Ulf von Lilienfeld-Toal and Stefan Ruenzi
CEO Ownership, Stock Market Performance, and Managerial Discretion
Journal of Finance | Volume 69, Issue 3 (Jun 2014), 1013–1050

What is the impact of CEO ownership on stock market returns? We examine this question by considering investment strategies which are based on publicly available CEO ownership information. Strategies which select firms into a portfolio based on CEO ownership outperform the market significantly by up to 10% per year. The cumulative abnormal equal- and value-weighted return of a strategy that invests in a high managerial ownership firms is shown in Figure 1. This outperformance is also observed after controlling for standard risk factors (e.g. Fama-French-Carhart factors). We can also show that this result is robust and holds in a variety of specifications, models, samples, and time horizons.

A puzzle?

These results are puzzling as we only use publicly available information to set up our investment strategy: The information on ownership information of CEOs has to be disclosed and we built our portfolios based on past disclosures, that is, based on public information. However, in an efficient market, all publicly available information should be reflected in the share price and—according to standard theories—we should thus see no impact of such information on future returns.

Possible explanations

In the second part of our paper we then investigate three possible explanations why we still see abnormal returns for owner-CEO firms. The first potential explanation uses the idea that owner-CEOs are better informed about the prospects of the firm and are only willing to hold large ownership stakes when they have positive private information. At the same time, this explanation assumes that the market is not fully efficient, that is, the market is not able to correctly interpret the positive information which is signaled to the market due the disclosure of the CEO ownership information. The second and third explanation build on the argument that managerial ownership is an incentive device and imply that owner-CEOs can be value increasing: it is assumed that owner-CEOs have strong incentives (due to their high ownership stake) to work hard, exert costly effort, and enough discretion to eventually increase the value of the firm. The two explanations differ with respect to the view on market efficiency. The second explanation builds on the assumption that the market is irrational and does not fully understand the incentive effects and the eventually value increasing impact of managerial ownership. Similarly as above, because the market does not interpret the signal of high disclosed ownership information correctly, stock prices at best partially reflect the positive effect of high CEO ownership. Thus, abnormal returns emerge only subsequently, when the consequences of the positive incentives effects become visible in the form of an increased firm value. The third explanation in contrast assumes that the market is fully rational and understands the value increasing impact of managerial ownership.

This final explanation is motivated by recent theories about trading of value increasing shareholders developed in Lilienfeld-Toal (WP 2010) and Blonski and WP Lilienfeld-Toal (2009). These papers argue that if a value increasing shareholder can trade her shares on the open market prior to exerting effort, an equilibrium for firms with high CEO ownership will typically be characterized by positive abnormal returns. The result why the information is not fully reflected in prices even in an efficient market is based on the argument, that a CEO could sell her shares at the high price which already reflects her high future effort. Selling shares is possible for the CEO, because the high ownership fractions we focus on in this paper (typically requiring a cutoff of 5% or 10% of the firm's outstanding shares being held by the CEO) are overwhelmingly voluntary, i.e., the CEO is not restricted from selling. However, if she did sell, her incentives to work hard (which justified the high price) would be destroyed and the initially high price would not have been a rational equilibrium to start with. In contrast, a situation with CEO ownership and positive abnormal returns can be an equilibrium in this setting. The reason why the apparent underpricing does not get arbitraged away by investors in such a situation is that all investors are fully rational in this model and thus know that they would bid up the price by buying the underpriced shares, thereby eventually triggering the CEO to sell and thus making everybody worse off.

Asymmetric information or incentives?

In our further analysis, we try to differentiate between the three explanations, i) asymmetric information and irrational markets, ii) positive incentive effects of CEO ownership and irrational markets, and finally iii) positive incentive effects of CEO ownership and rational markets. We find no evidence for the first explanation: various proxies for asymmetric information have no impact on our results. However, we do find strong evidence that managerial incentives play an important role in explaining the positive impact of CEO ownership on stock returns, that is, we find strong support consistent with explanations ii) and iii). Specifically, we argue that managerial incentives only matter if the CEO has some discretion to increase the firm's value. Otherwise, exerting effort would not result in a higher firm value. Consequently, we split our overall sample of firms into firms in which we have reason to believe that CEOs have a lot of discretion and firms in which the CEO has no discretion. We find that the positive impact of managerial ownership is particularly high for firms in which the CEO has a lot of discretion. At the same time, high managerial discretion without high managerial ownership is not associated with abnormal returns. Similarly, high managerial ownership but little discretionary power of the CEO also does not lead to the large abnormal returns we observe when CEOs have high ownership and at the same time a lot of discretion. We think this is an interesting result in itself, as the proxies we use for managerial discretion (like her power, free cash flows, little pressure from outside investors) are often interpreted as signs of bad governance. We show that the impact of these proxies on firm performance can be reversed, if we at the same time observe high managerial ownership, that is, if CEOs are incentivized to use their freedom in the right way from the shareholders point of view.

Rational vs. irrational markets explanation

To differentiate between the second and third explanation we need to understand whether markets are rational and understand the incentive mechanisms underlying managerial ownership or whether the market is irrational and does not fully understand this. In an effort to do so, we conduct a series of additional tests: first, we show that there is not much evidence of learning over time as the abnormal returns due to managerial ownership are fairly evenly distributed over time. This is highlighted in Figure 1 and speaks against an irrational markets explanation, because even if the market might not have understood the positive message send by high ownership initially, investors should eventually learn about this over time. We find no evidence for this to be the case.

1: Cumulative abnormal returns of high CEO ownership firms
This figure plots the cumulative abnormal return of a portfolio which goes long in high managerial ownership and short in low managerial ownership firms, where high ownership firms are defined based on a cutoff of 10% of all outstanding shares and low ownership firms are defined as firms where the CEO owns 1% or less of the outstanding shares. This figure is taken from Lilienfeld-Toal and Ruenzi (2014). Interpretation: High CEO ownership firms consistently and strongly outperform the market

Next, we make sure that our results are not only driven by small and opaque firms and firms that are generally characterized by strong limits to arbitrage and where inefficient valuations can persist. Given that it is more costly to set up a trading strategy in small stocks, such limits would be more severe among small firms. However, the evidence in Figure 1 shows that our results are even stronger based on a value-weighted portfolio—which puts a larger weight on large firm observations—as compared to an equal-weighted portfolio. Finally, we look at earnings surprises and find that investors are at best very mildly surprised by earning announcements. If investors would simply be unaware that firms with high ownership will perform well, they should continuously be positively surprised by the earnings of these firms.

What do firms with high managerial ownership do differently?

In an attempt to better understand what drives the good performance of high managerial ownership firms, we also examine firm policies. We find that firms characterized by high CEO ownership engage less in empire building and are able to run their firm more efficiently. Given that it is cumbersome and requires a lot of effort to run a firm efficiently, these results are also consistent with the abnormal returns we document being driven by incentives of owner-CEOs.

To summarize, in our article, we show that high-managerial ownership is associated with high abnormal stock market returns. We find convincing evidence that managerial discretion is crucial for managerial ownership to lead to high abnormal returns and that the combination of strong incentives and managerial latitude seems to be optimal.