Do managers time the market ?

Evidence from open-market share repurchases

Konan Chan, Univ. of Hong Kong and National Taiwan Univ.

David Ikenberry, University of Illinois at Urbana-Champaign

Inmoo Lee, National University of Singapore

2006 NTU International Conference on Finance , December 2006

December 2006 Chan, Ikenberry, Lee 2

Motivation Managers seem to have timing ability in making

corproate decisions IPOs: Ritter (1991) SEOs: Loughran and Ritter (1995) (Stock) Mergers: Loughran and Vijh (1997) Repurchases: Ikenberry, Lakonishok, Vermaelen (1995) Spin-offs: Cusatis, Miles and Woolridge (1993) Splits: Ikenberry and Ramanth (2002) Equity share in new issues: Baker and Wurgler (2002)

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Motivation (continued) Two major concerns

Biased methodology Bad model problem: Fama (1998), Eckbo et al (2000) Wrong method: Brav et al (2000), Mitchell and Stafford (2000) Time dependence: Gompers and Lerner (2003) Statistical test: Brav (2000)

Pseudo market timing: Schultz (2003) Managers do not have timing ability and they make corporate

decisions solely based on past market performance This will mechanically create the pseudo performance

following managerial decisions

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Pseudo market timing (Schultz (2003))

Assume no abnormal return in each period Issue when prices are high Abnormal return occurs only when in event-time, but

not in calendar-time Poor-performed firms get more weight in event-time

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Pseudo market timing

Key implications of PMT Strong relationship between corporate events and past

market performance The abnormal returns, if there is any, exist only when

the event-time approach is used Debate

Support (Butler et al (2005)): return predictability of equity share in new issues is due to PMT

Against (Baker et al (2006)): PMT explains only a small portion of equity offering decisions

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Goal of this paper Examine whether pseudo market timing can

explain the share repurchases decision Check if key implications of pseudo market timing hold How much abnormal return can be explained by

pseudo market timing? Examine if the performance is affected actual buyback,

an indicator of managerial perception of undervaluation

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Why repurchases? Out-of-sample test: past studies of pseudo

market timing focus on IPOs Examine the major motive to buy back: mispricing

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Data Open-market repurchases (Chan et al (2004))

1980-1996: 5,508 obs Sample selection

Size BM Share price >= $3 prior to announcements

Actual repurchase Quarterly cash flow statement

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Buy-and-hold abnormal returns

Matching firms: control size, BM, stock exchange Poor performance prior to announcements Strong outperformance following buyback programs

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Relationship between number of repurchases and past market performance

Except the months in the highest past return quintile, there is no strong relationship between the number of repurchases and past market performance

One would expect to observe many obs when past return is low

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Num

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Past three-months market returns

# of Repurchases Sorted by Past 3-months Market Returns

EW VW

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Past six-months market returns

# of Repurchases Sorted by Past 6-months Market Returns

EW VW

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Calendar-time abnormal return Carhart (1997) four-factor model regressions Portfolios include firms announcing buybacks in past 4 years OLS assigns equal weight to each calendar month WLS uses # of obs as weight, and converts back to event-time

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BHARs condition on actual buybacks Actual repurchase

Non-buy: no buyback at all Buy-less: buy back <= 4% of shares outstanding Buy-more: buy back > 4% of shares outstanding

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BHARs condition on actual buybacks

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CAR using RATS based on Carhart model

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Conclusion Evaluate the key implications of PMT

Open-market repurchase decisions do not strongly depend on past market performance

Strong abnormal returns are still observed when the calendar-time approach is used

Evaluate the performance condition on actual buyback activity There is a strong relationship between actual buyback

and future performance The relationship is particularly strong in value firms

December 2006 Chan, Ikenberry, Lee 18

Conclusion (continued) Pseudo market timing can explain only a small

portion of return drifts following repurchases The share repurchase decisions do not seem to

be explained by pseudo market timing, but indicate the managerial timing ability