What Happens When CEOs Have Skin In The Game?
The following blog was originally posted on Yahoo Finance.
Those who make investment decisions based on gut or instinct should always keep in mind that common sense tells us the world is flat. So, upon closer inspection, things that seem sort of obvious often aren’t. Indeed, one of the most profound academic insights of the past half-century, established by efficient markets pioneer Eugene Fama, is that much of active management outperformance historically had been attributable to an over-allocation to small-cap and value stocks; thus it was a systematic bias, not skill per se, that drove the observed “alpha.”
However, sometimes intuitive ideas actually do hold out in practice. To wit, the Wall Street Journal the other day had an interesting piece about one such anomaly. It referred to academic research demonstrating the outperformance of publicly-listed stocks run by owner-operators, meaning CEOs who own at least 5% to 10% of the company. Those with skin in the game were big winners.
At first cut, this does seem to support the bigger-picture idea that contrary to Fama and his acolytes, there are opportunities to exploit persistent market anomalies. They aren’t everywhere, but can be found from time to time. The trick, mind you, is to make sure they are grounded in well-tested evidence, not self-serving anecdote.
I checked out the source research and the intuition does seem to be compellingly borne out by the evidence. In a paper published by the Journal of Finance, European scholars Ulf Von Lilienfeld-Toal and Stefan Ruenzi point to “large positive abnormal returns” for such companies. How large? Where the CEO owned more than 5% of the shares, about 5.7% per year compared to similar companies not run by an owner-operator; where he or she owned at least 10%, the stock outperformed by 6.2% on an annual basis. (Importantly, the authors of the paper control for—and dismiss—some of the other potential explanatory factors, such as small size or price momentum.)
Assuming the statistical analysis is robust, the question is why? Why are the likes of Warren Buffett or Jeff Bezos associated with better performing stock prices? One possibility is “asymmetric information,” meaning that they know something about their companies’ prospects that most others don’t. Another possibility is incentives, meaning there’s a win-win scenario for making smart capital allocation decisions (and conversely, lose-lose if they don’t).
The authors vote in favor of the latter. I find this quite interesting because it suggests that CEOs don’t have a crystal ball into the future of their companies’ fortunes, but possibly do have the elbow grease to keep pushing for better results in light of the enrichening consequences of doing so. Indeed, Lilienfeld-Toal and Ruenzi see their research as further highlighting the strong relationship between corporate governance and asset prices.
While such anomalies tend to receive intense scrutiny–and I’m sure this one will continue to get vetted–there does seem to be, for now, some compelling evidence that when owners act like true owners, good things–known to academics as large positive abnormal returns–happen.