Are Stock Buybacks a Good Idea for Small- Or Micro-Cap Companies? Here's What the Data Suggests

Publicly traded companies reward shareholders in two ways: through share repurchases and dividends. According to S&P Dow Jones Indices, buybacks have surpassed dividends in the U.S. since 1997, becoming the dominant form of corporate payoffs.

It should come as no surprise that share repurchases have ballooned over the last two years as they came under heavy scrutiny in 2020. At that time, many companies were criticized for buying back shares in the months before the pandemic —significantly reducing their cash pile at a time when it was needed the most and resulting in requests for bailouts when the pandemic hit.

Other companies caught flak for buying back shares instead of paying furloughed employees during the height of the pandemic. However, despite these controversies, there can be some real benefits to share repurchases for companies and investors alike.

Advice for micro- and small-cap companies considering buybacks

Before we dive into the data on stock performance around share repurchases, I’d like to share some simple advice for micro- and small-cap companies considering buying back shares. For example, it generally is inadvisable for companies this small to repurchase their shares if they are unprofitable. Additionally, companies that have raised outside capital in the last 18 months or that will need to do so in the next 18 months probably shouldn’t buy back shares.

If you consider your company to be a growth company, a better course of action would be to use all that extra capital to grow instead of to buy back shares. However, if you don’t see any additive use for excess capital, your company probably isn’t actually a growth company. In that scenario, it’s probably best to just give it back to shareholders directly.

On the other hand, there is a tiny percentage of micro- and small-cap companies that have tons of cash flow, are heavily owned by institutions, and are slow-growing. Companies in this category are really the only ones that have any business repurchasing their shares. 

New buyback records expected this year

Of course, not every management team comes to the same conclusions as those above when deciding whether to buy back their shares. During the first quarter of 2022, 36 companies in the small-cap Russell 2000 repurchased at least $100 million worth of shares, although that was more than three times the average of about 10 that have typically done so before 2021. A new all-time high for the volume of buybacks among Russell 2000 companies was set in the second quarter of 2022 at $18.6 billion.

Overall, Goldman Sachs estimates that buybacks will jump 12% this year to a record $1 trillion. According to Verity's Q1 2022 Stock Buyback report, total repurchase volume for the quarter was $310.4 billion, a 3.1% sequential increase and 63.6% year-over-year jump. However, the S&P 500 accounted for 84.5% of all the share buybacks during the first quarter. 

Why companies repurchase shares

Share repurchases occur when a company buys its own shares either on the open market or directly from shareholders and then retires those shares. When they buy directly, they often pay a premium on top of the price the stock is trading at on the open market.

Companies repurchase their shares for multiple reasons. Of course, they raise capital by issuing and selling new common and preferred shares, so they buy back shares to reward shareholders by returning capital to them. However, there are other reasons to repurchase shares, like consolidating ownership, boosting their stock prices, reducing their cost of capital, and increasing the financial ratios investors use to determine valuation.

Some companies buy back shares because they're sitting on a lot of capital and have nowhere else to invest it because there is no more room for expansion in their industry. Sometimes activist investors will notice that a company has a sizable pile of cash sitting around and will push for share repurchases to return that capital to shareholders.

Since every share represents a minuscule sliver of a company, it can make sense to consolidate ownership by repurchasing shares. Additionally, some companies buy back their shares because they think their stock is undervalued, a wise move in most cases when there is plenty of cash to work with.

How stocks perform following share buybacks

Perhaps the most obvious impact share repurchases have on stocks is raising the price. Many shareholders buy shares in a company after it announces a repurchase program. Additionally, repurchasing shares reduces the total number of outstanding shares because the company retires them, which also gives its stock price a boost. Research conducted over the years has found some interesting trends in terms of stock price movement before and after a buyback announcement.

S&P Dow Jones Indices found in a March 2020 study that buyback portfolios generate positive excess returns over their benchmark indices over a long-term investment horizon. This was true of all company sizes, from large-cap to small-cap firms. S&P Dow Jones also found that all buyback portfolios generated higher average monthly excess returns over their benchmarks in down markets than in up markets, no matter the weighting method that was used. When equal weighting was used, it had a greater impact on mid-cap and small-cap companies than on large-cap firms.

What happens before, at, and after a buyback announcement

Citing previous studies done by others, S&P Dow Jones Indices reported three key findings regarding movements in share prices around the time when share buyback programs are announced. First, two studies found that companies' stock prices are usually generating negative returns before management announces plans to repurchase shares.

Additionally, other studies found that companies usually generate significantly positive returns when they announce new repurchase programs. Two studies looked at a sample of almost 600 repurchases on the open market and more than 200 tender offers and found a positive abnormal return of around 2.7% and 7.6% over a three-day period.

Researchers also found that abnormal returns on a buy-and-hold strategy continued in the years following the announcement. One study on fixed-price tender offers found that prices remained at bargain levels for at least two years on average.

What's behind these performance drifts?

Another study suggested a theory to explain the performance drift following a repurchase announcement. The researchers proposed that the market was skeptical about buyback announcements resulting in a slow, gradual price adjustment. They also observed delayed market reactions to other corporate actions like initial public offerings, mergers and spinoffs.

When researchers looked at more than 1,200 open market buybacks, they found an average initial reaction of about 3.5%. That was consistent with previous studies showing an average initial reaction of about 3%. The researchers argued that it didn't appear plausible that managers would be able to detect such a minuscule undervaluation and decide to react.

Of course, when management buys back shares because they believe their stocks to be undervalued, they probably perceive the undervaluation to be substantial. As a result, the research suggests that the market generally ignores information about open market repurchases, resulting in a delayed reaction.

Long-term excess returns

In line with their theory, the researchers found an average abnormal buy-and-hold return of 12.1% for companies buying back shares over the four years after their announcements. Additionally, they found even larger performance drifts in companies with high book-to-market ratios.

Across a wider sample, researchers found that stocks generally saw the most significant positive long-term excess returns when the buybacks were triggered by a sudden plunge in the stock price over the previous six months. They also found that past performance appears to be a better predictor of undervaluation than other measures like book-to-market, size and the motivation provided by management when they announced their buyback program.

Looking at the stock performance on a broader scale, S&P Dow Jones Indices sought to quantify the outperformance of companies that are buying back shares by comparing it with the S&P 500. The firm found that its S&P 500 Buyback Index outperformed the standard S&P 500 in 16 out of 20 years, with the largest excess returns between 2000 and 2002, in 2009, and in 2013.

Final thoughts

Of course, there are pros and cons of buying back shares, just as there is with anything else. Repurchasing shares is generally seen as a shareholder-friendly action because it rewards them, especially if those purchases are done directly and pay a premium to the open-market price.

However, when a management buys back shares for the sole purpose of raising their stock price, investors would do well to exercise caution around the company. One impact of share repurchases is boosting the company's earnings per share because the number of outstanding shares has been reduced. In this scenario, the company may appear to be doing far better than it really is.

At the end of the day, it's easy to see why studies show that the stock prices of companies that are buying back shares tend to outperform over the long term.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.