Is Management Quality Value Relevant? via CSInvesting
Vineet Agarwal
Cranfield School of Management
Richard Taffler
The Management School, University of Edinburgh
Mike Brown
Nottingham Business School
15 January 2007
Abstract
Using a unique database of management ratings over a 14 year period, we find that quality of management is value relevant in that better managed firms have lower cost of equity, higher market valuations, more stable earnings, and higher profitability that persists over time. Paradoxically, while good management appears to be associated with lower subsequent market returns, this is entirely consistent with an informationally efficient market.
Is Management Quality Value Relevant? – Introduction
Management quality is conventionally viewed as a key determinant of future firm performance. High executive compensation levels are predicated on the argument superior top management abilities will enhance shareholder value and the financial press lionises the CEOs of successful firms viewing them almost in heroic mould as being directly responsible for their corporations’ successes (e.g. Blackhurst, 2001). In fact, Malmendier and Tate (2005) demonstrate that CEOs manage to extract significantly higher compensation after achieving superstar status. Likewise, sell-side analyst stock recommendations are predominantly driven by their views on the quality of the firm’s management and strategy (Breton and Taffler, 2001).
A number of studies have addressed the issue of whether there is a relationship between quality of management (management reputation)1 and firm performance. However findings are conflicting, with the relationship between management reputation and future stock returns variously positive, neutral (as predicted by theory) and negative, and similarly the relationship with future operating performance. This paper tests the relationship between quality of management and firm performance explicitly using a unique source of data and robust methods leading to clear conclusions. In particular, it addresses three important questions new to the literature: (i) is good management associated with lower cost of equity?, (ii) does good management have any influence on market value, and (iii) does superior operating performance persist in the case of better managed firms? Our results clearly demonstrate that well managed firms have lower cost of equity, have higher market value and continuing superior operating performance. ‘Good’ management enhances firm value and is not value destructive as argued, for example, by Malmendier and Tate (2005).
The resource based view of the firm states that sustainable competitive advantage (and superior operating performance over time) lies in possession of certain key resources (Barney, 1991). Under this framework, management quality itself is an intangible asset because it increases the firm’s credibility with employees, investors, customers and suppliers (Wade et al., 2006). D’Aveni (1990) also argues that managerial prestige improves organizational legitimacy and plays an important symbolic role in organizational performance and survival. Firms with well respected managements generate an ‘illusion of competence’ and are thus supported by their different stakeholder groups. In a similar vein, Suchman (1995) argues that appropriate media coverage can render firms more desirable and enhance access to resources as stakeholders are most likely to engage with organizations they consider to be more predictable and trustworthy. Similarly, Pollock and Rindova (2003) and Johnson et al. (2005) argue that the financial press does not only provide information for investment decisions but also influences the framework used to make such decisions. Cohen and Dean (2005) and Lester et al. (2006) find that having a reputable management at the helm at the time of an initial public offering (IPO) reduces information asymmetry leading to lower underpricing. Further, Chemmanur and Paeglis (2005) find that such firms have higher long term returns and stronger operating performance after the IPO; Chemmanur et al. (2004) show similar results in the case of firms making seasoned equity offerings.
On the other hand, Hayward et al. (2004) argue that good CEO reputation could arise from over attribution of superior performance to management quality. This can lead to CEOs becoming overconfident and also committed to strategies that worked in the past, hence making the firm less adaptable to changes in their operating environments leading to poor future performance. Similarly, Malmendier and Tate (2005) argue that good CEO reputation leads to behavioral distortions, poorer operating performance and value destruction. In parallel vein, Wade et al. (2006) find firms that hire star CEOs earn negative returns over the next year even though operating performance does not suffer. They argue this could be because of either the ‘burden of celebrity’, i.e., heightened expectations that are not realized, or because the market anticipates the behavioral distortions of star CEOs and penalizes their firms, with impact appearing in operating performance only with a lag.
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