A thing I used to do was go to companies and try to convince them to do various exotic flavors of share repurchase. This is in outline a thing that all bankers try to do – go to companies and (1) try to get them to do things and (2) if that’s going well, upsell to exotic flavors of those things – but the share repurchase angle is a challenging one because companies are universally and irremediably bad at share repurchase and everyone knows it. There are so many studies and they all basically say “you are dopes, stop buying back shares, you always buy at peaks and then sell at troughs, please for the love of God stop.” This is not really surprising: executives are by nature confident types, for one thing, so it’s a rare CEO who declines to buy his own stock on the grounds that it’s overpriced; for another, buyers buy things when they have lots of cash and feel rich, and shares are cheap when the issuer is running out of money and feels poor, so when the buyer and the issuer are the same you’ve sort of autocorrelated yourself into shittiness.*
Or so I thought. There is however an alternative explanation for why companies buy back shares that I have been giggling over for the last hour, and it is: because their managers are actually good at market timing and are sneakily insider trading for their own account through the corporation. Or so says Harvard Law professor Jesse Fried:
Not surprisingly, insiders use control of the firm to engage in indirect insider trading. Insiders acknowledge using repurchases to buy stock they believe to be underpriced and equity issuances to sell stock they believe to be overpriced. There is also a substantial body of empirical work in the finance literature documenting that repurchases and equity issuances are frequently driven by insiders’ desire to indirectly buy stock at a low price or sell stock at a high price.
Such indirect insider trading is likely to impose considerable costs on public investors in two ways. First, just like ordinary (“direct”) insider trading, indirect insider trading secretly redistributes value from public investors to insiders. To be sure, much of the indirect insider trading profits generated by firms are shared with public investors. But on average, public investors lose, and insiders systematically profit — to the tune of several billion dollars per year.
The theory is that (1) insiders make companies buy undervalued stocks, (2) that transfers wealth from public shareholders (who sell stocks that are undervalued by $X) to the insiders (who own on average 20% of the companies) as well as other public shareholders (who own the other 80%), and (3) therefore companies should disclose their purchases within two days, as insiders do, so that transfer of wealth won’t happen.
Like I said, I giggled over this for a while, since my impression was that companies tend to buy mostly overvalued stocks, in which case this theory would imply that such repurchases are actually a transfer of wealth from insiders (and other public shareholders!) to public shareholders with enough sense to sell into a share repurchase, so, yay? But actually the evidence is mixed-ish so my giggling was childish and stupid and you should believe what you want, though I’ll be sticking with my opinion until the moment I go back to flogging corporate share repurchases.**
I enjoyed Fried’s paper not only because it’s heartwarming to see someone who thinks that corporate insiders are competent at capital management but also because it rubs uncomfortably against two of my little conceptual obsessions. One is: when is your own intention to buy stock material nonpublic information, and when are you restricted from trading on it? We talked about one version of that question last week – a debate between activists and corporate interests over how much freedom activists should have to secretly build stakes in companies – and I mentioned then that corporations generally need to disclose their own intentions to buy back shares, so no one will be blindsided, and that that’s kind of weird because the only material nonpublic information there is their own intention.
But Fried comes from the other direction: he thinks that those disclosures – which, as he says, are pretty vague and don’t need to disclose anything particularly useful about size and timing of buybacks – are insufficient to give public holders a heads-up that their managers will be buying their stock because they think, in their wisdom or lack thereof, that it’s undervalued. And since he hypothesizes that buyback decisions are actually driven by management’s actual consideration of actual material information – not just their own desire to buy stock but actual information about the company’s prospects that they know and no one else does – then the real-time specific disclosure of that information is a good way to keep public shareholders informed and prevent insider trading.
Is that true? I dunno. In theory companies are supposed to disclose all their material nonpublic information before buying stock, though in practice the project-that-is-a-glimmer-in-the-CEO’s eye is never disclosed but may in hindsight look material. But you could extend that theory: if Bill Ackman is buying a big stake in J.C. Penney, he probably knows something that you don’t, something other than “I like J.C. Penney for no reason at all,” so why not make him disclose earlier and oftener? If your rule is “everyone who might know something needs to disclose all their trading,” that is a way stricter insider trading regime than we have now, and one with uncomfortable consequences for capital allocation.
My other little obsession is: if you’re a believer, as most people are, that corporations should be managed for the benefit of shareholders, what is a “shareholder”? If you’re the sort of fair-weather shareholder who sells out when the company’s buying – should the company be managing for your benefit? Or should the company be punching you in the face as much as is consistent with the letter of the law, in order to maximize value for the shareholders who stick around?*** (There is also the opposite question: if the company is selling shares, what are your duties to existing versus future shareholders? This is of interest perhaps to venture-backed tech IPO candidates thinking about lockups, for instance.)
If the answer is “management should work for shareholders, both those who want to stay and those who want to sell” – then isn’t that weird? Doesn’t that imply that the company should only buy back stock when it’s exactly correctly valued? (Or, equivalently, that it should never buy back stock, and just pay dividends when it has extra cash lying around?) If on the other hand the answer is “management should work for the company, and maximize the value of the enterprise,” then that implies that you do whatever you legally can to buy stock cheap from non-believing shareholders. That sounds a little more palatable to me.
Insider Trading via the Corporation [Harvard Law and SSRN]
* NEEDLESS TO SAY through my own diligent efforts and insights, as well as the cyclical timing quirk of stocks now being higher than they were at basically any point in my Wall Street career, all of my share repurchase programs worked out swimmingly, he said without checking.
** Here is where I casually Google the evidence and then present it in a biased way. There’s this McKinsey study that found that only 31% of buybacks from 2004 to 2010 earned a positive return. There’s this Fortuna Advisors claim that “Over the last decade, in fact, companies that spent the most on repurchases had a total shareholder return of 37 percent versus 127 percent for companies that spent the least.” There’s this Thomson Reuters study of S&P 500 companies that “found that repurchases were weakly to moderately negatively correlated with future returns” (and that is the source of the chart above). Also Warren Buffett agrees with me.
On the other hand, Fried’s paper cites a previous paper of his, which says “Recent studies have found that firms announcing repurchase programs and then repurchasing shares within the first year exhibit cumulative abnormal returns of 20% to 25% in the four years following the announcement,” based on a study looking at buybacks from 1980 to 1996. So maybe things have just changed? (See this paper, which finds a ton of buybacks right after the 1987 crash: different times, man, no one was buying back stock in 2008. I guess: volatile markets are good for timing efforts, end-of-the-world-hoard-your-cash volatile markets are bad.) Or maybe the time frame is the difference: companies are terrible market timers, but a company doing a buyback today is more likely to be in good shape in 4 years than one not doing a buyback today? If so … I mean, do you call that insider trading?
*** Again, I think Warren Buffett is quotable here:
There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds — cash plus sensible borrowing capacity — beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively-calculated. To this we add a caveat: Shareholders should have been supplied all the information they need for estimating that value. Otherwise, insiders could take advantage of their uninformed partners and buy out their interests at a fraction of true worth.
In other words: don’t trick the sellers, but if they’re willing to sell below intrinsic value, go ahead and buy, you don’t owe them anything but honesty.