Identifying economic shocks with stock repurchase programs

Hamouda, Foued Article Identifying economic shocks with stock repurchase programs Cogent Economics & Finance Provided in Cooperation with: Taylor & Francis Group Suggested Citation: Hamouda, Foued (2021) : Identifying economic shocks with stock repurchase programs, Cogent Economics & Finance, ISSN 2332-2039, Taylor & Francis, Abingdon, Vol. 9, Iss. 1, pp. 1-15, https://doi.org/10.1080/23322039.2021.1968112 This Version is available at: https://hdl.handle.net/10419/270144 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Submit your article to this journal Article views: 1985 View related articles View Crossmark data FINANCIAL ECONOMICS | RESEARCH ARTICLE Identifying economic shocks with stock repurchase programs Foued Hamouda 1 * Abstract: This paper aims to identify economic shocks in four developed countries that authorize different buyback programs. Previous research has revealed that there are few public debates about buyback activities and economic conditions. According to the free cash flow hypothesis, the total payout policy is in line with the real economy of each country. Using linear and non-linear bivariate causality tests, we find that buybacks and industrial production are endogeniously determined. In Japan, prior buyback programs indicated a change in economic growth. However, in the United States, changes in economic growth will increase repurchase activity before the financial crisis. This finding is interesting because it supports the idea that repurchase programs are a significant factor in determining economic shocks. It has extended and confirmed the knowledge and perception that stock repurchases could be used by financial economists to predict economic shocks. Subjects: Development Economics; Corporate Finance; Industry & Industrial Studies Keywords: industrial production; payout policy; buyback; business cycle; financial crisis 1. Introduction Why firms repurchase stocks have been a puzzle for more than 20 years. Firms have two ways of distributing liquidity to their shareholders; dividends or share repurchases. Without a doubt, shareholders will prefer the least expensive method that provides them with greater satisfaction. Unlike dividend, stock repurchase is a financial transaction in which firms offer to buy back a specific number of shares from their shareholders at a price that is generally higher than the market price. Many practitioners have questioned why firms are repurchasing shares and how this repurchase affects investors’ wealth. For example, according to the tax assumption, firms frequently use buyback programs to provide ABOUT THE AUTHOR Foued Hamouda is an assistant professor (and HDR) in the Accounting and Finance Department of Gabès University (Tunisia) and the Director of the “Observatory of Tunisian Southeast Companies”. His research interests include share buyback, insider trading, statistic modeling, corporate governance and risk management. He also serves as a volunteer reviewer of research projects with the Ministry of Higher Education. He has a number of publications (articles and book) in the field of accounting and finance. PUBLIC INTEREST STATEMENT This study aims to determine if buyback programs, and economic shocks are related. We employ linear and nonlinear causality between buyback programs and business cycle for the period of 1998–2016 using data from four developed countries. Our results show that buyback programs facilitate our knowledge of rapid economic growth change. With a focus on Japan, country that do not seem to promote buyback activities due to a number of barriers, prior buyback programs indicate a shift in economic growth. However, in the United States with a mature market, change in economic growth will boost repurchase activity. Since this research was conducted in major developed countries, it can be replicated and validated in other developing countries. Hamouda, Cogent Economics & Finance (2021), 9: 1968112 https://doi.org/10.1080/23322039.2021.1968112 Page 1 of 15 Received: 24 December 2020 Accepted: 08 August 2021 *Corresponding author: Foued Hamouda, URRED-Higher Institute of Management of Gabès, Rue Jilani Habib 6000 Gabès- Tunisia, Gabès University E-mail: [email protected] Reviewing editor: David McMillan, University of Stirling, Stirling United Kingdom Additional information is available at the end of the article © 2021 The Author(s). This open access article is distributed under a Creative Commons Attribution (CC-BY) 4.0 license. shareholders with a lower tax rate than dividends (Grullon & Michaely, 2002). As a result, shareholders receive an income (known as a capital gain) taxed at a lower rate than a dividend. Repurchases can also signal to the market that future revenues will be higher than anticipated. It can also signal that a firm’s shares are undervalued. Firms can buy back shares to report this undervaluation, which is not possible with dividend distribution. Furthermore, firms can use repurchase when they have excess cash flows that far exceed investment opportunities and reflect weak economic prospects. According to this hypothesis, multiple conflicts between directors and shareholders could arise. There is a high risk that executives will invest this cash flow in unprofitable (negative NPV) projects that do not maximize shareholder value. Repurchase programs can provide information that executives are not going to invest in unprofitable projects. As a result, repurchase programs will give a firm greater flexibility over dividends with multiple advantages. Given this flexibility, it is not hard to understand why firms repurchase stocks. However, stock repurchase has considerably evolved, especially following several stock market crashes or distress (e.g.: October 1987, 2007–2008 crisis) and during other periods, this growth was even higher. For example, the S&P 500 companies paid out more than 100% of their free cash in repurchase in 2019. According to Murphy (2012) “ . . . Buybacks surged to a record $180 billion in the fourth quarter of 2007 . . . ”. Firms spent about 26% of their total annual earnings on repurchases between 1984 and 2000 (Grullon & Michaely, 2004). After the September 11th attack, 329 companies made buyback announcements (September 12–28) compared to 565 before September 12th (Gu & Schinski, 2003). Thomson Financial’s aggregate data shows that firms that made up the S&P500 index in 2003 bought back $284 billion of shares and then $973 billion in 2006. In 2018 alone, they did a combined $806 billion in buybacks, and about $200 billion more than the previous record set in 2007. Overall, all these studies show a staggering upsurge in the magnitude of repurchases around financial distress. In this regard, repurchase programs determine what funds flow to investors and what funds are paid as dividends. It provides information about firm performance and the nature of the signal sent to the market (Comment & Jarrell, 1991; Fried, 2001; Ikenberry et al., 1995; Stephens & Weisbach, 1998). Since, the pioneering work of Lintner (1956); Millert and Modiglinit (1961) who put down the foundation for the modern understanding of payout policy, empirical and theoretical models have described repurchase as part of the free cash flow (Jensen, 1986) or the signaling hypothesis (Vermaelen, 1981). Between 1999 and 2000, expenses of industrial companies on share buybacks exceeded, for the first time, those allocated in dividends. Research on buyback programs is weak compared to dividend distribution. Research on buybacks has predominantly focused on their impact on corporate performance (Chan et al., 2004; Chen et al., 2018) and shareholders’ value (Manconi et al., 2019), particularly in the financial crisis when economic growth is weak. These studies underline the importance of the buyback to stabilize prices. Lambrecht and Myers (2012), for example, argue that buyback programs would be used when there are unexpected increases in free cash flow and that a positive economic shock should therefore correspond to a share repurchase increase. In this context, Bhabra and Luu (2015) showed that exogenous shocks to growth opportunities cause payout policy to change significantly, particularly with stock repurchase. Most of the current evidence supports the idea that repurchases have given managers more freedom to pay cash dividends on more stable terms and to repurchase in unstable conditions. Grullon and Michaely (2002) show that repurchases have become an important form of payout for corporations, but firms finance their buybacks with funds that otherwise would have been used to increase dividends. Accordingly, these studies show little public policy debate in the United States (US) and worldwide on repurchase activity and its implications for value creation, employment, income distribution, and economic growth. Straehl and Ibbotson (2017) show that it is statistically impossible to distinguish the long-run total payout growth rates from the macroeconomic growth rates. The authors find that the total payouts grow in line with the real economy. Similarly, Ibbotson and Chen (2003) show that earnings per share growth for US stocks is in line with US Gross Domestic Hamouda, Cogent Economics & Finance (2021), 9: 1968112 https://doi.org/10.1080/23322039.2021.1968112 Page 2 of 15 Product (GDP) per capita. In the same vein, Bernstein and Arnott (2003) show that during the twentieth century, a relationship has existed between net buyback and economic growth. Recently, Wang (2020) shows how repurchase programs grow in unconventional monetary policy. In this study, we seek to look for the relationship that may exist between buybacks and economic conditions according to the free cash flow and the signaling theory. When the economy is running below capacity, firms may distribute their cash flows differently to residual claimants compared to a higher or a booming state (Benartzi et al., 1997). In the environment of the Global Financial Crisis (GFC), markets are either stagnating or slowly recovering. In contrast, in a booming economy, firms experience abnormal increases in excess cash flow. This economic instability may encourage firms to prefer repurchases to dividends. Yet, many practitioners continue to rely on traditional models using dividends as a unique source of payment for corporate payouts. Firms are more likely to conduct investments in a bullish market period and a stock buyback in a bear market when economic conditions are unfavorable. However, the two payout methods are similar because, as dividend payments reduce retained earnings and hence common equity, repurchases are a direct reduction in the outstanding amount of common equity. Previous research has documented that buybacks generally vary more over time than dividends, and they are used more frequently with volatile earnings, particularly following periods of higher-than-expected profitability. All this supports the idea of a relationship between buybacks and economic conditions. In most cases, firms repurchase shares using the free cash flow or the conversion of stock options. According to the Free cash flow theory, firms will have the financial resources when investment opportunities are rare. This situation happens during periods of low economic activity, especially for large firms. As a result, we anticipate a significant relationship between buybacks and economic growth. We aim to show that these two variables have a causal relationship. We expect a rapid increase in buyback programs to signal the start of an economic slowdown because firms in this situation are confused about where to spend their free cash flow. Likewise, we also predict a business cycle slowdown as a result of inadequate investment opportunities, which pushes firms to buy back their shares. Consequently, our two hypotheses are: H1: The increase in buyback programs indicates a change in economic growth. H2: The fall in economic growth will cause an increase in repurchase decisions. This article contributes to the literature by analyzing the repurchase activity and business cycle in the United States (US), Canada (CAN), the United Kingdom (UK), and Japan (JAP) using nonlinear causality tests. First, we seek to understand how business cycles and repurchases are mutually determined. Second, we want to identify why, during the economic recession, major firms experienced different buyback decisions. 1 Usually, firms in developed markets repurchase their shares during the Financial Crisis period. In other words, we investigate the relationship between repurchase programs and business by relying on nonlinear bivariate causality tests where repurchase and business cycle are endogenous. Our methodology has the merit to identify indirect causalities between the two variables. It is important to understand the aggregate buyback program, particularly in financial crisis and take into consideration both earnings and the overall economy. If repurchase occurs in a wave, we predict a shortfall in the economic conditions in developed economies. Such an empirical exercise has not yet been conducted and remains largely unexplored. Specifically, this study explains some recent empirical research (Farrugia et al., 2011; Huang et al., 2017; Liang et al., 2013). The analysis reveals a nonlinear causality between repurchases and business cycle during 1998–2016 and, to a certain extent, after the 2007–2008 financial crisis in Japan, Canada, and the UK. In the US, Hamouda, Cogent Economics & Finance (2021), 9: 1968112 https://doi.org/10.1080/23322039.2021.1968112 Page 3 of 15 however, there is no evidence that buybacks and business cycles cause each other. This finding indicates that countries have different legislation, resulting in substantial differences in how buybacks are used, especially during the financial crisis. In the US, for example, we show massive use of buybacks even after the 2007–2008 financial crisis. In other countries, however, we conclude that firms use buybacks preceding a period of instability. This finding confirms that the financial crisis played a big role in increasing the cost of external financing and, hence, many firms tend to boost their payouts in the form of repurchases. The paper is organized as follows: Section 2 describes the data and outlines the empirical methodology. Section 3 discusses empirical results. Section 4 presents robustness checks and gives implications. Section 5 concludes the paper. 2. Data and methodology 2.1. Sample construction We employ monthly data from four developed economies (Canada, Japan, the United Kingdom, and the United States) for two reasons. According to previous studies, the buyback decision is usually announced in a developed market rather than in a less developed market. Second, our choice appears to be reasonable, because we want to know how these programs are used in countries that encourage buybacks, such as the United States and Canada, as well as countries that have strict rules before allowing firms to repurchase (such as Japan and the United Kingdom). Many countries prohibit repurchases and allow firms to repurchase only under certain conditions. 2 The choice of the above sample can improve our understanding of the stock repurchase volume before and after economic shocks. Our dataset is derived from the Thomson Financial DataStream between 1998 and 2016. The analysis relies on accurate measurement of stock repurchases. The measure is computed from the value of the “Purchases of Common and Preferred Stock” from the Worldscope Cash flow statement for the US, Canada and UK. This is the standard proxy developed by Stephens and Weisbach (1998). It is the funds used to decrease the outstanding shares of common and/or preferred stock. 3 This measure is a reasonable proxy that should capture the movements in buyback activity. Because Japan prohibited repurchases before 2001, we collected repurchase decisions from “Treasury shares” available in Financial Statements Statistics of Corporations by Industry and this data is available after 2004. 4 Similar to Stephens and Weisbach (1998), we compute the number of shares repurchased assuming that the shares were purchased at either (1) the average closing price or (2) the lowest price. Because stock repurchase is a rare decision, we collect all repurchases made by all firms in the corresponding country. On the other hand, the business cycle is presented by the total industrial production growth rate as suggested by Hamilton and Lin (1996). These data are derived from the The Organisation for Economic Co-operation and Development (OECD) dataset. Industrial production rate (IPR) is used in log term and computed as follows: Ln IPR tð Þ½ � ¼ ln IP tð Þ  ln� ½IP t 1ð Þ½ � (1) Where IP(t) is the Industrial Production on quarter t. Focusing on data characteristics and because buyback is a rare decision, we used the quarter rate of de-seasonalized buyback because of the seasonal characteristics of the series and on the restrictions placed in some countries. To make the series stationary, the first difference on repurchase data was used. Figure 1 shows the total industrial production index for the US, Canada, Japan, and the UK. As provided in this figure, we found a pronounced decrease in the industrial production growth rate of all countries (2 shaded areas) 5 ; The first, in 2001 and the second in 2009. Results based on autocorrelations and partial autocorrelations graphs show that buyback data exhibits seasonal Hamouda, Cogent Economics & Finance (2021), 9: 1968112 https://doi.org/10.1080/23322039.2021.1968112 Page 4 of 15 behavior. For this reason, we used the fourth-quarter differences to remove the seasonal influence. According to the augmented Dickey and Fuller (1979) unit root tests, some series are stationary (when only seasonally adjusted). Accordingly, there is no need to differentiate the series to make them stationary 6. Figures 2 and 3 illustrate the buyback growth rate in the full sample. Because Japan did not have sufficient data before 2007, we presented only figures after this date. We observe in Figures 2 and 3 two different breaks: the first in 2001 and the second in 2009 (in accordance with the industrial production growth rate). Therefore, we suggest that in the developed market, firms used buyback programs during the Global Financial Crisis (GFC) and we can ask how economic conditions and buybacks are related. As a result, we looked at causality before the GFC and for the entire sample to see whether buyback programs would detect economic shocks in the post-crisis period. 2.2. Methodology We developd our empirical analysis of the relationship between buybacks and business cycle using the linear Granger causality test. We are interested in whether buyback decisions lead to change in business cycle, or whether economic shocks lead to buyback activities. Because we’re interested in the “incremental predictability” of these variables, a Granger causality model looks like a good fit for our research. Granger causality can be modelled as follows: BCt¼∑ n j¼1 αBCtjþ∑ n j¼1 θREPtjþεt(2) Figure 1. Industrial Production Growth rate. This figure depicts the Industrial Production Growth rate (in log) for the United States, United Kingdom, Canada and Japan between 1998q1 and 2016:q4. Hamouda, Cogent Economics & Finance (2021), 9: 1968112 https://doi.org/10.1080/23322039.2021.1968112 Page 5 of 15 REPt¼∑ n j¼1 ωREPtjþ∑ n j¼1 #BCtjþεt(3) Figure 2. Stock repurchase growth rate. This figure depict stock repurchase growth rate computed as „ „Purchase of common and preferred stock divided by the lowest price during the quarter between 1998:q1 to 2016:q4 . Data for Japan was NA before 2006. Figure 3. Stock repurchase growth rate. This figure depict stock repurchase growth rate computed as„ „Purchase of Common and Preferred Stock divided by the monthly average price during the quarter between 1998:q1 to 2016:q4. Data for Japan was NA before 2006. Hamouda, Cogent Economics & Finance (2021), 9: 1968112 https://doi.org/10.1080/23322039.2021.1968112 Page 6 of 15 where BC is the business cycle, REP is the shares repurchased, and nis the optimal lag length based on the Akaike information criterion (AIC). All variables are in log and the εtsare the residual terms supposed to be white noise. Therearefourpossibleoutcomesfromtheanalysis: (1) Repurchase REPð Þ granger causes Business Cycle BCð Þif;in equation1;∑θ�0; (2) Business Cycle BCð Þgranger causes Repurchase REPð Þif;in equation2;∑#�0; (3) bi directional Granger causality if both 1ð Þand 2ð Þhold;or (4) no Granger causal relationship betweenBC and REP;ifneither 1ð Þnor 2ð Þistrue: 3. Empirical result and discussion Our methodology produces a total of 6 VARs estimated for each of Canada, the UK and the US and of four VARs for Japan. The results of the causality tests are reported in Table 1 and indicate a little evidence of bidirectional causality between the buyback and business cycle for the full sample period except in Japan. This finding is in line with Japan’s strict regulatory regime, which prohibited repurchases prior to 2001, (Kobayashi & Irome, 2001) and suggested that the inclusion of the financial crisis lead to stronger relationships. Thus, the distinction between pre- and post-financial- crisis periods is significant. Whereas in Canada and the US we strongly share a causality running from the business cycle to repurchase before 2007, it is different for the other regions. Specifically, we can observe significant causal relationships in the US suggesting that the business cycle is an important explanatory variable of buyback decisions and firms may consider buybacks as a tool to absorb the negative effects of the financial crisis. This is why buybacks are commonly used by US firms. The direction of causality is unidirectional and statistically significant at 5% level. As A.K. Dittmar and Dittmar (2008) explain, “ GDP growth has positive and significant power for predicting future repurchase activity.” A different picture arises when we consider the sub-period after 2007. Business cycle does not Granger causes repurchase in the United States because there is no motivation for firms to buyback after the financial crisis. As suggested by Liang et al. (2013) and A.K. Dittmar and Dittmar (2008) the motivations during the financial crisis period could be entirely different than longer sample periods and repurchases essentially depend on the firm’s life cycle stage. In Canada, it should be clear that, unlike other countries, we make no distinction between the pre and post-financial crisis, i.e. business cycle Granger causes repurchase. This means how persistent and strong the relationship is. It is clear that this result could be due to the strained ties between the free cash flow and the decision to repurchase. Straehl and Ibbotson (2017), for example, show that the total payouts (dividend and repurchase) and GDP grew at roughly the same annualized rate of 3.27% and 3.36% respectively. In the United Kingdom, however, business cycle coefficients on repurchase are also positive, but not statistically significant. This finding could be due to the timing of the repurchase. In the UK, firms may use of repurchase programs for different purposes other than to distribute the free cash flow. It should be clear that in Canada and the United States, there is no causal effect of buyback on the business cycle. We found relatively weak evidence that repurchase Granger cause business cycle. 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Journal of Hamouda, Cogent Economics & Finance (2021), 9: 1968112 https://doi.org/10.1080/23322039.2021.1968112 Page 14 of 15 Financial Economics, 9(2), 139–183. https://doi.org/ 10.1016/0304-405X(81)90011-8 Wang, L. (2020). Unconventional monetary policy and stock repurchases: Firm-level evidence from a comparison between the United States and Japan. Research in International Business and Finance, 51, 101091. https://doi.org/10.1016/j. ribaf.2019.101091 © 2021 The Author(s). This open access article is distributed under a Creative Commons Attribution (CC-BY) 4.0 license. You are free to: Share — copy and redistribute the material in any medium or format. Adapt — remix, transform, and build upon the material for any purpose, even commercially. The licensor cannot revoke these freedoms as long as you follow the license terms. Under the following terms: Attribution — You must give appropriate credit, provide a link to the license, and indicate if changes were made. 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