Sunday, October 23, 2011

Short Powerful CEOs

A recently published article in the Journal of Finance by Morse, Nanda, and Seru argues that if you generate a metric of CEO overreach, their stocks underperform. They define CEO malfeasoance using the example of Home Depot CEO Robert Nardelli, who in 2005 changed his incentive pay to be based on average diluted earnings per share, from the tota return to shareholders over the prior 3-years compared to their peers. This was very convenient to Nardelli, because he did much better on the new comparison over the old, and it abrogated the prior performance contract; a lookback option, as it were. Nardelli presided over a 6-year period (2001-07) where the S&P500 was up 12%, Home Depot lost 17%, and Nardelli pocketed a $240MM for his stewardship.

The researchers construct three different metrics of CEO power. One is whether he is also President or Chairman of the Board. Secondly,they uses insider ownership, the amount of stock owned by the directors. Lastly they capture the percent of the board appointed by the CEO. They use regression analysis to find that firms with high CEO power face a 4.8% decrease in firm value going forward.

It would have been nice if they put this into a long-short portfolio and showed the portfolio return characteristics. As the data covered the infamous tech bubble (1992-2003), a lot could be explained by the rather singular 2001-2 tech bubble, which while interesting, is much less interesting than if this result was more persistent across time periods. In any case, another reason to read proxy statement footnotes, and hopefully people will invest on this information which would be the best way to regulate it. Home Depot got what they deserved, those responsible, shareholders, suffered most.

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2 comments:

Anonymous #5 said...

I was expecting something about the Napoleon Complex for some reason...

Kevin said...

Did they describe a mechanism? It could be that firms give CEOs lots of power if they anticipate rough times in the future so that the CEOs can get stuff done. Even if they underperform the market, it seems possible that, conditioning on bleak future prospects, powerful CEOs add value.

The question then becomes: 1) Are shareholders not properly pricing CEO malfeasance, or 2) Are shareholders not properly pricing the firm's future fundamentals.

Hopefully there's a third option where shareholders are behaving rationally.