Ulf Von Lilienfeld-Toal
Swedish House of Finance

Stefan Ruenzi
University of Mannheim – Department of International Finance

May 1, 2013

Journal of Finance, Forthcoming

We examine stock market returns of firms in which the CEO holds a significant fraction of the
firm’s outstanding shares. We find that firms with high managerial ownership deliver higher stock market returns than firms with low managerial ownership in a trading strategy purely based on public information. This effect is most pronounced among firms with high managerial discretion, where outperformance amounts to up to 10% p.a.

Since the seminal work of Berle and Means (1932) it is often critically discussed that managers’ interests are not well aligned with shareholders’ interests in publicly traded firms. Principal agent problems arise, because managers typically are not owners of the firms they manage (Jensen and Meckling (1976)). Jensen and Murphy (1990) show that most CEOs of large US corporations indeed only hold very small fractions of their firm’s stock. However, there is also an often neglected but  significant minority of CEOs that are heavily invested in their own firms. For example, nearly 10% of the CEOs of S&P 1500 firms voluntarily held 5% or more of their company’s stocks in 2010. These holdings of ‘owner-CEOs’ usually constitute a dominant fraction of the respective CEO’s personal wealth. They provide strong incentives for managers to increase firm value. Many studies show that managerial ownership indeed has a strong impact on firm value and operating performance (see, e.g., Morck, Shleifer, and Vishny (1988)).

In this paper we examine whether there is an impact of managerial ownership on stock market
returns. We construct portfolios of firms with owner CEOs solely based on public information; our results show that such portfolios strongly outperform the market. For example, a value-weighted portfolio going long in firms in which the CEO voluntarily holds more than 10% of the company’s stock and short in no-ownership firms delivers annual abnormal returns of about 5% in the period 1988 to 2010. This result is obtained after controlling for the influence of the three Fama and French (1993) factors and the Jegadeesh and Titman (1993) momentum factor as well as based on alternative factor models. It is not due to very small ?rms as results for ?rms covered in the Execucomp database delivers even higher annual abnormal returns of about 9%. We obtain similar results in a multivariate setting after controlling for the impact of ?rm characteristics.

We identify three potential explanations why managerial ownership might lead to abnormal returns. The first explanation is based on information asymmetry arguments. CEOs might recognize that the firm is undervalued and thus take an ownership position to benefit from trading based on private information (Lin and Howe (1990)) or they might want to signal good project quality to outside investors (Leland and Pyle (1977)) by investing themselves. In completely efficient markets, this should only lead to a jump in firm value at the moment when ownership information becomes public but it should have no long-lasting impact on returns afterwards, when the information asymmetry is eventually resolved. However, if markets are inefficient, ownership information might not be fully reflected in prices and subsequent positive abnormal returns might be the result.

The second explanation is based on the argument that ownership can act as an incentive mechanism and is thus a corporate governance device. Like other corporate governance mechanisms, it helps to align interests between shareholders and managers by incentivizing managers to increase firm value. Gompers, Ishii, and Metrick (2003) and Cremers and Ferrell (2009) examine various other corporate governance mechanisms and find that the positive effects of these mechanisms are not fully priced but that good governance leads to positive abnormal returns.3 Thus, our second potential explanation is that the positive incentive effects arising from managerial ownership are also not fully priced, but lead to the positive abnormal returns we find because the market is not fully efficient in understanding incentive effects.

Full article via: papers.ssrn