Repurchase Equity Research Articles

Cash flow investment, external funding and the energy transition: Evidence from large US energy firms

We examine the relationship between cash flow and investment in the US energy sector from 1988 to 2020. Our analysis incorporates firms’ financial constraints and the type of energy production in which they are engaged, distinguishing between brown and green generation. Our findings reveal a positive relationship between investment and cash flow for green energy firms, which behave similarly to constrained energy firms. While traditional brown energy firms tend to use higher cash flow to increase dividend payments and repurchase equity, green and constrained firms use it to repay debt and to fund investment. Our results suggest that policies aimed at strengthening the linkages between financial intermediaries and green firms could unlock cash flow resources for investment and innovation, facilitating the scaling up of operations during the energy transition. To ensure the sustainability of the transition, it is critical to reduce the reliance of green energy firms on internally generated cash flow, which is subject to volatility and cyclical macroeconomic conditions.

Teaching Slides on Short and Long Horizon Behavioral Factors

We propose a theoretically-motivated factor model based on investor psychology and assess its ability to explain the cross-section of U.S. equity returns. Our factor model augments the market factor with two factors which capture long- and short-horizon mispricing. The long-horizon factor exploits the information in managers' decisions to issue or repurchase equity in response to persistent mispricing. The short-horizon earnings surprise factor, which is motivated by investor inattention and evidence of short-horizon underreaction, captures short-horizon anomalies. This three-factor risk-and-behavioral model outperforms other proposed models in explaining a broad range of return anomalies. Daniel, Hirshleifer, and Sun (2020) is available at https://ssrn.com/abstract=3086063. Note: For further details, see Daniel, Hirshleifer, and Sun, “Short- and Long-Horizon Behavioral Factors,” Review of Financial Studies, 2020, 33(4): 1673-1736.

The FIN and PEAD Factors: Motivation, Construction, and Availability

This document provides an overview of the FIN and PEAD factors of Daniel, Hirshleifer, and Sun (2020) and describes their motivations, constructions, and availability. Based on investor psychology, Daniel, Hirshleifer, and Sun (2020) propose a theoretically motivated factor model that augments the market factor with two factors that capture long- and short-horizon mis-pricing. The long-horizon financing factor (FIN) exploits the information in managers’ decisions to issue or repurchase equity in response to persistent mis-pricing. The short-horizon earnings surprise factor (PEAD) is motivated by investor inattention and evidence of short-horizon under-reaction, and captures short-horizon mis-pricing. The 3-factor risk-and-behavioral model outperforms other proposed models in explaining a broad range of return anomalies. Daniel, Hirshleifer, and Sun (2020) is available at https://ssrn.com/abstract=3086063.

Short- and Long-Horizon Behavioral Factors

Abstract We propose a theoretically motivated factor model based on investor psychology and assess its ability to explain the cross-section of U.S. equity returns. Our factor model augments the market factor with two factors that capture long- and short-horizon mispricing. The long-horizon factor exploits the information in managers’ decisions to issue or repurchase equity in response to persistent mispricing. The short-horizon earnings surprise factor, which is motivated by investor inattention and evidence of short-horizon underreaction, captures short-horizon anomalies. This 3-factor risk-and-behavioral model outperforms other proposed models in explaining a broad range of return anomalies. (JEL G12, G14) Authors have furnished an Internet Appendix, which is available on the Oxford University Press Web site next to the link to the final published paper online.

Short and Long Horizon Behavioral Factors

We propose a theoretically-motivated factor model based on investor psychology and assess its ability to explain the cross-section of U.S. equity returns. Our factor model augments the market factor with two factors which capture long- and short-horizon mispricing. The long-horizon factor exploits the information in managers' decisions to issue or repurchase equity in response to persistent mispricing. The short-horizon earnings surprise factor, which is motivated by investor inattention and evidence of short-horizon underreaction, captures short-horizon anomalies. This three-factor risk-and-behavioral model outperforms other proposed models in explaining a broad range of return anomalies.

Do Capital Structure Adjustments by Takeover Targets Influence Acquisition Gains?

Existing theoretical models predict that takeover targets optimally increase debt and repurchase equity around takeover attempts. Ultimately, these leverage shifts should benefit target shareholders and enhance bargaining power in negotiations with acquiring firms. We show that target firms indeed issue higher levels of debt, and simultaneously repurchase more equity, relative to a set of matched firms, during the period from one year prior to takeover announcement through completion. We find that bank debt is the primary source of these debt increases. Lastly, we find evidence consistent with the expectation of improved bargaining power for target equityholders with target debt issuances. We document that compared to debt issued by non-target firms, announcements of debt issuances by takeover targets are associated with additional positive abnormal returns to target stockholders. Additionally, at least some of these target equity gains appear to come at the expense of bidder shareholders. These impacts on target and bidder abnormal returns are more significant for debt issuances occurring in the periods immediately preceding and following takeover announcement, as well as for issuances of bank debt. Debt issuances occurring after takeover announcement appear to reverse initially lower (higher) abnormal returns experienced by targets (bidders) upon takeover announcement itself, and further increase the likelihood of positive adjustments to acquisition premiums offered by the bidders to the targets.

The Profits–Leverage Puzzle Revisited

Abstract The inverse relation between leverage and profitability is widely regarded as a serious defect of the trade-off theory. We show that the defect is not with the theory but with the use of a leverage ratio in which profitability affects both the numerator and the denominator. Profitability directly increases the value of equity. Firms do take the predicted offsetting actions. They issue debt and repurchase equity when profitability rises, and retire debt and issue equity when profitability falls. Consistent with variable transactions costs, the adjustment is not generally sufficient to fully undo the profitability shocks. Accordingly, on average the leverage ratio falls as profitability rises.

Equity Issuances, Equity Mutual Fund Flows, and Noise Trader Sentiment*

We examine whether equity issuances initial public offerings (IPOs) and seasoned equity offerings (SEOs) are in part driven by investor sentiment by using equity mutual fund flows to proxy for the rational and/or irrational components of aggregate demand for equity. We find that more firms issue equity when flows are higher and repurchase equity when flows are lower. More firms file with the Securities Exchange Commission when predicted flows in the expected issuance month are greater. Price revisions are positively related to contemporaneous flows and unexpected flows. Initial returns are positively related to contemporaneous flows only for IPO issuances. These results are driven by retail, and not institutional, flows. Our evidence suggests that investor sentiment partially drives equity issuances.

Bank Regulatory Capital Adjustment and Ultimate Ownership Structure: Evidence from European Commercial Banks

We empirically investigate whether a bank’s decision to recapitalize is influenced by the separation between voting and cash-flow rights of the ultimate owner. We use a novel dataset on bank ultimate control and ownership structure of 442 European commercial banks to estimate an ownership-augmented capital adjustment model. We find that when the ultimate owner’s rights are identical, banks actively and equally adjust their capital upwards (i.e. raise equity) and downwards (i.e. repurchase equity) to reach their target. However, a gap between both rights makes banks reluctant to actively adjust their capital position upwards, presumably because they fear control dilution. Further investigation shows that such a behavior is more pronounced if the ultimate owner is a family or a state, or if the bank is headquartered in a country with weak shareholder protection. Our findings have several policy implications on the road to the final stage of Basel III in 2019.

Equity Issuances, Equity Mutual Fund Flows, and Noise Trader Sentiment

We examine whether equity issuances (IPOs and SEOs) are in part driven by investor sentiment by using equity mutual fund flows to proxy for the rational and/or irrational components of aggregate demand for equity. We find that more firms issue equity when flows are higher and repurchase equity when flows are lower. More firms file with the SEC when predicted flows in the expected issuance month are greater. Price revisions are positively related to contemporaneous flows and unexpected flows. Initial returns are positively related to contemporaneous flows only for IPO issuances. These results are driven by retail, and not institutional, flows. Our evidence suggests that investor sentiment partially drives equity issuances.

Profits and Capital Structure

In the static trade-off theory, when profits increase, the firm should issue more debt and reduce equity to shield the profits from taxation or agency abuse. When a corporate leverage ratio is explained by firm profits, it is well-known that a negative regression coefficient is usually found. The literature (e.g., Myers (1993), Fama and French (2002), and Welch (2007)) considers this negative relationship to be a particularly serious rejection of the static trade-off theory.In this paper, we show that the literature has misinterpreted the evidence as a result of the wide-spread use of familiar, but inappropriate, empirical methods. We make four main points.1. We show that highly profitable firms do actually tend to issue debt and repurchase equity. The least profitable firms tend to reduce debt and issue equity. These facts are empirically very robust.2. Firm size plays an important mediating role in this relationship that gets hidden when leverage ratios are used. Large firms tend to be more active in the public debt markets, while small firms tend to be relatively more active in the equity markets.3. The type of empirical work that is appropriate depends on the model to be tested. We present a simple static trade-off agency-based model of capital structure. According to the model, the appropriate testing structure is a pair of regressions: one explaining debt, and the other explaining equity. When we estimate this model, we find the model's predictions perform rather well. Profits are not properly exogenous according to the model. We discuss how to deal with the exogeneity problem within the context of the model.4. In the model, issuing decisions depend on market conditions ('market timing'). Empirically, bad market conditions have a particularly strong impact on small and low-profit firms. Larger and more profitable firms are less strongly affected by market conditions.Contrary to what is usually believed, the empirical evidence on profits and capital structure seems easy to interpret from the perspective of the static trade-off theory.

Capital Structure Swaps and Shareholder Wealth

Abstract We show how capital structure swaps can increase the wealth of a firm's long‐term shareholders when a firm's debt or equity is misvalued. We review the conventional rule that a firm should issue equity and use the proceeds to retire outstanding debt (an equity‐for‐debt swap) when equity is overvalued, or repurchase equity with proceeds of new debt (a debt‐for‐equity swap) when equity is undervalued. We also analyse the more complex case where a firm's debt and equity are both undervalued, showing the optimal swap may be to issue undervalued equity, contrary to the conventional rule.

Mimicking Behavior in Repurchase Decisions

Behavioral biases associated with base rate neglect, anchoring, ambiguity aversion, and robust control may foster an environment in which mimicking may influence decision-making. This study tests for the presence of mimicking behavior in security repurchase decisions. After controlling for variables reflecting financial operating motives and mispricing associated with limits to arbitrage, results show that debt-equity choices in repurchase events are significantly enhanced by the occurrence of recent similar choices made by the firm's competitors. Specifically, the probability of opting to repurchase equity (debt) is positively associated with the size of the firm conducting the largest percentage equity (debt) repurchase in the same industry in the prior year. Moreover, the mimicking activity is observed for smaller-sized firms, but not for larger firms. The findings are consistent with the premise that managers of smaller firms are generally less skilled and experienced, and more prone to be influenced by decision shortcuts such as mimicking the actions of peers.

Capital Structure Swaps and the Intrinsic Wealth of Long-Term Shareholders

We show how capital structure swaps can increase the wealth of a firm's long-term shareholders when a firm's debt or equity is misvalued. We review the conventional rule that a firm should issue equity and use the proceeds to retire outstanding debt (an equity-for-debt swap) when equity is overvalued, or repurchase equity with proceeds of new debt (a debt-for-equity swap) when equity is undervalued. We also analyse the more complex case where a firm's debt and equity are both undervalued, showing the optimal swap may be to issue undervalued equity, contrary to the conventional rule.

Evidence of Excess Returns on Firms That Issue or Repurchase Equity

Between 1927 and 1992, portfolios of the stock of the 5 percent of firms with the lowest annual change in shares experienced returns over the subsequent five years that averaged 12 percentage points more per year than the returns to portfolios of the 5 percent of firms with the highest change in shares. The difference in returns is greater in more recent years and was positive for all of the final 33 years of the sample. The difference is apparent for portfolios of firms of all sizes and industries. The market beta of the returns to the portfolios of repurchasers exceeds only slightly that of the returns to the portfolios of issuers, insufficiently to account for more than a small part of the difference in average returns.