Monday, 28 April 2008

Say you will – that’ll do

How to reward CEOs and other top executives is an ongoing area of discussion and research. Often it is claimed, of course, that executive compensation should be closely tied to the performance of the firm (but that stock options – an often-used way of rewarding executives – are quite imperfect, for instance because they can be exercised over an extended time regardless of performance).

Yet, it is not easy to measure “the performance of the firm”. Performance in terms of what? And performance over what period? Therefore, a decade or two ago, the use of so-called “long term incentive plans” came about; simply put, top executives receive rewards (in the form of stock or cash) on specific dates dependent on whether specific performance goals are met. Such incentive plans are thought to much more precisely link rewards to managerial performance, encouraging executives to direct their attention to long-term profitability rather than short-term gains.

The stock market (that is, investors and analysts) loves them. Ample studies in financial economics show that when firms announce the adoption of long-term incentive plans (for example through press releases or proxy statements), their stock price immediately shoots up. Managers may not always like them – getting rewarded (or not) based on very specific targets at very specific points in time sort of spoils the fun a bit – but it was also hard to resist them; not adopting one of those thingies made you look “illegitimate”. Hence, the top managers of many firms decided to adopt them after all.

Professors James Westphal and Ed Zajac decided to study the stock market effects of these long-term incentives plans once again, but they did something more. First, as expected, examining 408 large US companies, they too found that adopting firms’ share prices went up immediately when they announced that they were going to install such an incentive plan.

Yet, then Jim and Ed also examined whether it mattered how you worded the announcement statement. Specifically, they measured whether the firm's justification for adopting the incentive plan explained that it did so to tie CEO compensation more closely to shareholder wealth (that is, “all the right reasons” for investors; for instance Alcoa did this), instead of a more general description, for instance some sort of HR description (“this plan enhances our ability to attract talent”; AT&T) or no explanation at all. And they found that upon announcement, the stock price of the firms “who used all the right words” went up with 2.4%, while the stock price of the other firms announcing the same plan (but using some other type of explanation) only increased with half of that (1.2%). That is, double benefits from the same thing, by only choosing your words a bit more carefully! That’s easy money.

Then though, it got really interesting. Next, Jim and Ed examined what happened to the stock price of the firms that announced that they were going to adopt a long-term incentive plan but, subsequently, did not actually do it… (a whopping 52% of firms did this!).

This is what they found: First, they found that the stock price of those firms went up on announcement of the plan just like it did for the others (and why not, the stock market could not yet know they were not actually going to implement it!). Then Jim and Ed measured what happened to the stock prices the week following the announcement (when they still had not actually adopted the scheme): nothing; stock price was still up. Then they measured what had happened after a month; stock price still up… Then they measured the outcome after a full year; stock price still up…!

Stock prices went up after announcing the incentive plan. Stock prices did not go down even when the firm subsequently did not actually implement the scheme! Speaking about easy money!!

Is the stock market stupid, or what?! Well… perhaps the answer partly is ‘yes’… but it is probably also a bit more subtle than that. Apparently you and I, investors and analysts, care about firms using the right language but we care much less about what they actually do. Hence, we reward their symbolic behaviour, rather than their real actions. We may not even be fully aware of it but that’s what we value: unlike Caesar's wife Pompeia (who, according to Caesar, not only had to be virtuous but also appear virtuous), we want a firm to appear virtuous; yet we don't care whether she really is!


vlade said...

Few comments:
- how did the study distinguish bewtween correlation and causality?
- how could you show that the fact the stock was up at some later time was not related to other factors - i.e. that the non-implementation did get factored into the price but some other factors have managed to overcome it?
Both of the above especially if the timing was during a bull market, so that small and steady moves up would be rather common.

Maybe studies like this would be better done in bear market? :)

Freek said...

These are good questions but, with a large enough sample and sophisticated statistical techniques, you can "control" and rule out such effects. And Ed Zajac and Jim Westphal do this very well. You can look up all the details of their academic study here: J.D. Westphal & E.J. Zajac. "Symbolic Management of Stockholders: Corporate Governance Reforms and Shareholder Reactions," Administrative Science Quarterly, 43, 127-153, 1998.