In theory, buybacks are a signal that a corporate insiders, the people in the best position to job a company’s true worth, think that the stock price is currently undervalued. It’s a theory with problems (like the role of executive compensation), but you can understand why buybacks can move the market. Utpal Bhattacharya from Hong Kong University of Science and Technology and Stacey Jacobson of Southern Methodist University School of Business have a slightly different question.
“Why is the mere announcement of an open-market share repurchase program, which involves no commitment to purchase shares, regarded as good news by the market,” they ask.
They argue that for many companies, announcing a repurchase program is enough of a signal to trigger a price correction even if the buybacks never actually materialize.
24% of companies don’t follow through on open-market buyback announcements
According to Bhattacharya and Jacobson’s model, when a company first announces a buyback program, it gets the attention of speculators who check to see if the stock price might be underpriced. If there is a large underpricing then enough of the speculators will move in that the price at least partially corrects. But if the underpricing is negligible, or the stock appears fairly valued to speculators, then management will have to follow through on its buyback program to send a stronger signal to the market.
To back this up they divide companies into two camps: those that did and did not follow through on announced open-market buyback programs between 1985 and 2012. They found that 24% of companies didn’t buyback any shares in the year following the original announcement and 13% didn’t repurchase any shares in the four year period following the announcement.
Smaller companies without much coverage benefit most from buyback announcements
The 24% that don’t repurchase, in addition to having higher abnormal returns and abnormal trade volumes following the announcement, had lower market caps, institutional ownership, analyst coverage, and advertising expenditures than the rest of the sample. Taken together, it looks like a group of companies that are undervalued simply because no one has been paying attention to them. Individual investors don’t typically have the resources to dig through small-caps at random hoping to find a great opportunity, and institutional investors don’t bother because even a big success on too small a scale doesn’t move the needle.
See full PDF here.