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The Effect of Share Repurchases on Corporate Investment – Evidence from the Nordics

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The Effect of Share Repurchases on Corporate Investment – Evidence from the Nordics The effect of share repurchases on corporate investment – evidence from the Nordics Martin Torbjörnsson Supervisor: Mikael Bask Master Thesis in Economics 2020 Department of Economics Uppsala University 1. Introduction During the last decades, firms have started to repurchase their own stock on the open market as an alternative way to redistribute cash to shareholders compared to normal cash dividends. Firms repurchase shares on the stock exchange using the firm’s cash and then proceed to cancel the bought shares, reducing the number of outstanding shares. Even though no cash are paid to shareholders’ bank accounts, it creates value by reducing the total number of outstanding shares which then allows the remaining shares to be worth a larger share of the firm and entitled to a larger share of the profits. Lately, a criticism towards repurchases has emerged as insiders may use these programs to trigger earnings-per-share bonus programs or spend corporate earning in an inefficient way by repurchasing shares instead of taking advantage of available investment opportunities to facilitate the long-term growth of the firm. If firms choose to sacrifice investment in favour of repurchasing to please shareholders, this could not only have a negative long-term effect for the business growth of individual firms, but also have a negative impact on the economy as a whole as many of the listed firms are some of the largest employers. Investing firms tend to need to start hiring new workers in order to expand, which creates a demand for both skilled and unskilled labour. Lazonick (2014) states that firms listed on the S&P 500 spent 54% of their earnings on repurchase programs and another 37% on cash dividends, leaving a small portion left for corporate investment or increased wages for already hired workers. The phenomenon of firms sacrificing investment in favour of repurchases has been vastly studied using US data and recent research supports the conclusion that firms are sacrificing investment in favour of repurchases (VanDalsem, 2019; Almeida et al., 2016). This study aims to investigate if a similar relationship exists in the Nordic region, where very little research has been done in this subject. Do Nordic firms behave in a similar way, prioritizing short-term gains for shareholders by executing share repurchases beyond the optimal level or are they repurchasing due to lack of growth opportunity? Repurchases has yet to become as popular as it has been for US firms the past few years, which creates the expectation that Nordic firms may not be as willing to make the sacrifice for increased repurchases, due to less pressure from shareholders. This means that the effect for repurchases on investment is expected to be smaller than in similar studies in the US. This paper adds to current literature by extending this question to the Nordic region, which is of 2 relevance to policy makers, as well as investors. For policy makers, this type of research is crucial in order to understand if firm insiders use repurchases for reasons other than redistributing cash to shareholders, in order to form adequate policies. Investors usually want to maximize the growth of the firms they are investing in, which makes this type of research important in order to be aware of potential skewed incentives. Using data from the main stock exchanges in Sweden, Norway, Denmark and Finland. The sample consists of 800 firms studied from the beginning of 2000 through the end of 2019. The main outcome variables proxying corporate investment are capital expenditures, change in employment and R&D expenses. This thesis will study the relationship between these variables using both value of repurchases and a binary variable reflecting the decision to repurchase. A Heckman (1979) model will be used to deal with the issue of sample selection bias. The findings of this paper are not consistent with previous studies made on US data and show no evidence that the Nordic firms included in this sample does sacrifice corporate investment in favour of repurchases. The evidence suggests that repurchases are made after taking advantage of available investment opportunities. This is consistent with the hypothesis as repurchases has not become as popular in the Nordic countries, the firms do not face the same pressure to repurchase in order to please shareholders. The rest of this paper is organized as follows. Part two covers previous research regarding share repurchases, as well as research made for relevant variables and theory used in this paper. Part three covers the data selection and methodology used to identify the effect of interest. Part four presents the descriptive statistics and the main results of the study. In part five the specification is tested for robustness and part 6 offer the concluding remarks. 2. Previous Literature Almeida et al. (2016) employs a regression discontinuity design to find effects of repurchases on firm investment outcomes. The discontinuity exploited is that firms that are on track to just miss their earnings-per-share targets are much more likely to spend corporate money on repurchases compared to firms that are to just beat their target. Manager compensation programs are often conditioned on meeting specific targets, such as earnings-per-share. The corporate insiders use repurchases programs as a way to trigger these compensation programs by increasing the size of repurchases if the firm is close to meeting targets. The authors conclude 3 that managers are willing to trade increased investments and increased employment for repurchases that allow them to meet analyst earnings-per-share forecasts. VanDalsem (2019) recently studied if family owned businesses are different from other firms when it comes to reducing corporate investment in favour of repurchasing more shares and employs a two stage Heckman (1979) approach to purge the sample from selection bias. Family firms are defined as when a member of the founding family has a prominent role in the firm, either CEO or member of board, or has a significant equity stake. The study concludes that family owned firms are less likely to repurchase shares and when they do, it’s less likely to be associated with decreases in corporate investment compared to non-family owned firms. In contrast to these findings, Bhagwat and Bruine (2018) find no support for the thesis that firms repurchase on the expense of capital expenditures and argues that firm prioritize investment and then proceed to pay out whatever is left of the profit to shareholders. According to the agency theory firms that do not face attractive investment opportunities usually spends their spare cash investing in projects that are negatively yielding and reduce the value of the firm. The free cash flow hypothesis was developed by Jensen (1986) where he argues that repurchases is an instrument to manage cash available to managers when firms go into a more mature phase with shrinking investment opportunities. The theory predicts that repurchases should be associated with less profitability, less investments and less cost of capital. Chu & Liu (2016) studies investment in the real estate market and finds that firms that have high cash flows or higher cash reserves tend to pay more for new investments in real estate. Grullon & Mikealy (2004) studies the information content signalled by the initiation of share repurchase programs and finds that they are not an indication of increased operating performance but associated by a significant reduction in systematic risk and cost of capital. They also conclude that repurchase programs are much more likely to be initiated by firms that lack attractive investment opportunities. Their findings are also consistent with the free cash flow hypothesis as they find that repurchasing firms spend less on investment and reduce their cash reserves by increasing pay-outs. Firms that have excess cash after making attractive corporate investments, should redistribute these to shareholders rather than making negatively yielding investments. Previous literature has faced difficulties observing “Investment Opportunities” as it is typically known only by 4 insiders. To tackle this problem several other studies (VanDalsem, 2019;Almeida et al., 2016;Boudry et al., 2013) has used Tobin’ Q to measure investment opportunities. Tobin’s Q is the ratio of a firm’s market value and replacement cost of assets and hence reflects the average realized return on the firm's capital. Lang and Litzenberger (1989) show that this can be used to find over- or underinvesting firms. Tobin’s Q will be less than one for firms if the current replacement value for all assets is greater than the firms market value. If a firm’s investments are increasing with size and are decreasing in marginal efficiency, Tobin’s Q will be less than one for over-investing firms. Firms that still have opportunities to invest with positive yield, will have a ratio of higher than one. Some studies have tried to create advanced algorithms to calculate Tobin’s Q (Lindenberg and Ross, 1981; Perfect and Wiles, 1994; Lewellen and Badrinath, 1997). However, Erickson and Whited (2006) found when evaluating these algorithms that they tend to lower the number of observations and introduce other issues such as sample selection bias. They later conclude "Researchers are just as well off using a simple measure of q as using a computationally complex measure". De Cesari et al. (2012) investigates timing of repurchase transactions based on ownership structure. This study also identifies heterogenous effects among investor types where institutional owners are less successful to purchase own shares at a bargain price compared to insider owners. Palladino (2020) show some evidence that insiders tend to time their personal sale of shares with repurchase programs. She concludes as managers do not have to announce dates of repurchase, they can easily time them for own personal gain.
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