Market response and firms' operating performance surrounding actual share repurchases : evidence from Hong Kong

Abstract

Share repurchases have become a popular payout method to distribute cash flows to shareholders not only in the U.S. but also other countries. There is a substantial amount of research on share repurchase using datasets in the U.S. However research outside the U.S. is still limited, especially in the Hong Kong market. Results from the U.S. and other countries cannot be applied to the Hong Kong market due to the differences in disclosure requirements, the regulatory environment and investors' perceptions. Furthermore, most of those studies are based on repurchase announcements not the actual repurchases.

This study examined the firms' share price and operating performance surrounding actual share repurchases in the Hong Kong stock market using a sample of 1339 repurchase events from the period of November 1991 to December 2001. In addition, this study also examined the motivations behind share repurchases. The empirical results show that, on average, firms engage in share repurchases when their stocks are under-valued and repurchases are followed by abnormal positive returns. Among repurchases, the stock price performance varies across firms' size and market-to-book ratios. The market responds most favourably to repurchases that are made by small and "value" firms. This suggests that smaller firms are usually less analysed and more likely to be under-valued, hence the market reacts more favourably when they repurchase.

In addition, our results also show that repurchasing firms had been experiencing an abnormally high level of cash flow and contraction in investment opportunities during the years preceding the share repurchases. Instead of investing in non-profitable projects, firms decided to return the cash to shareholders through share repurchases, which reduce the agency cost of free cash flow and thus increase the shareholders' wealth. The increases in shareholders' wealth explain why the market responds positively to share repurchases.

We found no evidence of the "earnings" signalling hypothesis and the leverage hypothesis. Results show that there was no significant improvement in the repurchasing firms' earning performance and no increase in financial leverage.