When is repurchase a good exercise?
According to Buffett, when it passes the two tests:
- A company has ample funds to take care of the operational and liquidity needs of its business;
- The stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated.
However, in practice he wrote, “We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions – even serious ones – are innocent; many CEOs never stop believing their stock is cheap.”
In the study “Overconfidence and the Timing of Share Repurchases” by J. Handy and S. Underwood, (June 2015), the authors divide CEOs into ‘moderately confident’ and ‘overconfident’. This is done using the Kolasinski and Li method of confidence measurement, defined as, “those CEOs who purchase their own company’s stock in the secondary market and who ex post earn a negative abnormal return over the next 180 days”.
This study is motivated by the observations that behavioural biases like managerial overconfidence can have a great impact on many corporate decisions. We study in particular the interaction between overconfidence and the way that firms carry out their open market repurchase programs.
We find that overconfident managers are more likely to repurchase at higher prices, while moderately confident managers seem to repurchase at lower prices and during periods of relative undervaluation. In general, we find that overconfidence can help to explain previous findings that managers are poor at timing repurchases. Overconfident managers repurchase much less efficiently than their more moderately confident peers. Our results suggest that the presence of an overconfident CEO or CFO can increase the repurchase price premium by 3.5% and over 6% if both the CEO and CFO are overconfident.
In contrast, we find no statistically significant price premium paid by moderately confident CEOs if using the minimum price benchmark. In fact, using the average closing price benchmark moderately confident managers could potentially be repurchasing at over a three percent discount. If we extend the overconfidence classification system to include more corporate insiders within the sample, we see the same general pattern – as insider overconfidence increases, firms repurchase less efficiently.