In an important study, three professors - David Ikenberry of Rice University, Houston, Josef Lakonishok of the University of Illinois, Urbana-Champaign, and Theo Vermaelen of INSEAD, the European Institute of Business Administration, Fontainbleu, France - contend the market in the short-run underreacts to buybacks, essentially ignoring them.
But in the long term, over four years, the average excess return after an announcement is 12.6% over a control group of stocks.
This lag in reaction, where in some cases "prices remain at bargain levels for at least two years," appears to allow time for investors to take advantage of the repurchase announcements. It's surprising such a promising strategy hasn't been exploited by portfolio managers.
The professors examined the stocks of 1,239 companies that announced they would repurchase their stocks on the open market.
Although corporations sometimes buy back stock through fixed-price tender offers or so-called Dutch auction tender offers, their use of these methods of repurchasing is relatively rare. Most corporations repurchase shares on the open market. From 1980 through 1990, the period the professors studied, open-market stock repurchases accounted for 90% of the total dollar value of all repurchases.
They note corporations repurchase stock for a variety of reasons, including capital structure adjustment, takeover defense and substitution for cash dividends. One of the most important is what they call "signaling," using the repurchase announcement to convey information to the market, such as the management's view of its shares as undervalued.
"(W)hether the signals are deliberate or not, the signaling hypothesis generally relies on market efficiency," they note. "If the stock market is informationally efficient, price should immediately adjust in an unbiased manner upon the announcement of a repurchase, and fully reflect the 'true' value of the new information. Furthermore, no wealth transfer should occur between long-term shareholders and those selling shares back to the firm."
But the study shows that in the two days after such repurchase announcements, shares on average return about 3.54%, a magnitude of response the professors call not convincing.
"Placed in perspective, 3% is not that much greater than the standard deviation of daily stock returns for many companies," they note.
"If managers (of corporations) are reacquiring shares because of mispricing, it is more likely that they perceive valuation errors substantially greater than 3%. The professors hypothesize "the market may be skeptical of the claims of undervaluation," ignoring the signal conveyed by the repurchase announcement, and thus prices adjust only slowly over time.
That in fact is what may happen. They found that over a four-year period, prices of stocks in repurchase programs had an average return of 12.6% more than their control group.
"Managers of (corporations) who repurchase their own shares appear to have been correct, on average, in assuming that they can buy these shares at bargain prices to the benefit of their long-term shareholders," they note.
"Apparently, investing in companies after they announce open-market share repurchase programs is a profitable long-run strategy."
For value stocks, the research is more compelling. In the four years after repurchase announcements by these companies, the value stocks averaged an excess return of 45%.
In short, the study shows the market appears to be less than informationally efficient, something any active equity manager would support, even if they have yet produced the evidence in their performance.
