Posted by: Aaron Pressman on May 16, 2007
There’s a fascinating new academic paper mentioned over on hedge fund manager Victor Niederhoffer’s blog about possible monkey business in stock buybacks. Companies that buy back their own shares have been found to outperform the market subsequently. But why is that? Three researchers at Pennsylvania State University, assistant professors Guojin Gong, Henock Louis and Amy Sun, studied (PDF file) some 1,720 share buy backs made from 1984 through 2002, looking at companies’ earnings reports before and after the transactions. The study only included open-market buy backs where the total dollar value was at least 1% of a company’s market value.
The results may surprise — and could point to the next chapter in the ever-lengthening book of corporate scandals and manipulations. The researchers found strong evidence that companies manipulated their earnings downward prior to buy backs. This kind of reverse earnings management would tend to depress a company’s stock price and allow more shares to be retired. And after the buy back, earnings bounced right back. With more shares retired, companies got a bigger pop in improving earnings per share.
Finding earnings manipulation is no small task but there’s a growing body of academic literature. One method researchers focus on a firm’s return on assets compared to similar firms and look for short-term deviations not experienced by the peer group. After crunching the data, they found that quarterly returns of companies buying back shares were, on average, 0.57% lower (measured as a percentage of a company’s total assets) than normal just before the repurchase announcement while returns at similar companies not doing buy backs were 0.06% higher than normal on average in the same quarters. Diving in deeper, the researchers found that the more shares bought back (as a percent of all shares outstanding), the greater the amount of apparent earnings manipulation.
Now it could be that there is correlation here but not causality. In other words, maybe firms that have bad earnings or suffer poor performance are more likely to buy back shares in larger quantities. If that’s the explanation, then there is nothing nefarious about the correlation. The researchers tried to address that issue in a couple of ways. They threw out any examples with companies undergoing restructuring and found the correlation still held. They also compared the pre-buyback operating performance of companies that did share repurchases to average performance in their industries. They found that share repurchasers actually had better than average operating performance before engaging in buybacks. And looking at the two years before and two years after a buyback, they found that companies were much more likely to suffer these bouts of poor earnings just before a buy back. All in all, it looks pretty fishy.