Do Share Buy Back Announcements Convey Firm Specific or Industry-wide Information? A Test of the Undervaluation Hypothesis

Transcription

1 1 Do Share Buy Back Announcements Convey Firm Specific or Industry-wide Information? A Test of the Undervaluation Hypothesis Isaac Otchere * & Matthew Ross Centre of Financial Studies Faculty of Economics and Commerce The University of Melbourne VIC 3010 Australia * Corresponding author: iko@unimelb.edu.au Tel: (61) , Fax: (61)

2 2 Do Share Buy Back Announcements Convey Firm Specific or Industry-wide Information? A Test of the Undervaluation Hypothesis Abstract In this paper, we examine the information content (firm specific) and information transfer (other firm) effects of share buy back announcements using a unique Australian data where the stated reason for the buy back is undervaluation of the firm's stock price. Consistent with the US studies, we find that such share buy back announcements signal positive information about the announcers and their rivals, suggesting that both the announcing firms and their industry rivals were previously undervalued by the market. The results show that while shareholders of firms announcing share buy backs that are motivated by undervaluation of the share price earned statistically significant abnormal returns of 1.25% on the announcement day, the shareholders of rival firms earned significant abnormal returns of 0.39% on day +2. The market reaction of industry counterparts thus appears to occur with a lag. For the three days surrounding the announcement, announcing firms' shareholders earned a statistically significant abnormal return of 4.30%, while rival firms' shareholders earned abnormal returns of 1.39%. Consistent with our conjecture, we find that the magnitude of the abnormal returns of the share repurchases that are motivated by undervaluation of shares are larger than have been documented for these US market where managers are not legally required to disclose the motives for the share repurchase. We also examine whether the first share buy back announcement in the industry or in a buy back program conveys more information than subsequent announcements but we do not find any significant results. The degree of similarity in cash flow and investment opportunities between the repurchasing firms and their industry counterparts, and the degree of competition within the industry significantly explain the variation in the observed industry (information transfer) effects. Keywords: share buy backs, contagion, competitive, information transf er, undervaluation JEL Classification: G14, G35 Acknowledgments: We gratefully appreciate comments and suggestions from the participants at the 2000 Northern Finance Association (NFA) Conference in Waterloo, Canada, 2000 PACAP/FMA Conference in Melbourne, Australia, 2000 Asia Pacific Finance Association (APFA) Conference in Shanghai, China, and seminar participants at the University of Tasmania School of Accounting and Finance.

3 3 1. INTRODUCTION Share buy backs have become one of the most popular equity management tools in recent years, especially in the US and increasingly in Australia. For example, Bagwell and Shoven (1989) report that share repurchases increased from 12% of total cash payouts before 1984 to 31% of total cash payouts from 1984 through to Ikenbery, Lakonishok and Vermaelen (1995) also report that the value of share repurchases from 1985 to 1993 was $334 billion. Moreover, in 1996 alone, share repurchases hit a record of $176 billion in Several studies have examined the effects of share buy back announcements on the stock price of the US announcing firms. Vermaelen (1981, 1984), Comment and Jarrell (1991), Raad and Wu (1995), and Ikenberry, Lakonishok and Vermaelen (1995) have documented positive market reactions by the announcing firms to share repurchase announcements. The positive wealth effects have most often been attributed to the information signalling hypothesis which predicts that firms use share buy back as a vehicle to signal new and positive information about their future earnings prospects. That is, managers undertake share buy backs because they believe that their firm is undervalued. 2 While prior studies have documented significant stock price reaction of about 3% for the stock repurchasing firms, most of these studies do not examine whether the share repurchase announcements also convey industry-wide information and, hence, whether the announcements have valuation effects on industry counterparts. 3 But, depending upon the reason for the perceived improvement in the repurchasing firm s earnings prospects that induces the stock repurchase, the stock price of industry counterparts could also be affected. If share buy back announcements are motivated by managers' desire to communicate

4 4 information about the future prospects of the firm, then it is possible the undervaluation may be an industry-wide phenomenon (contagion effects). In that case, the valuation effects will spill over to industry counterparts. Alternatively, that firm might have gained market share at the expense of the industry counterparts, thus rivals will be negatively affected (competitive effects). We examine both the contagion and competitive industry valuation effects in this paper. In an earlier study of share repurchases, Vermaelen (1981) examined several of hypotheses (including signalling, bondholder expropriation and tax hypotheses) relating to share repurchases and concluded that the signalling hypothesis best explains the observed effects than the other hypotheses. However, until now, an elaborate test of information signalling hypothesis as it relates to share repurchases has been hampered because of data limitations. In the US for example, managers are not legally required to disclose their motive for share repurchases (Raad and Wu, 1995, Evans and Gentry, 2000), and in most cases they do not explicitly reveal it when they announce stock repurchases. Any attempt to test the signalling/undervaluation hypothesis is therefore blurred by the lack of disclosure of the motive. In Australia, however, the Corporations Law that regulates share repurchases and the Australian Stock Exchange (ASX) listing rules require managers of companies that undertake share buy back to disclose the reasons for the share repurchases. The Australian share buy back environment thus provides a unique data set to test the undervaluation hypothesis. It also allows for a test of whether the undervaluation is an industry-wide or firm-specific phenomenon. This paper analyses an Australian data set by examining the market reaction of

5 5 both buy-back firms and their industry counterparts to the announcement of on-market share buy back where the stated motive for repurchasing shares is stock price undervaluation. We recognize that managers might initiate share buy back for reasons other than signaling (such as the availability of excess cash, lack of investment opportunities or as part of a defensive strategy to avoid takeover). 4 It is thus possible that the real reason for the share buy back is the availability of excess cash or lack of good investment opportunities but managers may not admit to these reasons because investors could interpret that to imply the dearth of growth opportunities. However, even if the share buy back announcement is motivated by these alternative reasons, it is also possible that investors could react positively to the announcement. If managers announce that they have excess cash beyond what is required to finance profitable projects, the share buy back is likely to elicit positive response from the market because the return of capital leads to the resolution of agency problems. Thus, there is no particular reason for managers to use undervaluation of shares as the reason for the buy back (other than to signal information to the market) if the intention is to elicit a positive response to the announcement. Since, it is not possible to ascertain the credibility of the managers reasons for the share buy back when the announcement is made, we assume that managers provide honest and credible reasons for the share buy back and proceed to analyse this unique data set. This study is different from prior studies for two main reasons. First, by examining those share buy backs whose stated reason is undervaluation of stock price, this study provides evidence on the signalling power of share buy backs that are explicitly used by management

6 6 to signal their belief that their firm s shares are undervalued. The results therefore provide strong evidence on the undervaluation hypothesis relating to share repurchases. Second, given the disclosure requirements in Australia, it is expected that the market reaction to share repurchases announcements by Australian companies would be greater than that documented for firms in the US where investors are required to make conjectures about the managerial motives for undertaking the share buy back. Assuming that the market believes in the managers' stated reasons, a stronger market reaction is expected, given that the disclosure would probably reduce the difficultly that investors have in determining the information content of the announcements. We first analyse the market reaction of both the stock repurchasing firms and their industry counterparts to the announcement and document evidence consistent with the existence of intra-industry effects for share buy back announcements. Firms whose share buy backs were motivated by undervaluation of shares were found to experience statistically significant abnormal returns of 4.308% for the three days surrounding the announcement, while rival firms also experienced abnormal returns of 1.391% for the same period. This finding is consistent with the notion that share buy back announcements contain industry relevant information that results in an upward revaluation of the rival firms' values. Also, consistent with the predictions, the market reaction associated with these price-induced announcements is greater than has been documented in prior studies for the US market where managers are not legally required to (and often do not) disclose their motive for share repurchases.

7 7 We also examine whether the announcement of the first share repurchase in the industry or in a firm's buy back program conveys more information than subsequent announcements. If share repurchases have industry-wide valuation effects, then the first buy back announcement is likely to elicit stronger reaction from industry counterparts than subsequent ones as the market learns from the first announcement (Clinch and Sinclair, 1987). Similarly, for firms that implement a buy back program, the first announcement may be more informative than subsequent ones. However, we did not find any evidence of stronger information content or information transfer for the first announcement. Lastly, we employ univariate and multivariate regression analyses to ascertain which firm specific variables explain the observed rivals' reaction. We find that the degree of similarities in cash flow and investment opportunities between the repurchasing firms and their industry counterparts and the degree of competition within the industry significantly explain the variation in the observed industry effects. The rest of the paper proceeds as follows. In the next section, further discussion is provided on the share buy back and information transfer literature as well as on the Australian share buy back environment. Sections 3 and 4 present the data and methodology, while the results are presented and discussed in sections 5. The conclusion is provided in Section CORPORATE PAYOUT AND INFORMATION EFFECTS Share buy back is one mechanism that firms use to return cash to shareholders. 5 There is a substantial amount of research on share repurchases using data from the US. Baker et al

8 8 (1981), and Wansley et al (1989) have shown that managers initiate share buyback programs for a number reasons, including signalling of management's confidence about the future earning prospects, excess cash, lack of sufficient investment opportunities, provision of shares for employees bonus plans, as a substitute for dividends, and as part of a defensive strategy to avoid takeover. Several hypotheses have also been developed to explain the reaction to share buy back announcements. Vermaelen (1981), for example, examines the price effects of US companies that repurchased their capital and found statistically significant two-day abnormal returns of 3.37% around the announcement date. To explain this result, the author examines a number of hypotheses including information signalling, capital restructuring, bondholder expropriation, and personal tax hypotheses and concluded that the signalling hypothesis best explains the market reaction by the announcing firms. The signalling hypothesis suggests that, based on their perception of the true or intrinsic value, managers believe that their firm is underpriced in the market. Managers initiate share repurchases in an attempt to signal new information about their firms' future expected earnings. 6 Subsequent US studies (eg. Dann (1981), Asquith and Mullins (1986), Comment and Jarrell (1991), and Ikenberry, Lakonishok and Vermaelen (1995)) provide further support for the signalling hypothesis. Prior studies have also shown that investors use announcements by one firm to make inferences about other firms that operate in the same industry. Such announcements convey to the market place industry-wide information or changes in the competitive position of firms in the industry. The information transfer hypothesis suggests that if share buy back announcements convey industry-wide information, then rival firms will be affected in the

9 9 same manner as the announcing firm (contagion effects). 7 However, if the announcements signal information relating to improvements in the future earnings prospects of the firms due to changes in the competitive position or market share of the announcing firms in an industry, then the effects on the rival firms will be negative (competitive effects). Corporate announcements for which information transfer effects have been documented include earnings (Foster, 1981, and Clinch and Sinclair 1987), bank failures (Aharony and Swary, 1983), merger proposals (Eckbo, 1983), bankruptcy announcements (Lang and Stultz, 1992), going private events (Slovin, Sushka and Bendeck (1991), and public offerings of common stock, convertible debt and straight debt (Szewczyk 1992). Erwin and Miller (1998), Hertzel (1991), Firth (1996), and Otchere (2000) provide intra-industry evidence in relation to two different corporate payouts. Firth (1996) and Otchere (2000) document significant intra-industry information (contagion) effects associated with regular dividends and dividend initiation announcements respectively. However, information transfer studies relating to share repurchases have provided different conclusions. Hertzel (1991) finds that rivals have little or no reaction to the announcement of self tender offers, while Erwin and Miller (1998) document a negative (or competitive) stock price reaction for rivals of firms that announce open-market repurchases. Harris and Ramsay (1995) examine share buyback in Australia and find statistically insignificant results. They attribute the results to the strict regulation that governed the share buy back in Australia. Lamba and Ramsay (1999) document abnormal return of 1.2% for the buy back and confirm the conjecture by Harris and Ramsay (1995) that the stringent regulation of share buy back in Australia during made them less effective as a credible signalling mechanism. In this paper, we use data on share buy back

10 10 announcements that managers state are motivated by share price undervaluation to provide evidence on contagion and/or competitive effects associated with share repurchases. 2.1 AUSTRALIAN SHARE BUY BACK ENVIRONMENT The legal requirements of share buy backs in Australia are contained in Part 2.4, Division 4B of the Corporations Law. The legislation permits five types of ordinary share buy backs. 8 However, this study examines only on market buy back since most of the buybacks have been the on-market type. 9 Share buy backs were only permitted under the Corporations Law in November However, the first Corporations Law Simplification Bill introduced in 1995 simplified administration procedures which, in turn, has led to an increase in share repurchases. One requirement imposed by the Australian Stock Exchange listing rules is that all companies intending to conduct an on-market buy back must disclose a reason for undertaking the transaction. 10 Such a requirement does not exist in the US or the UK, hence, any study of the signalling power of buy back announcements in these countries must examine the full sample of share buy backs, regardless of the managerial reason underlying each. The availability of the unique share buy back data in Australia allows us to examine the impact of share buy back announcements that are explicitly being used by management to signal information to the market. Examining the impact of such announcements is important given that they provide investors with the knowledge that a firm s management believes their share price is undervalued.

11 11 3. DATA AND SAMPLE SELECTION PROCEDURE The sample includes announcements of share buy backs that were initiated between January 1991 and July These buy backs were identified using the Australian Stock Exchange (ASX) datadisc and the IRESS database. Firms that announced other (confounding) events around the event period (-5 days to +5 days) were removed from the sample. To be included in the sample, the firm must have announced on-market share buy back with 'undervaluation' of shares as the stated reason for undertaking the share repurchases. In addition, the firms should have at least 100 daily stock price data prior to the announcement for the purpose of estimating alpha and beta. A final sample of 132 repurchasing announcements satisfied these criteria. The share repurchases were undertaking by 73 firms operating in 39 industries with 9% of the firms from the resource sector and 91% comprising industrials. The average number of announcements in each industry was 3.4. Rival firms operating in the same industry as the repurchasing firms were chosen according to the ASX three-digit industry classification scheme. 12 Rival firms that announced confounding events around the announcement date were eliminated from the study. A final sample of 3200 rival firms is included in the study. The number of competitors in each industry ranged from 1 to 78 with an average of 24.3 firms. The industry counterparts were formed into 132 rival firm portfolios. Closing share price data for these firms as well as the data for the All-Ordinary Accumulation Index (all of which have been adjusted for changes in market capitalisation) were also obtained from the IRESS database. Table 1 shows the yearly distribution of the share buy back sample and their industry counterparts. Clearly share buy

12 12 backs have gained popularity since 1995 when the first Corporations Law Simplification Bill was introduced in [Fix table 1 here] 4. METHODOLOGY The initial stage of the analysis involves examination of the abnormal return behaviour of both the repurchasing firms and their industry counterparts following the share buy back announcements. Daily returns for the sample firms were calculated using the continuously compounded method as: R it = Ln[(P it + D it )/P it-1 ] (1) where R it is the return on firm i shares on day t; P it is the price of firm i on day t; D it is the dividend paid on company i s shares on day t and P it-1 is the price of firm i on day t-1. The expected returns for each firm were calculated as: E(R it ) = α i + β i R mt + u it (2) where ER it is the expected return for firm i on day t, α and β are the alpha and beta respectively and were calculated using an estimation window of 100 days prior to the event window, R mt is the return on the All Ordinaries Index for day t and u it is the residual error. To determine the market reaction by each firm, the abnormal returns were calculated as the difference between the observed returns and the expected returns as AR it = R it - E(R it ) (3) where AR it is the abnormal return for firm i at time t, R it is the observed return for firm i at time t. The abnormal returns of each firm were calculated for each day of the eleven-day

13 13 event period from day -5 to day +5. These abnormal returns were averaged across firms in order to draw inferences about the impact of the share buy back announcements. 13 The daily abnormal returns were then aggregated over various event windows to obtain the cumulative abnormal returns and were subsequently tested for statistical significance. The information effect is captured by the five-day (-2 to +2) abnormal returns as it is likely that the returns on the day of the announcement (day 0) may not fully reflect the abnormal returns associated with the announcement. 5 RESULTS AND ANALYS IS 5.1 Announcing Firms' Reaction to share repurchase announcements The average abnormal returns and cumulative abnormal returns for the share repurchasing firms are presented in Table 2. As was expected, shareholders of firms that announce share buy back earned positive abnormal returns around the announcement. While eight of the eleven days in the event window exhibit positive abnormal returns, only the excess returns on days 2, 0 and 1 are statistically significant. The announcement day's abnormal returns of 1.253% are significant at the 1% level (t-statistic is 3.76), while the returns of 2.391% on the day following the announcement is also significant at the 10% level (t-statistic is 1.81). [Fix table 2 here] The results lead to a number of interesting conclusions. The existence of a positive abnormal returns of 0.335% (significant at 5%) on day 2 suggests that the market gains knowledge of the share buy back prior to the announcement. 14 The large abnormal return on day +1

14 14 suggests that investors can earn a statistically significant abnormal return after the announcement is made. The significant market reaction on day +1 could be due to the fact that the announcement was made at or near the close of trade thus resulting in the market not impounding all the information contained in the announcement until the next day. The cumulative abnormal returns for the days surrounding the announcement and the percentage of firms in the sample that experienced positive cumulative abnormal returns are shown in Panel B of Table 2. These cumulative abnormal returns which range from 3.783% to 4.804%, depending on the time period for which the returns are cumulated, are all significant at the 1% level. The results indicate that buy backs motivated by undervaluation convey good news about the announcing firms that the market participants use to revise upwards the values of the firms. [Fix figure 1 here] Figure 1 shows an interesting phenomenon relating to the share buy back announcements. Over the 3 days preceding the event period (ie day -5 to -3), the stock prices, on average, do not show any stark evidence of good or poor performance. However, from day -2, the market gains knowledge of the buy back and between days -1 to +1, the stock prices increase significantly, reflecting a positive revaluation of the stock in line with managers perception that the stocks were hitherto undervalued. It is interesting to note from the CAR graph that the returns did not revert back to the pre-announcement level of no abnormal returns. This

15 15 finding is consistent with the results of Raad and Wu (1995) and suggests that the market believed that the share price was indeed undervalued. 5.2 Rivals' reaction to share repurchases announcements Depending on the reasons for the undervaluation of shares and, hence the announcement of the share buy back, the stock price of rival firms may be affected. If the undervaluation is due to factors specific to the announcing firm then the rival firms' returns will not be affected. However if the announcing firms' shares are perceived by investors to be undervalued for reasons relating to the industry, then it is likely that the announcements will signal information relevant to the industry counterparts. In that case, investors will use the information contained in the share buy back announcements to reassess the rivals' values. Table 3 and Figure 2 show the daily abnormal returns and cumulative abnormal returns for the rival firms on each of the event days around the share buy back announcement date. Shareholders of rival firms earned significantly positive abnormal returns of 0.385% two days after the announcement. This result suggests the presence of intra-industry information effects. In aggregate, the buy back announcements appear to signal positive information about the values of the firms that operate in the same industry as the announcing firm. [Fix table 3 here] The results also show that, on average, the revaluation of the industry rivals' share price appears to occur with a lag, since the abnormal returns for the announcing firms occur on

16 16 days 0 and +1, while the rivals' reaction (intra-industry effect) occurs on day 2. This result is consistent with previous empirical studies that have documented similar effects in terms of the time it takes for the market to re-value rival firms following the announcement of industry relevant information by other firms in the industry. 15 [Fix figure 2 here] Panel B of Table 3 shows the cumulative abnormal returns for the industry rivals for different windows surrounding the announcement day and the percentage of rival that exhibit positive cumulative abnormal returns. The cumulative abnormal returns for all event windows are statistically significant, at least, at the 10% level, except for the three-day (-1 to +1) event window. The percentage of firms with positive cumulative abnormal returns also suggests that the results are not driven by a small number of firms. Figure 2 shows the revaluation effects of the rival firms over the eleven-day event window. The CAR graph shows that the significant abnormal returns documented for day 2 do not revert back to the pre announcement level. Therefore we conclude that share buy back announcements on average reveal positive information about those firms operating in the same industry as the announcer. These results imply that the rival firms were also undervalued at the time of the announcement. The 5-day (3-day) cumulative abnormal returns of 0.72% (0.15%) documented for the rivals are larger than the -0.27% (-0.25%) documented for the US market by Erwin and Miller (1998). Furthermore, given that these returns are positive, we can conclude that, on average, the contagion effects of the buy back announcements dominate any competitive effects. However, the positive valuation effects vary across the sample. For

17 17 instance, while the seven-day cumulative abnormal returns for the industry portfolios are 1.391%, 41% of the industry portfolios exhibit negative cumulative abnormal returns. Thus, quite a significant number of firms in the sample experience a competitive effects. 5.3 CROSS-SECTIONAL ANALYSIS OF RIVAL FIRMS' ABNORMAL RETURNS Determinants of the industry counterparts' abnormal returns In this section we examine the effects of several industry and firm specific characteristics that have been hypothesised to influence information transfer effects. The factors examined include the degree of competition in the industry, degree of similarity in cash flows between the announcing firms and their industry counterparts, the size of the announcing firm, and the magnitude of the announcing firms' abnormal returns. First, announcements that convey little or no information about the repurchasing firms are likely to convey little or no information about the industry in which the firm operates (Foster, 1981 and Erwin and Miller, 1998). Alternatively, announcements that are accompanied by significant price reaction by the announcers are more likely to affect the valuations of rivals. It is therefore expected that the greater the announcing firms' abnormal returns (ARAF), the greater the industry rivals' abnormal returns. Laux, Starks and Yoon (1998), and Erwin and Miller (1998) also show that any contagion or competitive effect would be more pronounced in industries that are characterised by low levels of competition. The lower the level of competition within an industry (COMPETITION), the more likely the firms operating within the industry will be able to

18 18 exploit new profitable opportunities. 16 It is therefore expected that the size of the cumulative abnormal returns of the industry portfolios will be larger for industries with a small number of firms, whether the effects are positive or negative. Furthermore, if the share buy back announcement reflects an improvement in the repurchasing firm s expected cash flows because of a positive industry wide influence, then the positive announcement effects may be contagious within the industry. Such contagion should be more prominent for industry counterparts with similar cash flow and investment opportunities as the repurchasing firm. Consistent with Firth (1996) and Erwin and Miller (1998), the degree of similarities is proxied by the stock return correlation between the repurchasing firm and the industry rivals over the period -100 days to 5 days. It is therefore expected that the greater the correlation of stock return (CORRELATION), the greater the abnormal returns of the industry rivals. Moreover, the larger the size of the share repurchasing firm, the greater the likelihood that the market will identify it to be more representative of the industry in which it operates. Large firms are more likely to reveal in their announcements industry relevant information that will most probably affect rival firms' valuations (Firth, 1996). Thus, the larger the repurchasing firm s market capitalisation (SIZE), the larger the expected information transfer and therefore the larger the magnitude of abnormal returns of the industry counterparts. Firm size is proxied by the logarithm of the repurchasing firm's market capitalisation.

19 19 Companies intending to purchase a large parcel of their shares sometimes implement share repurchases programs where the share buy back is phased in gradually. For such programs, the first announcement may have a stronger impact than subsequent ones. A dummy variable (FIRSTCOMP), that takes on a value of 1 for the first announcement and 0 for announcements that are continuations of a buy back program, is used to capture the effects of learning by the market of the share buy back. Also, we argue in this paper that the share buy back announcements may convey information about industry-wide share price undervaluation. If the whole industry in characterised by undervaluation, then managers of other firms may attempt to convey that information through share repurchases. However, since the market learns from these announcements, it is expected that the first announcement will convey stronger industry effects than subsequent ones. To examine this conjecture, a dummy variable (FIRSTIND), which takes on a value of 1 for the first industry share buy back announcement and 0 for any subsequent announcements, is used to determine the first time effect. The test of the determinants of industry effects is conducted with the use of both univariate and multivariate analyses RESULTS OF UNIVARIATE TESTS The share repurchases firms were divided into two according to the sample median of each of the first four firm-specific variables discussed above, namely ARAF (-t,t), CORRELATION, SIZE and COMPETITION. The cumulative abnormal returns of the industry portfolios for the two sub-samples for different windows were computed and tested for statistical significance. Furthermore, for each of the variables, the cumulative abnormal returns of the sub-sample were tested for difference in means. Table 4 summarises the results of the

20 20 univariate test. Cumulative abnormal returns of the industry portfolios for the event periods (- 2, +2), (-3, +3) and (-4, +4) were chosen for examination as they show strong statistical significance (see Panel B of Table 3). However, the abnormal returns for the portfolios for the (-3 +3) and (-4, +4) periods are not significantly different and therefore the rest of the discussion is based on the five-day (-2, +2) returns. Share repurchases announcements for which the stock returns of the repurchasing firms are strongly (positively) correlated with their industry rivals' show more positive industry effects. That is, announcements made by firms that are similar to their industry counterparts (those above the median of the CORRELATION variable) exhibit statistically significant five-day abnormal returns of 1.381%. In contrast, those industries that are characterised by a low degree of similarity experience statistically insignificant abnormal returns of 0.023%. The difference in means is statistically significant at the 5% level. Similarly, for those announcements that had strong impact on the announcing firms themselves (ie. those for which the announcing firms' abnormal returns are greater than the sample median), the industry effect is strongly positive. For these announcements, the five-day industry rivals' abnormal returns of 1.595% are statistically significant at the 1% level, as compared to the insignificant 0.152% return for the low-impact announcements. The difference in means is significant at 1%. The size of the announcing firm and the number of companies operating within the industry have little or no effects on the cumulative abnormal returns of the industry rivals. While the announcements by larger firms result in a statistically significant five-day abnormal return of 1.093%, as compared to an insignificant return of 0.350% for relatively smaller firms, the difference is not statistically significant at conventional levels.

21 MULTIVARIATE (CROSS SECTIONAL) ANALYSIS In order to provide a more robust set of results regarding the explanatory power of the variables discussed above, a multivariate cross-sectional regression is employed using both the descriptive and dummy variables in order to explain any variation in the cumulative abnormal returns of the industry rivals: CAR i(-2,2) = β 0 + β 1 ARAF(-t,t) i + β 2 CORRELATION i + β 3 SIZE i + β 4 COMPETITION i + β 5 FIRSTCOMP i + β 6 FIRSTIND i (4) where CAR i(-2,2) is the cumulative abnormal return of the portfolio of rival firm i over the 5-day event window (-2 to +2) and all the other variables are as defined before. The results are shown in table 5. The coefficients reported in table 5 were estimated using the White (1980) procedure because the Breush-Pagan test suggested the presence of heteroscedasticity in the error terms of the standard OLS regression. [Fix Table 5 here] Of the independent variables, only CORRELATION is statistically significant in explaining the industry information effects. The coefficient of is statistically significant at the 1% level. This result suggests that the cumulative abnormal returns of the industry portfolios are positively related to the degree of similarity between the announcing firm and its rivals. In addition, the sign of this variable suggests that industry rivals experience a positive information transfer effect if their stock returns are positively correlated with the announcing firms' returns. These results are as expected, given that any contagion (or positive) effect is expected to be larger for rival firms with similar cash flow and investment opportunities as

22 22 the announcing firm. The results are consistent with the univariate test results discussed in the previous section. Surprisingly however, the coefficients of the dummy variables representing the first announcement of a share buy back program or the first share buy back announcement in the industry are not significant. This suggests that subsequent share buy back announcements in the industry or in a firms share repurchase program are as informative as the first announcement. The F-test that the independent variables do not jointly explain the CAR is rejected at the 5% level. The adjusted R 2 for the regression is 5.71%. Interestingly, while the univariate analysis suggests that the announcement period returns of the share buy back firms are positively related to the returns of the industry rivals, no such relationship is found for the cross-sectional regression Heterogeneous industry effects. The findings (reported in table 5) that the explanatory variables are mostly statistically insignificant may be explained by the fact that the sample contains industries that experienced both positive and negative effects following the share buy back announcement. 18 Thus, it is possible that these variables are significant in explaining the industry effects, but summing up these heterogeneous effects to determine abnormal returns can result in no returns just because positive and negative returns cancel out to not significant effects. To provide evidence on this score, the sample was divided into two on the basis of whether the industry rivals' reaction was positive or negative. This categorisation enables the examination

23 23 of whether there are factors that influence the magnitude of the abnormal returns of the industry portfolios given that the effect is known to be positive or negative. The crosssectional regression results for the portfolios that experienced negative and positive information transfer effects are presented in table 6. [Fix Table 6 here] The COMPETITION variable is the only explanatory variable that is significant. The coefficient is for the industries that experienced contagion (ie. positive) effects and for those that experienced competitive (i.e. negative) effects. The signs of both coefficients are as expected. The negative sign on the competition variable for the contagion effects suggests that the cumulative abnormal returns of the industry portfolios are negatively related to the number of firms in the industry. This implies that the positive (contagion) effects are stronger for those industries that are characterised by a low degree of competition since the few firms can exploit the good prospects to their advantage. Similarly, the positive sign on COMPETITION for those industries experiencing competitive (negative) effects suggests that the negative effects are larger for industries with a lower degree of competition. In other words, the negative effects are more pronounced in industries with a smaller number of firms (a low level of competition). It is of interest to note that CORRELATION is statistically insignificant when the industry rivals are categorised into two according to whether the abnormal returns are positive or negative. The results in tables 5 and 6 suggest that while CORRELATION can explain

24 24 variations in the abnormal returns of the industry rivals, it does not explain the returns when the sign of the industry effect is known a priori. CORRELATION determines in part whether the industry counterparts' abnormal returns are negative or positive, hence by dividing the sample according to the sign of the industry effects, we have implicitly separated the sample on the basis of the return correlation. It is therefore not surprising that the correlation variable has lost its significance. The test again fails to support the hypothesis that the size of the announcing firms or their announcement period return is related to the cumulative abnormal returns of the industry rivals. The F-statistic for both contagion and competitive industry effects are statistically significant with adjusted R 2 of 6.80% and 12.66% for contagion and competitive effects respectively. 6 LIMITATIONS AND FUTURE DIRECTIONS AND CONCLUSION i Limitations and future directions This paper analyzes share buy back announcements that are motivated by undervaluation of shares. The results of the study should be interpreted in light of the implicit assumption we make that managers honestly communicate the reason for the share buy back to investors and therefore, we did not test for competing explanations for the results. To the extent that managers may make misleading statements regarding their motives for the share buy back (which may be difficult to prove), the results of the study should be interpreted with caution. An area worth further investigation is a test (in the spirit of Vermaelen 1981) of the competing explanations for the market reaction to share buy back announcements (signalling, bond holder, personal taxes, excess cash, takeover deterrence hypotheses) with a view to

25 25 ascertaining whether the alternatives to signalling are more relevant to the Australian market given the different legal and institutional framework from that of the US. ii Summary and conclusion This paper provides evidence that share buy back announcements that are motivated by undervaluation of the sample firms' stock price signal new information about the values of both the share buy back firms and the industry counterparts. The results show that on average, shareholder of firms announcing share buy backs that are motivated by undervaluation of shares earned statistically significant abnormal returns of 1.25% on the announcement day while those of rival firms also earned significant abnormal returns of 0.39% on day +2. For the three days surrounding the announcement date, shareholders of firms announcing share buy backs earned statistically significant abnormal returns of 4.30%, while those of industry rivals earned abnormal returns of 1.39%. For both the share buy back firms and their industry counterparts, the cumulative abnormal returns do not revert back to the pre-announcement levels, suggesting that the share buy back announcements that are motivated by share price undervaluation convey value relevant information about the industry as a whole. Although the market believed the managers who announced such share buy backs that their stock was undervalued, the undervaluation was not just firm specific but rather an industry-wide phenomenon. The finding of large cumulative abnormal returns for both the sample firms and net contagion (positive) effects (see panel B of tables 2 and 3) are interesting results as the latter contradicts the results of Erwin and Miller (1998) who document a competitive (negative) effect for the

26 26 industry counterparts. Erwin and Miller (1998) find that announcing firms experienced a statistically significant five-day (three-day) abnormal returns of 3.43% (3.35%) while nonannouncing rival firms experience a significantly negative stock price reaction of -0.27% ( 0.25%). In this study, we document five-day (three-day) abnormal returns of 4.30% (3.78%) for announcing firms and 0.72% (0.15%) for industry counterparts. Our results are consistent with the conjecture that because managers are required to disclose their motives for undertaking the share buy back, the share repurchase announcements that are motivated by undervaluation of share price have stronger information content and information transfer effects than those that do not require such disclosures. Our results also suggest that, in the aggregate, contagion effects of buy back announcements dominate any competitive effects. This results therefore supports the hypothesis that share buy back announcements that are motivated by the undervaluation of stock price signal positive information regarding the values of both the announcing firms and their industry counterparts.

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29 29 Appendix 1: Classification of sample firms as per Australian Stock Exchange Industry Classification Industry Group: Total % of Total Industrials Banking and Finance Building Materials Chemicals Developers and Contractors Diversified Industrials Engineering Healthcare and Biotechnology Insurance Investment and Financial Services Media Agriculture and Related Services Automotive Computer and Office Services Entrepreneurial Investors High Technology Miscellaneous Industrials Miscellaneous Services Retail Telecommunications Tourism and Leisure Sub-total (a) Resources Energy Gold Other Metals Sub-total (b) Grand Total (a+b)

30 30 Table 1 Yearly distribution of share buy back announcements * Share buy back firms Industry Rivals Year Number % of Total Number % of Total Total % % Only buy backs announced prior to the end of July 1999 are included * The industry counterparts were formed into 132 portfolios.

31 31 Table 2 Daily abnormal returns and cumulative abnormal returns for the announcing firms This table shows the daily abnormal returns and cumulative abnormal returns for share buy back announcements for each day of the event window. The t-statistics reflect a two-tailed test that the average abnormal returns are different from zero. The asterisks (*), (**), (***) represent significance levels at 10%, 5% and 1% respectively. Panel A: Abnormal returns and daily cumulative abnormal returns for announcing firms for each day of the event window Day Returns (%) t-statistics CAR (%) ** *** ** Panel B: Cumulative abnormal returns for announcing firms Days Returns (%) t-statistics % of CAR > 0 (-1,1) *** 64 (-2,2) *** 64 (-3,3) *** 67 (-4,4) *** 67 (-5,5) *** 67