What Buybacks Do To Stock Prices
from May/June 2006
Big buybacks used to be a pretty reliable signal that a company’s stock would outperform the market for the next few years. Fortune magazine made that discovery in a study it did back in 1985, and a shelfful of academic studies have confirmed the finding in the years since. But academics have lately found that the world of buybacks has changed in important ways. The latest evidence: While the stocks of some types of repurchasers still outperform the market following buybacks, most do not.The most interesting recent work on this subject was done by Theo Vermaelen and Urs Peyer of the INSEAD business school in France. Studying buybacks that happened through 2001, Vermaelen and Peyer found that stocks of companies making open-market repurchases outperformed the market only if they met two criteria: The stock performed poorly in the six months before the announcement, and management said it was buying because the shares were undervalued or were “the best use of the money.”
Stocks of companies making open-market repurchases that didn’t meet those criteria (about 95% of the total) held no special magic for investors. In addition, big returns were limited to small companies; their stocks, on average, outperformed the market by 50 percentage points over the following four years. The largest outfits showed modest outperformance, but it was not statistically significant, and there were plenty of duds. In the 18 months after Microsoft said it would repurchase $30 billion of its shares, the stock price rose just 5.3%, compared with a 13.8% rise in the S&P 500. And Intel’s share price dropped 17% in the three months following its announcement of a $25 billion buyback.
One reason for the change in stock-market results seems self-evident: Wall Street is not Lake Wobegon, so it’s impossible for everyone to be above average. The deeper reason is a sea change in the motives for repurchases. It used to be that most big buybacks were done by managers who believed that their shares were seriously undervalued, or by companies conducting major restructurings or leveraged recapitalizations. The announcement of a buyback would send the shares up by several percentage points, but usually no more than that. Investors took buybacks as a positive sign but in most cases weren’t fully convinced that management was right—or that it was telling the whole truth. As a result, the average buyback stock would outperform the market for several years only if, as was often the case, the company’s performance confirmed management’s optimism.
Bear in mind that it was not the repurchase itself that caused stock to outperform. Rather, it was the tax savings from substituting debt for equity in a leveraged recapitalization, or improvements in operating results from a restructuring, or the simple fact that management was right in believing that the company’s prospects were better than investors perceived and warranted a higher valuation.
