Institutional Foresight: Do Institutions Profit from Repurchase Announcements?

Transcription

1 Institutional Foresight: Do Institutions Profit from Repurchase Announcements? Vinh Huy Nguyen 1 Suchismita Mishra 2 Pankaj Jain 3 JEL Classification: D82, G14, G20, G35 Key Words: Intermarket sweep orders, repurchase announcements, institutions 1 Assistant Professor, California State University Fresno, Craig School of Business, 5245 N Backer Ave. PB 249, Fresno, CA VinhN@csufresno.edu 2 Associate Professor, Knight Ridder Research Fellow of Finance, Florida International University, College of Business Administration, S.W. 8th Street RB 204BA, Miami, Florida mishras@fiu.edu 3 Professor, George Johnson Professor of Finance, University of Memphis, Fogelman College of Business and Economics, 3675 Central Avenue, Memphis, TN 38152, pankaj.jain@memphis.edu

2 Institutional Foresight Do Institutions Profit from Repurchase Announcements? Abstract Share repurchases create an asymmetric information environment for institutional investors. The firm and its insiders know the announcement s timing and whether or not there will be actual implementation of share repurchases. Institutions do not have this information ex-ante, but do they have the foresight? We test this using daily intermarket sweep order, biweekly short interest, and quarterly 13(f) data. Institutional trades around repurchase announcements are unprofitable. ISO traders and short sellers appear to be mistiming their trades, selling prematurely at lower prices. However, there is an exception high-turnover transient institutions profit around repurchase announcements by properly timing their trades.

3 I. Introduction Institutional Foresight Do Institutions Profit from Repurchase Announcements? Regarded as sophisticated traders by both academics and practitioners, institutional investors may have the ability to interpret corporate news and events to trade profitably. In our paper, we show that this perception may not always be true, particularly around share repurchase announcements when other informed participants are also active. In the context of our study, there are three players: the institutional investors, the firm and registered insiders. Institutional investors the biggest investors in U.S. equities holding approximately 75 percent of U.S. stocks (Alexander, Peterson, Beardsley 2014) are known to have superior research skills. Admati and Pfleiderer (1988) explain that institutions trade based on information about upcoming events only if the expected profit is higher than the cost of obtaining the private information. Using data with more precise execution price and time, Puckett and Yan (2011) find that institutional investors earn abnormal positive returns on their trades. Although institutional trading skills may be superior to the average investor s, the presence of more informed players, such as the firm and its corporate managers, alters the relative information advantage and trading patterns of all market participants. In case of repurchases, the announcing firm is supposedly the most informed about its current financial condition and future earnings. The firm also has the advantage of deciding if it will follow through with actual implementation of share repurchases and the timing of such repurchases. If the firm decides to do so, it becomes a trader of its own shares. Therefore, unlike other corporate events, such as earnings announcements, that tend to resolve uncertainty (Lee, Mucklow, and Ready 1993), repurchase announcements are unique because they lead to heightened uncertainty. In addition, as an integral

4 part of the company, the insiders 4 have private information, which might be reflected in their personal portfolio choices and trading decisions (Kyle 1985). The private information of insiders sometimes may be different from the public disclosures made by the firm. Hence, the trading activities of insiders may reveal information to outsiders. Strong insider buying before the announcement of share repurchases of an undervalued firm is a good buy signal for institutional investors. Conversely, strong insider selling before the announcement of an overvalued firm is a sell signal for institutional investors. Because insider trading is publicly available, this information can help institutional investors gain more insight to trade profitably. While it is clear that all three players are informed, there is information asymmetry that exists between the participants. Essentially, this is a battle of champions between the institutional investors, firm, and insiders. Do the institutions have the foresight to trade profitably when they are pitted against the other informed and active players? We select the announcement time to test institutional foresight because it is a period of heighten uncertainty. We know that the information signaled in repurchase announcements by the firm and its insiders to investors about the valuation and future growth of the company has a significant announcement effect (Ofer and Thakor 1987). Many researchers have documented the significant positive market reactions to repurchase announcements (Ikenberry, Lakonishok, and Vermaelen 1995; Peyer and Vermaelen 2009; Bargeron, Kulchania, and Thomas 2011). However, in our sample, 35 percent of the firms do not follow through with actual share repurchases within two years. Thus, repurchases create a number of possible future scenarios and heightened uncertainty. In one scenario, the firm may truly be undervalued at the time of the announcement. If the institutions have the foresight, they should buy. In another scenario, the firm may be 4 We define an insider as any person who is directly or indirectly own more than 10% of the firm s equity or who is an officer or director of the company according to Section 16 of the Securities Exchange Act of 1934.

5 overvalued and the announcement might merely be a tool to artificially support insider selling by temporary boosting stock prices. If the institutions have foresight, they should sell after the price run up. Alternatively, a firm may be fairly valued and the repurchase announcement can be a method of attracting analysts and investors attention. In the latter two scenarios, false signaling can transfer wealth from investors to the insiders and firm (Fried 2005). In summary, the true intention of repurchase announcements is unknown. The share repurchase environment is a rather complicated one for institutional traders. They need to use their skills to decipher multiple messages from different sources. To be profitable the institutions need to have the skills to deal with the complex, multi-level signals. Our paper differs from prior research on repurchases in several important ways. First, we focus on the complexity and dual nature of the repurchase signals in the announcement period due to the presence of firms and insiders as highly informed participants in the market. Second, we focus on the sophisticated institutional investors decisions around the announcements. Our contribution is different from De Lisle, Morscheck, and Nofsinger (2014) because they analyze institutional selling around repurchases implementations, which resolve the uncertainty created by the initial repurchase announcement. Because institutional investors hold the majority of U.S. equities, logically, they would take the opposite side of the firms actual repurchases for the right price. They are the liquidity providers when the firms are actually repurchasing. Arguably, less is known about the firm s follow-through intention and the insider s trading activities during the announcement period. Institutional investors are not subject to strong counterparty purchases during the days before the announcement. The prior literature also does not assess if institutions benefit economically from trading around repurchases. We fill this gap in the literature by extensively analyzing institutional profitability during the announcement period. Third, to capture

6 the sophisticated trading strategies of institutions, we examine their activities from the full range of intraday to quarterly frequencies. Specifically, we use three different measures of institutional trading: intraday and daily intermarket sweep order, biweekly short interest, and quarterly 13(f). Thus, we cover institutional trading strategies related to both long and short positions. Overall, we find that institutions do not trade profitably around share repurchase announcements when prices generally appreciate in response to the possible undervaluation signal. With good foresight, institutions should be buying before the announcement or sell only when the stock price is at the peak. However, we find that ISO traders are selling during the five days around the announcement. These sell trades are prematurely executed as the price run-up can last for quarters. Similarly, short sellers are also unprofitable. While we expect the short sellers to not trade around the announcement, they appear to be exhibit abnormal short selling during the first three biweekly periods. During this early stage of the price run-up, the stock price has not fully appreciated, and therefore, the short sellers will end up covering their opened position with higher prices. Finally, we find that the transient institutions, who have a short-term investment horizon and a high portfolio turnover rate, are the exception to the rule. They appear to have the foresight to be profitable. They are properly timing their trades by buying shares during the preannouncement quarters and selling during the post-announcement price run-up. These findings are robust when compared to the findings of the control sample of non-announcing firms, the sample of announcing firms during the non-announcing time, and the sample of non-contemporaneous events. Our in-depth analysis of institutional trading in a period of heightened information asymmetry around repurchase announcements shows that institutions are generally unable to overcome the firm s and insiders information advantage.

7 II. Literature Review The information signaling hypothesis in the share repurchase literature posits that if the firm believes its shares are undervalued, it can signal such information to the market using repurchase announcements (Bhattacharya 1979, Miller and Rock 1985, and Vermaelen 1981). However, this undervaluation signal if not backed by actual implementation can be quite misleading. Considering that a large proportion of announcement events are not followed through with actual share repurchases, it is possible that the announcing firms are employing a signaljamming strategy. According to Fudenberg and Tirole (1986), firms can interfere with other participants information gathering and decision making process by providing signals that may not be entirely true about the firm. These disturbances or noisy information may lead others to make poor decisions with unfavorable outcomes (Mirman, Samuelson, and Urbano 1993). In the context of share repurchases, the institutional investors are the information gatherers and their decision making process is affected by the signals sent by the firm and its insiders. These dual signals can help the institutions make profitable trades if this information accurately portrays the status of the firm. While there are papers related to undervaluation signaling or signal jamming, our paper is unique because we are the first to study the interaction between the institutions, firm and insiders around repurchase announcements when all three parties are actively competing against each other. We fill this gap in the literature by explaining if the institutions have the skills to decipher the complex compounding nature of the information signaled by the firm and insiders. Since repurchase announcements can attract a significant amount of attention from outsiders, the decision to announce needs serious considerations. An undervalued firm can benefit from such attention by attracting investors with only the announcement and no actual implementation of repurchases (Bhattacharya1 and Jacobsen 2016). Insiders also like share

8 repurchase announcements. If they were net purchasers of the firm s shares, then the announcement serves as a good catalyst to boost the stock price to a level that is profitable for the insiders to sell their shares. If the insiders had been selling their shares, then the postannouncement price run-up allows them to continue selling without significantly impacting the stock price. Effectively, the announcement can provide a price support. Thus, even before the announcement, the institutional investors appear to be at a disadvantage. Both the firm and insiders have had time to think about how they can use the announcement to their benefit. Furthermore, because the firm controls the timing of repurchase announcements and the decision to follow through with actual buybacks, the odds are even more against the institutional investors. The institutional investors do not have the same control and private information as the firm and insiders. Hoping to reduce the information advantage of the firm and insiders, lawmakers have established key regulations to increase transparency and reduce market manipulation. However, are these laws effective? Beginning in January 2004, the SEC requires that the announcing firm discloses its repurchase activities every quarter. They must disclose the total number of shares repurchased during the previous quarter, the average price paid for those shares, the number of shares that were purchased as a part of a previously announced plan, and the maximum number of shares that could be repurchased. Although the new regulation aims to curb the firm s incentive to exploit the investor s information disadvantage, the disclosure is not made public until months after the transaction. This delay makes the disclosure less useful in reducing information asymmetry in the market, especially during the announcement period. Apart from requiring firms to disclose their repurchasing information, lawmakers also established Rule 10b-5, which requires insiders 1) to refrain from trading the firm s shares when they have material nonpublic information or 2) to disclose the information. However, to be

9 charged with breaking Rule 10b-5, the insiders have to intentionally deceive others. Fraud due to negligent behavior will not invoke Rule 10b-5. Furthermore, the information has to be material, giving the insiders an unfair advantage to unduly influence the market. Otherwise, the insiders are free to trade. The regulation also allows insiders to establish multiple 10b-5 plans, which facilitate the sales of a predesignated number of shares at regular intervals. While the intentions are good, the insiders can still work around these restrictions by canceling the planned sales if they perceive good information is in the near future. This does not break insider trading laws as no transactions were executed. Hence, no liabilities were created. In addition to Rule 10b-5, the insiders need to follow the SEC Section 16(b) short-swing profit rule, which states that the insiders must return any profit gained from the buying and selling of the company stock within a six-month period. This regulation is designed to discourage insider trading with non-public information. Similar to the other regulations, there are ways to get around the short-swing rule. The insiders can avoid violating Section 16(b) by waiting until the six-month period ends, allowing them to keep all the profit. Although Bonaime and Ryngaert (2013) do not assess the role of institutional trading like we do, they find that insiders appear to be the most active around large repurchases, and the firm enjoys higher abnormal returns when the insiders are net buyers than when they are net sellers. It appears that the regulations are not as effective in curbing the information advantage held by the insiders and the firm. Both players stand to gain from the event. The firm gets a stronger price increase from the insider buys, and the insiders get to sell the purchased shares at a higher price after the appreciation. These two players are on the same team supporting each other s strategic decisions. Conversely, the institutional investors are left behind. They are not on the same team as the firm and insiders. This is why our study of repurchase announcements is unique. In other

10 research (Grinblatt and Titman 1993; Daniel, Grinblatt, Titman, and Wermers 1997; Chen, Jegadeesh, and Wermer 2000; Wermers 2000; Baker, Litov, Wachter, and Wurgler 2010), institutional investors appear to have the ability to trade profitably. They exhibit significant stockpicking skills or that they are able to generate abnormal returns around earnings announcements. While these results may be descriptive of institutional investors, the circumstances of these evidence are not the same as they are in share repurchase announcements a time when more uncertainty is generated from the event than it resolves and when the firm and insiders are actively trying to outperform the institutions. In our paper, we present a scenario where the institutions, with all of their might, may not be able to overcome the synergetic advantages created by two informed and active players Although our focus is on the signaling aspect of repurchase announcements, we recognize that repurchase announcements may have other purposes. Repurchases can be used to fund corporate acquisitions, manage the dilutive effects of employee stock options, boost the reported EPS, and reduce excess cash available to management (Jensen 1986; Bens, Nagar, Skinner, and Wong 2003; Skinner 2008). Additionally, we focus on all types of repurchase announcements rather than examining only or some combination of Dutch-auction, fixed-priced tender, or openmarket repurchases (Louis and White 2007) to include signaling effects from all repurchase announcements. We are also aware of the literature closely related, yet very different to our paper. In De Cesari, Espenlaub, Khurshed, and Simkovic (2012), the authors explain that the repurchasing firms can buy their shares back at a bargain price if the firms have little institutional interest. Without institutional involvement, the firms can take further advantage of the information asymmetry by buying back shares from less informed traders. However, based on the findings of De Lisle, Morscheck, and Nofsinger (2014), institutional investors are active around actual

11 repurchases; they are net sellers when the firms are implementing repurchases. This strategy is beneficial for the institutions only if they purchased these shares at a lower price, preferably before the stock price run-up. Our paper extends this conversation further by providing insight into the trading activities of the institutional investors before the actual implementation. We aim to answer questions related to whether or not institutions have the foresight to properly time their trades when there are multiple forces working against them in an environment where they are not the most informed participant. III. Hypothesis Development Based on the prior literature, it is well-established that institutional investors are informed. To test their foresight, we use share repurchase announcements as the setting for our study. Share repurchase announcements can gauge the institutional investors ability to overcome other informed and active market participants. Chakravarty, Jain, Upson, and Wood (2012) provide evidence that ISO trades are associated with larger information share than NISO trades, which are mainly used by liquidity traders. Therefore, we suspect that ISO traders will be able to properly time the execution of their orders. For the purpose of developing our formal hypotheses, we consider a three-period timeline in Figure 1. The time t=0 represents the repurchase announcement. At time t=-1, if the firm is undervalued, then it would make more sense to announce share repurchases. However, depending on the motives of the insiders, the firm may announce its repurchase event when the firm is overvalued or fairly valued at time t=-1. The second signal about the firm s undervaluation or overvaluation is contained in the insider s decision to buy or sell, respectively, at time t=-1. We expect prices to appreciate after the announcement at time t=1 irrespective to the undervaluation or overvaluation of the firm. For the overvalued firms, prices would depreciate at

12 time t=2 because of the lack of follow through. For the undervalued firms, prices would continue to appreciate at time t=2 in response to the actual implementation of repurchases. If the institutions have foresight, we expect ISO traders to purchase shares at time t=-1 before the postannouncement price run-up in t=1 and/or t=2. Similarly, with good foresight, we expect the institutions to sell shares of overvalued firms at time t=1 and sell shares of initially undervalued at time t=2 when the firms stocks have reach full price appreciation due to the actual implementation of repurchases. We also expect short sellers to time their trades accordingly. Christophe, Ferri, and Angel (2004) find that short sellers can generate positive and significant profit around earnings announcements. Although earnings announcements do not have the same level of uncertainty, the ability to trade profitably around these events is a good indication that they may also be able to profit from other corporate announcements. Lastly, we also believe that certain institutional investors described in the 13(f) database are able to profit from share repurchase announcements. That certain institutional investor is more likely to be an investor with a short-term investment horizon and the ability to quickly turnover the portfolio to reflect the ever changing trading environment around repurchase announcements. While it is clear that these institutions are skilled traders, are they able to replicate the same success around share repurchase announcements when the insiders and firm are actively participating? Hypothesis 1: Institutional investors can trade profitably around share repurchases announcements. For the second hypothesis, we further expand the main question to tests the relevance of the second signal from the portfolio activities of insiders around the time of repurchase announcements. The repurchase announcement signal is further strengthen if the insiders are also

13 buying the stock themselves. In contrast, the validity of the announcement is questionable if in fact the insiders are personally selling the stock. Insider net trade direction is determined based on their transactions during the previous six months when they are found to be active (Chan, Ikenberry, Lee, and Wang 2012). We believe that insider trades are a valuable source of information to investors. The more often insiders trade, the more information is revealed to the public, giving investors more opportunities to reallocate their resources and potentially make some profits (Manne 1966; Bernhardt, Hollifield and Hughson 1995). According to Bonaime and Ryngaert (2013), actual repurchases accompanied by net insider buying result in significantly higher and longer-lasting abnormal returns than when insiders are net sellers. We believe that insider trading during the pre-announcement period could also provide information to investors as it does during the actual share repurchase, and it would be wise for the institutions to study the insider s trading pattern so they can respond profitably. Hypothesis 2: Institutional investors can trade profitably around share repurchase announcements keeping in mind the second signal from insider trading. The third hypothesis tests if institutional investors can trade profitably given all the possible positions taken by the insiders and firm. This means dividing the full sample into six sub-samples based on insider trading, and whether or not the firm actually repurchases shares within eight quarters similar to Bonaime (2012) shown in Figure 2. Given all the scenarios, we expect institutional profit to be the highest when all three players institutions, insiders, and firm are purchasing shares. The undervaluation signal is strongest when the insiders are net buyers and the firm follows through with actual repurchases. Combined, they signal to the market that the firm is poised for future earnings growth. Hence, institutional investors can earn positive and significant

14 profit if they buy more shares before the post-announcement price run-up. In contrast, increased institutional selling beforehand may indicate the absence of institutional foresight. Hypothesis 3: Institutional investors can trade profitably in the complex signaling environment of share repurchases taking into account insider trading and the firm s follow-through decision to actually implement repurchases. IV. Data The data for share repurchases are from the Securities Data Company (SDC). Our repurchases sample 5 has 3,394 repurchase announcements from 1878 firms reported from September 2007 to December The firms announce the repurchase of approximately billion shares and actually repurchase billion shares at an average repurchase price of $ In total, these firms spent $1.2 trillion to repurchase their shares (SDC). We evaluate institutional profitability using three different datasets: 1) TAQ provides intraday and daily ISO trading activity including the exact timestamp, price, quantity, and trade condition, 2) Compustat provides biweekly short interest position data, and 3) Thomson Reuters 13(f) provides quarterly institutional holding which will also capture institutional trading activities not included in the ISO and short interest data, such as the changes in institutional holding resulting from trades executed in the up-stairs market. We calculate profit by using CRSP closing prices. ISO are limit orders that automatically execute in designated markets while simultaneously submitting orders in the markets with better prices. ISO represent 31% of the volume and 38% of trades in our sample. Fully integrated in September 2007, ISO are mainly used by informed institutional traders to sweep multiple markets of their liquidity, although possibly at an inferior 5 In another sample, I excluded all repurchase announcements that coincide with other corporate news, such as dividend announcements, earnings announcements, merger and acquisition announcements, and stock splits, to avoid any confounding influence. My results are robust even when the contemporaneous events are excluded.

15 price (Chakravarty, Jain, Upson, and Wood 2012). ISO traders are more concerned about execution speed and order fulfillment. Faster execution gives institutional investors more opportunities to trades profitably as price-sensitive information is released, for example, in repurchase announcements. Hence, we focus on ISO to determine if institutional investors can make a profit using a more aggressive trading mechanism. We also analyze the trading activities of short sellers, which account for approximately 26% of the daily volume (Alexander, Peterson, Beardsley 2014), to determine if these sophisticated traders can benefit from repurchase announcements. Considering that there is a price appreciation after the announcement, we expect to see a significant decrease in short selling up to the price run-up. Our third dataset, Thomson Reuters 13(f), provides a big-picture summary of institutional trading. The 13(f) data provide required filings of institutional investment managers with over $100 million in assets. We use the quarterly updates to understand long-term institutional trading and to determine if institutions profit in the quarters around the announcement. Using the Bushee (2001) method of classifying the 13(f) institutions, we are able to study in-depth if institutions with different investment time horizons and styles are able to profit in the presence of the firm and its insiders. The first type is the transient institutional investors, who have a high portfolio turnover and highly diversified portfolio holdings. These are the institutions most likely to pay close attention to corporate announcements and respond to them by altering their holding and position frequently. According Bushee (2001) and Puckett and Yan (2011), this trading strategy generates significant abnormal returns. The second type is the dedicated institutional investors, who maintain a very low portfolio turnover and larger average portfolio investments. Quasi-indexer institutional

16 investors also have low portfolio turnover but highly diversified portfolio holdings. Both dedicated and quasi-indexer investors have longer investment horizons. Lastly, for the other variables, we use analyst forecast data from W/B/E/S, accounting data from Compustat, and insider trading data from Thomson Reuter TFN U.S. Securities and Exchange Commission Form 4. V. Findings Daily intermarket sweep order traders Our analysis of daily ISO trading covers three distinct periods similar to Jain and Wang (2013): the pre-announcement period is the five days [-5,-1] window leading up to the announcement date, day 0 is the announcement day, and the post-announcement period is the five days [+1, +5] after the event date. Although we are studying the perceptiveness of institutional investors before and on the announcement date, we include the post-announcement period to evaluate the institutional investor s immediate reaction to the repurchase information. Based on the well-documented, positive market reaction to the announcement, we expect institutional investors to be net buyers around these three periods. Purchasing these shares before the price run-up reaches its peak is a profitable strategy. Rather than observing a net buying trend, we found evidence of significant negative institutional trade imbalance 6 for all 11 days shown in Table 2. During the pre-announcement period, we expect institutional investors to take a neutral trading position if they are not be able to predict the timing of the announcement. If they do have the foresight, we expect them to be net buyers. Therefore, to see that these investors are presenting themselves as sellers even before the firms announce their repurchase intention is rather surprising. 6 Trade imbalance is calculated as the net shares traded in the quarter normalized by the number of shares outstanding expressed in basis points.

17 The significant trade imbalances of -0.8**, -1.3***, -1.2***, -0.7***, and -0.9*** on days [-5, - 1] relative to the announcement day shown in Table 1 Panel A suggest that the institutional investors do not perceive value in these firms before the repurchase event. On the announcement day and during the post-announcement period, institutional investors would still be profitable if they are net buyers. Yet, we observe significant negative trade imbalances during both periods ranging from -0.5*** to -1.8*** shown in Table 1 Panel B The net selling trend suggests that institutional investors do not foresee the possible gains that follow repurchase announcements and are selling to the better-informed traders. To consider the effects of insiders, we separate the full sample based on whether the corporate insiders are net buyers or net sellers in the period surrounding the repurchase announcement. Our method of classifying insider trade direction is similar to that of Bonaime and Ryngaert (2013). The announcement event is considered net selling if insider sales exceed insider purchases by at least 0.01% of the firm s market capitalization. The announcement event is considered net buying if purchases exceed sales by the same requirement. Otherwise, the event is associated with neutral insider trading. These classifications are based on the transactions of insiders during the previous six months relative to the announcement because insiders are found to be most active during this period based on the findings of Chan, Ikenberry, Lee, and Wang (2012). We find that institutional investors do not take cues from insiders; institutional investors are still net sellers with trade imbalances ranging from -0.2 to -1.4*** when insiders are net buyers shown in Table 1 Panel A and B. Finally, we divide the full sample into six sub-samples based on insider trading and the firm s decision to follow through after the announcement. In the sub-samples where the firms follow through with actual repurchases within eight quarters, institutional investors are net sellers

18 in both the pre- and post-announcement periods. In fact, the highest negative trade imbalance of 2.1*** is on day +1 in the subsample with the follow-through signal. This result suggest that institutional investors do not have the foresight to purchase more shares around the announcement period to resale to the firm later at a higher price. Table 1 also shows the institutional trades for the announcement-only subsamples given the different insider trading patterns. In all three announcement-only subsamples, institutional investors are generally net sellers although the net selling trend is not as strong as in the follow-through subsamples. In summary, we observe that institutional investors are strong net sellers during the days around repurchase announcements. Next, we evaluate if the sell trades executed during the days around the announcement are profitable. Daily institutional profit is determined using the exact ISO sell prices in each of the [- 5, +5] day and CRSP daily closing prices on day +90 relative to the announcement. We find that the institutional ISO sell trades opened during day [-5, +5] and closed +90 days after the announcement result in significant losses. In the full sample of all repurchase announcements, the losses of the sell trades initiated during the pre-announcement period of [-5,-1] are 5.26%***, 5.68%***, 6.04%***, 6.09%***, 6.36%*** shown in Table 2 Panel A. These figures support our initial belief that selling before the announcement is not a profitable strategy. Selling on the announcement day is also not a good decision because it results in a loss of 5.24%*** shown in Table 2 Panel B. The sell trades initiated during the post-announcement period of day [+1, +5] result in significant losses, 4.46%***, 4.21%***, 3.93%***, 2.60%***, -3.23%*** shown in Table 2 Panel B. While these losses are significant, they are not as large as the ones in the preannouncement period because stock prices have risen due to the announcement. When we examine institutional sell profitability considering different positions taken by the firm and insiders, we find that selling is still an unwise decision. For instance, the sell trades initiated during day -5 in the

19 subsample with net insider buying has a loss of 3.83%***, and the loss on day -5 in the subsample where the insiders are net buyers and the firm actually repurchase is 3.05%**. Furthermore, when we estimate the impact of the average number of shares sold on the +90 day profitability shown in Table 3, we find that the number of shares sold negatively affect profit even after controlling for the possible actions by the insiders and firm. For example, for every share increase in the average number of shares sold by institutional investors on the announcement day, profit decreases by 0.01%**. While the economic impact on sell trade profitability during the announcement day may appear minimal, the impact can be as high as a decrease of 0.10%*** in profit for sell trades initiated on day -2 or a decrease of 0.08%*** for sell trades on day +2. The evidence shown in Table 2 and 3 suggests that institutional investors should not be selling. Instead, they should be buying more shares around the announcement, particularly when the insiders are net buyers and the firm is committed to buying back its shares. We believe ISO traders are not profitable not only because they are trading in the wrong direction, but also because of the aggressive nature of these traders. ISOs are used mainly to sweep multiple markets of their liquidity and will trade through the best prices to fill the orders. Therefore, as the institutions are selling their shares, they are doing so at lower prices. Essentially, institutions are making the wrong bet at inferior prices. Biweekly short sellers In our second measure of institutional trading, we turn our attention to the short position traders. We expect the short sellers to refrain from trading around the announcement period as stock prices have not fully appreciated. Any abnormal shorting during this period could result in significant losses. To measure abnormal short selling we use two different methods. The first

20 measure calculates abnormal short interest as the difference between the benchmark period short interest and the test period short interest. The second measure calculates the Christophe, Ferri, and Angel (2004) abnormal short selling as the average number of share sold short in the test period divided by the average number of shares sold short in the benchmark period minus one. The benchmark period in both figures is six biweekly periods before the announcement period, ending approximately one quarter before the announcement. Using both measures of abnormal short interest, we find significant abnormal short selling in the immediate three biweekly periods after the repurchase announcement as shown in Table 4 Panel B. The abnormal short interests in periods [+1, +3] are 0.22%*, 0.27%**, and 0.22%*; the CFA abnormal short interests in the same biweekly periods are 7.31%*, 8.15%**, and 7.87%*. Again, we find evidence of abnormal selling around the announcement period before stock prices have reached their peaks. To determine if the short sellers poor timing affects their profitability, we calculate profitability for several windows, [+1,+4], [+1,+5], [+1,+6], [+1,+7], and [+1,+8], after the announcement. We measure profit as the difference between the proceeds from the sale and the cost to close the position using CRSP closing prices. Table 5 shows the number of shares sold short and covered as well as the profits for the cumulative biweekly periods. We observe that the abnormal short selling that occurred in the post-announcement [+1, +3] biweekly period is not completely covered until the end of the +8 biweekly period. The significant abnormal short selling in the post-announcement [+1, +3] biweekly period leads to a significant loss because the cost to close the short position is higher than the revenue from the opening trades. Most noticeably, the short sellers loss increases as we expand the trading window. We find that any trading intervals between the time of abnormal short selling, biweekly period +1, to the time that the shares are covered in biweekly period +8 result in a loss of 0.627%***. The loss is a result of the short sellers

21 poor timing relative to repurchase announcement. They appear to be short selling the shares too soon. As we have shown with the long-run +90 day ISO profit, the price appreciation lasts beyond the first three biweekly periods, so the significant short selling during the [+1, +3] biweekly period is premature. Similar to the ISO results, we conclude that short sellers are not able to trade profitably around repurchase announcements. Quarterly transient institutional investors So far in our analysis we find that institutions do not have the foresight to trade profitably. They appear to be selling before the announcement before the price run-up. In our third measure of institutional trading, we find that there is an exception. We begin our investigation of quarterly institutional trading using the 13(f) data. We analyze institutional trading for eight quarters before and after the announcement quarter. In Table 6, we show that the announcing firms during the non-announcing time, quarters [-8, -5], are associated with significant positive or neutral institutional trade imbalance. The trade imbalances from Q-8 to Q-5 are 0.10%*, 0.08%, 0.17%***, and 0.22%***. During the pre-announcement period of quarters [-4, -1], institutional investors exhibit similar trading patterns as in the nonannouncement time. The trade imbalances from Q-4 to Q-1 are -0.04%, 0.12%***, 0.28%***, and -0.03%. Once the firm announces repurchases in Q0, institutional investors change their trading behavior. They become net sellers. Institutional investors exhibit a trade imbalance of -0.50%*** starting in the announcement quarter, Q0, and the negative trade imbalance lasts for the next six quarters. The trade imbalances from Q+1 to Q+6 are -0.53%***, -0.39%***, -0.47%***, %***, -0.29%***, and -0.08%** respectively. After these quarters of significant net selling, institutional trading reverts to a neutral trading position in Q+7, which means that repurchase announcements do affect institutional trading and the effects last for approximately seven quarters.

22 In fact, in our control sample of non-announcing firms, we find that there is a positive trade imbalance for the quarters around the announcement with varying degrees of significance. The positive trade imbalances range from 1.45%*** in Q-8 to 0.27% in Q+8. This control sample shows that the firms with no connections to repurchase announcements are associated with net institutional buying. Now that we have a better understanding of how institutions trade on a quarterly basis, we apply the Bushee (2001) classification method to identify which type of institution is driving this overall trend. As we suspected, transient investors seem to be influenced by the announcements. Figure 3 shows how transient investor trading pattern changes throughout the 17 quarters. During the non-announcement time, these investors are net buyers exhibiting a positive trade imbalance of 0.10%* in Q-8, 0.19%*** in Q-7, 0.23%*** in Q-6, and 0.15%*** in Q-5 shown in Table 1. This trend continues into the pre-announcement quarters [-4, -1] with trade imbalances of 0.09%*, 0.15%***, 0.08%, and 0.00%. However, they become net sellers starting in the announcement quarter with a trade imbalance of -0.25%***, and the net selling persists for the following three consecutive quarters with trade imbalances of -0.22%***, -0.11%**, and -0.13%***. Moreover, the significant negative trade imbalance pattern during this time is associated with a significant positive cumulative average abnormal return of 5.55%***. Then in Q+4, these investors revert back to their neutral or net buying pattern with a trade imbalance of 0.07% rising to 0.38%*** in Q+8. We believe that transient institutional investors would be most affected by repurchase announcements compared to the other two types because they are more focus on short-term gains. Transient investors are more likely to be cognizant and responsive to corporate news. Although the other two investor types may be aware of the announcements, they are less likely to change their long-term goals in response to the news release. In assessing transient institutional

23 profitability, we estimate a regression model using the transient trade imbalance and previous quarterly holdings shown in Table 7. We also control for the trading of dedicated institutions in addition to the number of shares authorized for repurchase, the number of shares outstanding, EPS surprise, market risk premium, SMB, HML, and MOM. We find that the higher transient net selling is associated with higher profit. In summary, during the pre-announcement period, these transient traders are net buyers. Once the price run-up occurs post announcement, these traders sell their shares as the price increases. Because these investors are more flexible they can take advantage of the announcement event until the price appreciation disappears, at which point they revert to their normal trading behavior. VI. Robustness To ensure that both institutional trading and profitability are not influenced by other corporate events, we create two samples with the ISO data. In one sample, the share repurchase announcements do not coincide with other corporate news, such as dividend announcements, earnings announcements, merger and acquisition announcements, stock dividends and stock splits. In the second sample, all the share repurchase announcements coincide with at least one of the corporate events listed. The results are shown in Table 8. Like before, we calculate ISO profitability using the exact sell prices on the announcement day and CRSP daily closing prices on day +90, but this time, we include other closing days, such as +5, +30, +45, and +60. First, we find that the sell trades results in significant losses in both samples. In the sample with no contemporaneous events, the losses for day +5, +30, +45, +60, and +90 are 2.18%***, 4.01%***, 4.13%***, 5.67%***, and 6.36%***, respectively. The losses for the same periods in the sample with contemporaneous events are 1.56%***, 2.18%***, 2.31%***, 3.33%***, and 3.86%***. Secondly, we notice that the contemporaneous events help to reduce the losses of the sell trades.

24 We believe that some events that coincide with the share repurchase announcements may not bear good news, such as earnings announcements, which can bring down the stock prices. As a result, some of these sell trades may be profitable due to the bad news. However, in the big picture, these contemporaneous events do not affect profitability as the numbers are still negative and highly significant. Finally, we include a comparative analysis of ISO trade imbalance between the testing period of day [-5, +5] and the post-announcement, benchmark period of day [+360, +540]. The benchmark period was selected based on the overall trade imbalance of institutional investors. Approximately a year after the announcement, institutions appear to exhibit a neutral or positive trade imbalance. Table 9 presents the differences in trade imbalance and prices for the respective periods. The difference in trade imbalance is calculated as the trade imbalance of the testing period minus the trade imbalance of the benchmark period. A negative difference suggests that ISO traders are selling more during day [-5, +5] around the announcement than during the benchmark period. With the exception of day +5, institutions are selling more during day [-5, +4] most significantly on day -3 and +1. Moreover, the prices during the two periods show that institutions should be buying more shares when prices are low during the testing period and sell during the post-announcement benchmark period when prices are high. VII. Conclusion Although share repurchases are associated with significant post-announcement return, the uncertainty around these events makes it difficult for institutional investors to trade profitably. The institutions do not know if the firms will announce share buybacks, the timing of such announcements, and whether or not the announcement will be followed by actual implementation of repurchases. They are also competing with the insiders whose trades during the six months

25 create a second signal that may strengthen or weaken the information in the original repurchase announcement signal. We find that almost half of the announcements in the sample is associated with net insider selling, a third associated with net insider buying, and the rest to a neutral insider trading position. It appears that institutions, particularly the ISO traders, are selling their shares before the announcement. This is a rather unprofitable strategy for the ISO traders because they should be buying share because repurchase announcements generate a price run-up. Strong insider selling during the six months before the majority of the announcement events can depress stock prices to a level that is profitable for ISO traders to purchase and resale for a profit at a later time towards the peak of the price run-up. Similar to the ISO traders, the short sellers exhibit significant shorting during the [+1, +3] biweekly periods relative the announcement. These short sellers are not profiting from repurchase announcements. They open their short positions too soon at the beginning of the price appreciation and close their short interest approximately 16 weeks after the announcement when the average price is still high. Finally, in our analysis, we find that transient institutions are the exception. Their short-term investment approach and responsiveness to corporate news appear to serve them well around repurchase announcements. They accumulate shares in the pre-announcement period and resale these shares during the price run-up in the postannouncement period, which turns out to be a profitable strategy. Our findings suggest that institutions with the exception of transient investors are generally not profitable around share repurchase announcements. VIII. References Admati, A., Pfleiderer, P., A theory of intraday patterns: volume and price variability. Review of Financial Studies 1, 3-40.

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30 Figure 1 Timeline of Repurchase Announcement, Insider and Institutional Trades, and Actual Implementation of Repurchases TIMELINE Pre-Announcement Period (t=-1) Announcement Period (t= 0) Post-Announcement Period (t=1) Repurchasing Period (t=2) No Announcement Overvalued Insider Sell Institutions Should Sell No Repurchases Announcement Fairly Valued No Announcement Institutions Should Sell No Repurchases Price Stabilizes Announcement No Announcement Institutions Should Sell Undervalued Insider Buy Institutions Should Buy Actual Repurchases Announcement

31 Figure 2 Sample Division by Hypothesis This figure shows how the full sample is divided for each of the three hypotheses. The first hypothesis (H1) tests if institutional investors can trade profitably using only the information from the announcement. H1 uses the full sample. The second hypothesis (H2) tests if institutional investors can trade profitably using information from the announcement and insiders. H2 divides the full sample into three sub-samples based on net insider buying, selling, and neutral position. The third hypothesis (H3) tests if institutional investors can trade profitably using information from the announcement, insiders and the firm s decision to follow through with the implementation of actual repurchase transactions. H3 further divides the full sample into six sub-samples based on insider transactions, and whether or not the firm actually repurchases shares within eight quarters.