Share Repurchases as a Tool to Mislead Investors: Evidence from Earnings Quality and Stock Performance 2006 NTU Conference Konan Chan, David Ikenberry, Inmoo Lee, and Yanzhi Wang Presenter: Yanzhi Wang

Share Repurchases as a Tool to Mislead Investors 2/23 Outline Background Motivation Data Empirical results –Summary statistics, quarterly earnings announcement return, analysts forecasts revision, top-executive stock option, long run buy-and-hold return, operating performance, actual buyback status, factor model analysis, etc. To save time, not all of them would be presented. Conclusion

Share Repurchases as a Tool to Mislead Investors 3/23 Background Why is repurchase important? –Grullon and Michaely (2002) report that from , spending by U.S. firms on share repurchases grew at a rate of about 20% per year. This contrasts with the comparable growth rate in dividends of only 6%. –Compared to initial public offerings, aggregate repurchases over this period were nearly three times greater than the proceeds raised through IPOs. Stock repurchases have gained increasing popularity since The aggregate announced value amounts to $1,420 billion during , whereas 488 billion for IPOs.

Share Repurchases as a Tool to Mislead Investors 4/23 Background Why do firms announce repurchases? –Signaling undervaluation –Dividend substitute –Free cash flow disgorgement –Capital structure adjustment –Prevention of dilution from employee stock option –Defense against a hostile takeover

Share Repurchases as a Tool to Mislead Investors 5/23 Background How does the market react to repurchases? –In the short run, repurchase announcement gains significant AR of 1.79% –4 years post to repurchase announcement, long run buy-and-hold return is 15.6% –The positive AR provides the evidence that repurchase is a good news to the market.

Share Repurchases as a Tool to Mislead Investors 6/23 Motivation Do we knowingly learn why firms announcement repurchases? –In 1998, Institutional Investor reported survey results of CFOs as to why they repurchase stock. Among the various choices was the category “to support the stock.” –Open-market buybacks given the structural flexibility managers have to forego purchasing any shares, thus announcements might be like the form of “cheap-talk.”

Share Repurchases as a Tool to Mislead Investors 7/23 Motivation This inherent flexibility affords managers the chance to initiate programs, even if their intention to acquire stock is not based on a perception of misvaluation or some other value-enhancing motive. However, such measures of managerial intent are unobservable. Here, we consider earnings quality as a proxy for the propensity of managers to potentially mislead investors through a buyback program announcement.

Share Repurchases as a Tool to Mislead Investors 8/23 Empirical Finding This paper considers whether manipulation of investor expectations may be a primary factor in a sub-set of repurchase announcements where managers may be under pressure to otherwise support stock prices. We do this by focusing on firms with low earnings quality. Prior to the repurchase announcement, these low earnings quality firms are desperate to take some actions, and may serve open market share repurchase announcement as an inexpensive means to send a false signal to the market.

Share Repurchases as a Tool to Mislead Investors 9/23 Empirical Finding Initially, the market does not seem to pay attention to earnings quality when buyback programs are first announced, which suggests a pooling equilibrium. However, the stock returns of firms with low earnings quality do not outperform in the long- run. The operating performance of these firms even shows clear evidence of deterioration after the announcement. These evidences are consistent with our manipulation story. We also check other possibilities in explanation of what low earnings quality firm behaves; as a result, our hypothesis is the most consistent explanation to the empirical results.

Share Repurchases as a Tool to Mislead Investors 10/23 Issue To investigate the misleading intend of buyback programs, some key questions of interest are: Q1: Given that we cannot directly verify managerial intent, is there any evidence which suggests that the managers of buyback firms with low earnings quality are under pressure to boost stock prices?Q1 Q2: Do we find any evidence that investors recognize this pressure and react accordingly?Q2 Q3: Is the operating and long-run stock return performance of suspect buyback firms worse compared to the generally favorable case?Q3

Share Repurchases as a Tool to Mislead Investors 11/23 Data We form a sample of open-market repurchase announcements from two sources: Wall Street Journal Index for the period , and Securities Data Corporation (SDC) which begins comprehensive coverage in To reduce time clustering, we eliminate announcements that occurred in the fourth quarter of We exclude firms whose share price at the time of repurchase announcement is below $3 to avoid the skewness of the long term return. The final sample includes 7,628 separate cases.

Share Repurchases as a Tool to Mislead Investors 12/23 How to Observe the “ pressure ” ? Regarding the question why earnings quality could proxy the managerial intent, we argue low earnings quality firms suffer pressure and accordingly take some actions (like buyback shares announcement). The pressures we observe include: –Prior AR- low earnings quality and with poor prior performance firms (High-L group) –Quarterly announcement return –Analysts forecasts revision –Top-executive stock options holdings

Share Repurchases as a Tool to Mislead Investors 13/23 Operating performance

Share Repurchases as a Tool to Mislead Investors 14/23 Quarterly earnings ann. return

Share Repurchases as a Tool to Mislead Investors 15/23 Analysts forecasts revision

Share Repurchases as a Tool to Mislead Investors 16/23 Stock option of top-executives

Share Repurchases as a Tool to Mislead Investors 17/23 Answer to Q1 Q1 Overall, the evidences here are consistent with the idea that managers in high DA firms in our sample may have been under pressure to reverse an otherwise negative trend in market events, for example, the quarterly announcement return and analysts’ forecast. From the view of stock options, top-executives of low earnings quality firms both hold pessimistic prospect and have greater incentives to lift the stock price up, which is again consistent with the idea above.

Share Repurchases as a Tool to Mislead Investors 18/23 What ’ s the market reaction? In the short-run, we find that, consistent with the evidence regarding earnings myopia, the market does not sort out differences in earnings quality across buyback programs as they are announced. In both high and low earnings quality firms, the initial market reaction is about the same, slightly higher than 2% (shown in Table 1). This provides the answer to our Q2.Table 1 Q2 The result still holds even we control the other factors. This support a pooling equilibrium of open market share repurchase announcement.

Share Repurchases as a Tool to Mislead Investors 19/23 Announcement Return Regressions

Share Repurchases as a Tool to Mislead Investors 20/23 Long run performance The low earnings quality firm who has the pressure to lift its stock price intently announces share buyback; since this repurchase announcement doesn’t signal the good news, accordingly we argue the performance of the low earnings quality firm will not improve even deteriorate in the long run. Two measures of long run performance are examined: the long run buy-and-hold return and abnormal operating performance.

Share Repurchases as a Tool to Mislead Investors 21/23 Long run buy-and-hold return

Share Repurchases as a Tool to Mislead Investors 22/23 Abnormal operating performance

Share Repurchases as a Tool to Mislead Investors 23/23 Answer to Q3 Q3 To the extent that a sub-set of buybacks is manipulative in intent, we do not observe any material long-term abnormal performance for low earnings quality firms, either operationally or measured by stock performance. This contradict to the traditional signaling hypothesis suggesting outperformance of repurchase announcement.