Higher Stock Returns When CEOs Own More Shares

Executive compensation is a controversial topic. US CEOs earn 373 times the average worker, and so it takes them less than a day to earn the same as an average worker does in a whole year. But, despite attracting most attention and ire, the level of pay is actually not so important for firm value. Average pay in a top-500 firm is $13.5 million – huge in anyone’s eyes. But, the average size of a top-500 firm is $10 billion, so the salary is only 0.135%. That’s not to say that the level of pay doesn’t matter – a firm can’t be blasé about $13.5 million (else you could justify every wasteful expenditure saying that it’s small compared to firm value) – but other dimensions of pay may be more important.

In particular, much more important than the level of pay is the sensitivity of pay – how it varies with performance. But, this dimension is also controversial, in particular the use of bonuses. Bonuses are often awarded for “on-target” performance (whereas many rank-and-file employees simply get their salary for “on-target” performance); the performance targets can be too easy; and the CEO can game the system, focusing on one target to the exclusion of others. For example, a bonus based on sales or earnings growth may cause the CEO to ignore corporate culture. In addition, while an even higher bonus is paid for good (rather than on-target) performance, the bonus is sometimes barely reduced for poor performance – it’s an asymmetric “heads I win, tails I don’t lose” scenario.

Equity compensation – giving the CEO shares – solves many of these issues. In the long-run, the stock price captures all the channels through which the CEO can improve firm value – if he pollutes the environment, invests in his workers, engages in a restructuring, all of these actions eventually affect firm value. (Of course, the key words are “in the long-run”, so the stock should come with a long vesting period). There is no ambiguity as to which measure to reward (sales growth or earnings growth?) or what target to set (2% or 5%?), nor asymmetry – the value of the CEO’s shares rises with good performance and falls with bad performance.

But, where’s the evidence? In an excellent paper in the 2014 Journal of Finance, Ulf von Lilienfeld-Toal and Stefan Ruenzi find that a strategy of buying shares in which the CEO has a high level of stock ownership, and shorting shares in which he has low ownership, earns 4-10%/year (depending on the definition of “high” and “low”). This result suggests not only that CEO incentives “matter”, but also that the market doesn’t recognize that they matter. Even though CEO ownership is public information, the market doesn’t take it into account (perhaps because, like the media, it’s focused on the level of pay) – and so investors can earn superior returns by trading on it.

Of course, correlation doesn’t imply causation. The positive relationship could be because CEOs have inside information on firm value, and are more willing to accept stock (rather than cash) when they expect future stock returns to be high. So, to suggest that the effect is causal – high equity causes the CEO to take better decisions – they show that the effect is stronger in settings in which the CEO has greater discretion. These are firms in which:

  • Sales growth is high, which gives the manager resources (e.g. free cash) that he could waste, as well as power (the board is less likely to interfere if the CEO has delivered high sales growth)
  • Low institutional ownership and weak external governance – when investors are not monitoring the CEO, he has greater discretion
  • Weak product market competition. If the product market is competitive, the CEO has to maximize value (even if he had weak equity incentives) to stay in business; if there’s little competition, he can slack off
  • The CEO is the founder, also correlated with power

Like any paper, there are a few unanswered questions. The authors only include stock that the CEO voluntarily holds (i.e. has vested but the CEO has not sold). They don’t include unvested stock, nor options. Both unvested stock and options also provide the CEO with incentives to maximize value, so I would be interested to know whether the results hold when including these dimensions also (and any investor wishing to use this as a trading strategy might want to back-test the strategy including all incentives – vested stock, unvested stock, and options). Regardless, the paper makes a very important contribution highlighting the dimensions of CEO compensation that investors, the media, and the public should focus on – the sensitivity rather than level of pay, and suggesting that equity ownership may have a causal effect on firm performance rather than simply reflecting the CEO’s private information.